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If 2020 made equity investing look easy, here’s how you navigate volatility, business cycle now


The fall in equity markets in March 2020 and the subsequent recovery to new highs were both unprecedented. The sharp drop and the almost V-shaped recovery in the markets were accompanied by intermittent bouts of volatility. No one could predict the low point or had the confidence in the recovery till November 2020.

There were doubts initially, whether the market rally would be durable (i.e. backed by fundamentals) or if it was temporary, fuelled by global liquidity. The confidence in the rally returned only once the broader indices went past the previous highs.

Calendar 2020 taught us market timing is a folly. In March and April 2020, the biggest learning was why not to take cash calls and why not to bet on macros. If you had perfect knowledge of Covid-19 and took cash on the way down, you would have been left high and dry with your call in the next month or two.

A lot of people I have met say “‘if’ I had sold in end-February 2020 at the onset of the Covid-19 news and ‘if’ I had re-entered in April, I would have done very well.”

I would just say that when there are two ‘ifs’ in the equation, the probability of successful execution goes down to 25 per cent i.e. 50 per cent for each ‘if’. It’s best not to entertain such ‘ifs’ in hindsight.

This analogy is not only true for timing the equity market, but also for making any investment decision based on an economic prediction or timing business cycles of an industry or any similar top-down factors.

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Business cycles affect different sectors in different ways. Every industry has its own business cycle. For example, the auto sector has a deeper business cycle compared with that of the energy sector, which is primarily linked to one factor: international crude oil prices.

For a winning portfolio, it is best to have a balanced approach. Hence, it is advisable to diversify, as some sectors are pro-cyclical and others counter-cyclical. A portfolio of high-beta pro-cyclical stocks may work well in a rising market, while it may become more susceptible in a market correction. This is exemplified by the fact that when the market falls, portfolios that go overweight on defensives fall the least, and hence, in March and April 2020, it was widely believed (quite on the hindsight) that amid the Covid-19 pandemic, consumer sectors and pharma were the places to be.

But from there on, cyclicals led by metals probably gave multiple times more returns than the defensives. None of this could be predicted in advance in order to be able to presciently steer portfolios in either direction.

On the contrary, a portfolio based on bottom-up stock selection and which is well-balanced across cyclical and non-cyclical sectors pivoted at varied macro-cycles can ensure that alpha does not get easily overwhelmed by non-stock-specific risk factors over any reasonably medium to long time periods.

A robust stock selection criterion is key to wealth creation. After all, building a portfolio is all about including stocks that can deliver higher alpha through market cycles. There are many approaches for stock selection that a fund manager can take depending upon their investment philosophies and goals. The most common approach is valuing a stock on the basis of P/E ratio.

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In my view, it does not reflect the true value and cash flow position of a company. For instance, the investment framework we follow at White Oak is premised on the belief that outsized returns are earned over time by investing in great businesses at attractive values. Our cash flow-based valuation framework is designed to better capture the attributes (return on incremental capital, scalability, and good management) of great businesses compared with the traditional P/E metric. A cash flow-centric approach is dynamic and offers a better picture of the finances and, thus, aid the process of valuing a company in a more accurate way.

The market gains of the past year may have made equity investing look so easy, especially for the nearly one crore first-timers who entered the market during the Covid lockdown period. Prudent asset allocation and portfolio development are critical not only to enjoy the gains, but also to shield your portfolio from bouts of volatility. This is the time to avoid confusing luck for skill. It happens very rarely at the end of a financial year that even the worst performer in Nifty has delivered positive returns to ensure thereby that you just couldn’t have gone wrong.

Having said so, the current sentiment is positive. This will ensure that the positive momentum continues, and the bulls will be back in charge after some correction, maybe on account of possible disruption due to the second wave of Covid or rising bond yields in the US. The government has used the Covid crisis to execute longstanding reforms in labour laws and privatisation to unlock India’s growth potential.

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Also, the $27 billion production-linked incentive (PLI) scheme for 13 key sectors will facilitate ‘Make in India’ and help capture market share amid the Covid-led supply chain disruptions.

All the measures announced by the government will act as a tailwind for earnings and, hence, the market. After multiple false starts in the past, a new growth cycle appears to have begun for the Indian economic and, thus, the market, and it will afford enough wealth creation opportunities, as the structural issues that held back growth get addressed.

(Aashish P Somaiyaa is CEO of White Oak Capital. The views are his own)



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