Market dip makes large-cap stocks more attractive
If stock market returns of 2014 are an indication, should it mean that similar returns are going to be possible every year? Is investing in equity always supposed to give double-digit returns year-on-year? No. This sky-high expectation is built on a wrong assumption, and it’s illogical to expect year-on-year returns in the high-double digits from the market.
Stock market returns in 2014 were a combination of deep undervaluation, which has since risen significantly to fair value levels. The year made investors mistakenly believe that stock market returns have to be positive every month, and high every year. This expectation has to be reset.
One cannot get positive returns from the stock market every year, let alone it meeting return expectations of 25-30% per annum. Stock markets are known to hit investors with negative returns every now and then. The derivatives market is another place where people believe that they will get more than 20% returns. Consequently, whenever there is an unwinding of speculative positions, markets correct. And whenever such corrections take place, investors see only gloom, which is not logical at all.
Having said that, equity assets are good investments to make for the longer haul, such as for three to five years, especially with economic reforms taking place. The economy is now recovering slowly and there are small telltale signs of a pickup in investments along with the government increasing its spending.
However, investors are not fully grabbing the opportunities that an unwinding of speculative positions sometimes offers. By investing during market dips, investors can get more mutual fund units, for instance, for the same amount of money as opposed to when markets are higher.
One such opportunity passed by recently. Due to a series of negative news, including the Greek debt repayment crisis, globally, stocks took a small breather and corrected, presenting a good opportunity to invest.
These investing opportunities may not come all the time. But whenever they do, stay alert for a quick investment—whether small or big—in equity assets.
Don’t bank on leveraging
While the outlook is good, equating the structural growth story to the 2002-07 cycle is irrational. We started the 2002 cycle with very low leverage, and we over-leveraged to the extent that deleveraging is still continuing in infrastructure and real estate.
It is a known fact that during a deleveraging cycle in infrastructure and allied sectors, growth cannot accelerate. Currently, the rest of the economy may be leveraging, but that will not lead to a situation where you could see large returns from the market. This is because you need infrastructure and real estate to begin the leveraging cycle. That appears to be at least two-three years away.
What has been happening in the market instead is that the derivatives segment is seeing deleveraging. As a result, large-cap stocks corrected quickly as leverage happens only in large caps where derivative trading is allowed. Mid cap stocks, by contrast, appear more expensive as these have not seen a correction, especially since these have not been a part of the derivative unwinding that took place recently.
Valuation gap in large caps
There may be a few opportunities in the mid-cap space, but if you are looking for undervalued stocks, there are far more opportunities in the large-cap space. Over the past few months, plenty of funds entered into the mid-cap category, as a result of which, these stocks appear to have crossed the rich valuation zone. Some of these funds are likely to move into large caps now and begin the switch from mid caps purely on valuations.
I am from the camp that believes mid-cap stocks are relatively expensive; in some cases, extremely expensive, even today. In fact, about six months ago, we had a similar view that large-cap stocks were quoting on the higher side. But since then, some large-cap names have corrected. A few notable high quality names have corrected significantly in the consumer, pharmaceutical and information technology sectors. So, investors have an opportunity that is ripe for the picking in the large-cap diversified equity funds space.
One point worth a mention is that while the market is up significantly from where the bull run in equities started back in October 2013, we are still miles away from the overvalued or bubble territory. Sure, equity valuations are above average, but only marginally above the mean.
We have been seeing over the past few months that the market is quick at pricing quality companies at higher levels. This could make it difficult for investors to get better price bargains in quality large-cap stocks sometime down the line. So, perhaps a prudent strategy for now may be to invest in good quality companies whenever there is a valuation gap, as we are seeing at the moment.