India Review- Economic Gloom yet “Stock Market Boom”
India’s economic and market structures are widely misunderstood and 2019 undoubtedly complicated matters further for the casual observer. While 5% GDP growth over the past year would be the envy of almost every other country in the world, for India, it was a major disappointment. This resulted from a sharp pullback in credit from the non-bank financial sector during the year after an unexpected large-scale default occurred in late 2018. The effect on investment and household consumption was severe and far worse than most anticipated. Yet, the headline Sensex Index climbed nearly 15% (local currency) in 2019, to a succession of record highs to cap a fourth straight annual gain. What does one make of these conflicting figures?
One of the core reasons for this stark divergence between a slowing economy and an apparently robust stock market is the monumental amount of retail savings making its way into the equity market. In actuality, a deeper dive into the Indian economy and its stock market reveals the recent performance of the economy and its stock market has not been that out of step, after all. As for the 15% advance of the Sensex, only three companies accounted for 65% of all of the advance: Reliance Industries Ltd, ICICI Bank Ltd. and HDFC Bank Ltd. (three of the four largest stocks in the country). The same goes for the NIFTY 50- the largest 15 stocks accounted for the entire advance of the 50 stock index.
Basically, retail savings in India is now finding its way into mutual funds and overwhelmingly went into large cap, blue chip style funds that are dominated by the biggest 15-20 stocks in the market. Financial advisors in the country campaigned aggressively using the slogan “ Mutual fund Sahi Hai ” which translates to “mutual fund is the right choice”. India is a peculiar case, where many companies with unambiguously high P/E ratios are considered the safe-haven stocks despite the high price premium. Unfortunately, buying high P/E stocks is a proven losing strategy over the long-term, whether in India, the United States, or Romania.
The BSE Midcap and Small Cap Indices declined in 2018, and again in 2019, falling during the past calendar year 2.1% and 5.9% in local currency terms, respectively . This performance far more closely aligns with the relative disappointment in the Indian economy over the past year, as well as, the performance of the country’s 5,000+ domestically listed stocks.
The silver lining to the sharp slowdown in credit creation over the past year is that is has crystalized the magnitude of problem to policy makers. As such, they have aggressively addressed the issue. In addition to the RBI cutting interest rates 1.35% last year, it has now made it mandatory for banks to link all new floating rate loans to an external benchmark (either the government three-month and six-month treasury bill rate, or the repo rate) to aid in the transmission of its policy rate. Similarly, the RBI has given assurances it will not let a major shadow bank fail, while cancelling many of the licenses for the worst performing shadow banks during the same time it has eased the lending standards for the better-performing ones.
In Octoberwe made the call that the 20-month stealth bear market in the majority of Indian stocks was over as a result of the combination of proactive fiscal and monetary policy initiatives gaining enough momentum to warrant long-term investors’ attention, at a time when consensus currently views India as being in the midst of an economic slowdown . In other words- there is a lot of stimulus in the pipeline, the worst of the slowdown is behind us, and quality mid and small cap stocks are cheap . In fact, early signs of a recovery are already appearing. One of the hardest hit areas in 2019 as a result of the breakdown of shadow bank credit was the issuance of new car loans. New passenger vehicle sales have clearly bottomed recently, as well as, other timely activity measures.
Below is the same study we first published in our October update. If our thesis is correct, now is the time to allocate to strategies that focus on mid and small cap companies, if history is any guide.
Thus far, our thesis and fund positioning seem to be spot on. Midcap stocks are up over 11% since the end of August through year-end. Unlike other major indices around the world that have also rallied, i.e. the S&P 500, the India Opportunity Fund’s long positions are a quite a distance from all-time highs and elevated valuations. In fact, during 2019, the S&P 500’s P/E ratio rose 28%, nearly accounting for all of the index’s gain for the year, whereas, most Indian stocks outside of the headline indices actually saw their valuations compress.
Simply stated, there is a very compelling case to be made to rotate out of the former and into the latter at the present juncture. Thank you for reading and wishing you a prosperous 2020!
