Are we in a bull market already?

How can we tell if we are already in a bull market?

Yes, the frontline Nifty Index is up over 11% from its lows in September 2019, but that isn’t a great indicator. The Nifty was up close to 350 points between 1st Jan 2018 and 30th Sep 2019, but the top-2 performing stocks accounted for 450 of those points (yes, you read it right. Stock number 3 to 50 cumulatively contributed more than a negative 100 points).

Off late, the stock returns have been more broad-based. Within the BSE-500 Index, more than a third of the companies have managed to outperform the index since its lows in Sept 2019; close to 15% of those companies have even returned twice the index returns. Yes – that is an important feature, but even that is not it.

The tell-tale sign of a bull market is the heightened willingness of the promoters to raise capital, and the willingness of the markets to fund it. For the rally in the equity markets to sustain, one needs the supply of capital (from domestic and foreign institutions) to be much higher than demand for capital (from corporates looking to raise money, government looking to divest stakes or a group of shareholders looking to cash-in on an investment).

From that standpoint, in CY2019, companies have raised only INR118b in initial public offerings compared to INR312b in CY2018. When we combine the Qualified Institutional Placements (or QIP), the picture for the year does not look as bleak. Nevertheless, we are still way short of CY2017.

Demand of capital

Now that the market seems to have shown a willingness to fund capital, let’s look at the willingness of participants to demand it. As per our calculations, we expect over INR2 trillion of paper to come to the markets over the next few months. Let’s look at the individual components separately.

a) Supply of paper by the government of India

The biggest supplier of the paper is likely to be the government of India. The recent tax collection data shows that the fiscal deficit for 6 months has reached c93% of targeted deficit for the year. That itself would not have been alarming, had the corporate tax cuts not been announced.

But since the tax cuts have been announced, we estimate that the centre maybe staring at a shortfall of INR500b, even after accounting for the excess RBI dividend.

Compared to the originally targeted divestment of INR1 tr, we note that the government has so far raised only INR174b. To make good on the originally targeted divestment, we are looking at a capital raise of INR876b, which may likely increase to INR1.4 tr if the government decides to make good on the tax collection shortfall.

b) Follow on offer to reduce stake to 75%

We estimate that FPO of over INR215b will have to happen over the course of the next few months. The initial public offerings that happened by March 2018, in theory, can be delayed for a few more months as shown in exhibit below, but in practice, it is unlikely that the promoter group will likely wait for the last possible month to bring the public shareholding up to required levels.

c) Risk capital raising

In addition, according to media reports that there are several companies in the fray to raise risk capital from the markets, totalling to over INR227b. They are listed below.

Supply of capital

Right, so we are looking to raise over INR2 trillion over, say, the next few months; but is that really that large? It would seem so, considering that over the last decade, the highest annual flow from domestic and foreign providers combined has been just over INR1.4 tr.

Conclusion

While the demand for capital is likely to cross INR2 trillion over the next few months, the supply of capital needs to be reassessed. Although the financialization of savings (assets moving away from physical assets and into financial markets) is ongoing, historically, it has not yet resulted in a number large enough to fund the demand of capital that we seek.

Take into consideration that (a) overall savings rate in India (both corporation and households) has slowed down over the past few years, and (b) the individual flow of capital into equity mutual funds/life insurance does track the recent returns. Given that the equity returns (from the broader markets) over the last two years have remained subdued, the incremental flows might not be as easy to come by.

The thesis of bull markets will likely get severely tested in its ability to help supply over INR2 tr to the seekers of the capital. It will be interesting to see if the recent broad basing that we have witnessed in the markets will likely continue if these companies indeed manage to raise the equity capital that they seek.

Disclaimers

Information in this blogpost is not intended to be, nor should it be construed as investment, tax or legal advice, or an offer to sell, or a solicitation of any offer to make investments with Buoyant Capital. Prospective investors should rely solely on Disclosure Document filed with SEBI.

Any description involving investment examples, statistical analysis or investment strategies are provided for illustration purposes only – and will not apply in all situations and may be changed at the discretion of principal officer. Buoyant Capital may have/have had holdings in the stocks at mentioned in this blogpost at different points in time.

Certain information has been provided and/or based on third-party sources and although believed to be reliable, has not been independently verified; the investment managers make no express warranty as to its completeness or accuracy, nor can it accept responsibility for errors appearing herein.

BSE-Small Cap Index study

Historically, many investors increase investments in rising markets, and withdraw them when markets are falling. Returns for such investors are often lower than investment returns.

The front line index (Nifty 50) fails to capture the extent of draw-down in broader markets. Nifty is down just c9% from its all-time-high, but more than two-thirds of all stocks that are currently trading have more than halved, and more than a third have fallen in excess of 70%.

Instead, we choose to focus on the BSE-Small Cap index. It is 854-stock index with INR2 trillion (20 lac crores) in market-capitalization and no sector represents more than 11% weight. Contrast this to other front line indices, where financials dominate; and when combined with consumers and technology sector, they account for more than two-third of the index—very lop-sided for the purpose of a broader analysis.

As of yesterday’s close, the BSE-Small Cap index was down close to 35% from its all-time-high (reached in January 2018); the fourth time it has happened since the start of this century. They say that history seldom repeats itself, but it certainly rhymes. A look at previous instances throws-up interesting results.

The BSE-Small Cap index had fallen more than 35% in 2004, 2008 and in 2010 before the rout that extends today. Now, it is certainly possible that a business that one thinks is mispriced today, would not immediately revert to fair valuation tomorrow itself. If could continue to trend down despite being undervalued based on several extraneous factors.

Nevertheless, that does not mean we cannot formulate an investment strategy around it. In each of the three instances that we mentioned above, if one had started systematically investing a constant sum each month from the first time the index hit a 35% draw-down, one would have ended up generating between 18% to 39% CAGR over the next three years; truly superlative returns. This is despite the fact that in the 2008-09 global financial crises, the index, having fallen 35%, fell another 68% over the next fourteen months; and yet, if one had continued the SIP through the fall, one would have generated 18% CAGR over a three year horizon.

The same study, when extrapolated over a seven-year SIP time-frame yields between 13% to 17.5% CAGR, again a stellar performance over a longer-time frame.

Today, a large majority of the interesting businesses are available at below what we believe is their fair value and we think the time is right to systematically increase allocation to such businesses. Buoyant’s portfolio is now firmly tilted (70% of investments) towards what SEBI classifies as small and mid-cap companies.

Howard Marks puts it succinctly, “the refusal to catch a falling knife is a rationalization for inaction. It’s our job to catch falling knives. That’s how you get bargains!”.

Disclaimer

Information in this blogpost is not intended to be, nor should it be construed as investment, tax or legal advice, or an offer to sell, or a solicitation of any offer to make investments with Buoyant Capital. Prospective investors should rely solely on Disclosure Document filed with SEBI.

Any description involving investment examples, statistical analysis or investment strategies are provided for illustration purposes only – and will not apply in all situations and may be changed at the discretion of principal officer. Buoyant Capital may have/have had holdings in the stocks at mentioned in this blogpost at different points in time.

Certain information has been provided and/or based on third-party sources and although believed to be reliable, has not been independently verified; the investment managers make no express warranty as to its completeness or accuracy, nor can it accept responsibility for errors appearing herein

Pledged shares and stock performance – correlation versus causation

The year 2019 witnessed a spectacular collapse of business conglomerate that was once considered very savvy. The share prices of its flagship companies have fallen as much 99% from their all-time highs, even culminating in a bankruptcy in just the last year. A common string across these companies was that the promoters had pledged a large percentage of their shareholding.

A common fallacy in investing is that ‘Great companies almost always make for great investments.’ We easily forget that Hindustan Uniliver, a great company, was not a great investment for the entire decade ending 2010. Recency bias is the phenomenon that people easily remember something that happened recently, compared to something that occurred a while back.

That seems to be at play when one looks at the stock performance of a few companies where promoter shares are heavily pledged. Despite the analysts’ increasing their expectation of forward earnings over the last one year, the stocks in the table below have fallen between 16% and 55%. These are very steep corrections, considering that the underlying businesses are not nearly as challenged as those stock prices suggest.

That brings us to an interesting concept of correlation versus causation. They don’t mean the same thing, even if they co-exist. Correlation indicates that two variables are moving in the same direction, whereas causation indicates that one event is causing the other.

For example, stock prices and promoter pledges are two different variables. In some cases, there has been a causal relationship (pledged shares have been sold in secondary markets which has led to lower share price), but there is no reason why they should be correlated (that is, share prices should not continue to fall just because promoter pledges stay high).
 

 
Disclosures

Information in this blogpost is not intended to be, nor should it be construed as investment, tax or legal advice, or an offer to sell, or a solicitation of any offer to make investments with Buoyant Capital. Prospective investors should rely solely on Disclosure Document filed with SEBI.

Any description involving investment examples, statistical analysis or investment strategies are provided for illustration purposes only – and will not apply in all situations and may be changed at the discretion of principal officer. Buoyant Capital may have/have had holdings in the stocks at mentioned in this blogpost at different points in time.

Certain information has been provided and/or based on third-party sources and although believed to be reliable, has not been independently verified; the investment managers make no express warranty as to its completeness or accuracy, nor can it accept responsibility for errors appearing herein.

Indian IT services companies – multiples should de-rate materially

If you are an analyst covering the Information Technology (IT) sector in India, chances are that you might not have remembered that India’s Union Budget was on 5th of July. Companies in your sector derive over 90 percent revenues from across borders; what could the finance minister have done to impact IT! And yet, I think they are among the worst hit in this budget; read on…

First, buy back of equities will now attract 20 percent tax, the same as dividends. Mature IT businesses throw large free cash flows (in the range of 75% to 100% of cash profits), and large companies distribute majority of it. Think of an IT company that generates free cash equivalent to 90% of cash profits, distributes a third of it as dividends, and two-thirds through buy backs. For that company, this budget has permanently eroded 12% of its value (20% tax on two-third profits).

Second impact is from the Ministry of Finance asking SEBI to evaluate whether a higher public shareholding (at 35% versus 25% currently) made sense in arriving at a superior price discovery. Two of the top three companies (in terms of incremental supply of equity) are in the IT sector. Cumulatively, we reckon that it would lead to incremental supply of INR800b; or an annual supply of INR400b if SEBI gave a two-year glide path.

Points one and two when read together should imply that IT companies go from INR450 annual reduction in float (buy back) to INR400b fresh supply. The combined shift is very large for the markets to absorb, in my opinion.

This comes at a time when IT companies are struggling to maintain margins. Two factors are at play here. One, INR has appreciated versus the USD on an average by 2-3% compared to 4QFY19. In absence of mitigating factors, margins should trend down. Two, US financial institutions are evaluating their overall IT spends (including those on services); BFSI accounts for 30-40% of topline for Indian companies. Lack of profitable growth would put further pressure margins that are already battling adverse currency movement.

Over last 18 months, multiples for IT companies moved higher following INR depreciation, accelerating growth and reducing float. All three are now reversing; and valuation multiples should follow.

Cheers,
Viral

Disclosures

Information in this blogpost is not intended to be, nor should it be construed as investment, tax or legal advice, or an offer to sell, or a solicitation of any offer to make investments with Buoyant Capital. Prospective investors should rely solely on Disclosure Document filed with SEBI.

Any description involving investment examples, statistical analysis or investment strategies are provided for illustration purposes only – and will not apply in all situations and may be changed at the discretion of principal officer.

Certain information has been provided and/or based on third-party sources and although believed to be reliable, has not been independently verified; the investment managers make no express warranty as to its completeness or accuracy, nor can it accept responsibility for errors appearing herein.