Defensive investing will be a bad bet
The rush to defensives is deafening. Equity investors are flocking to defensives such as consumer goods and pharmaceutical stocks. Companies that generate free cash and are able to maintain ROE (Return on Equity) and ROCE (Return on Capital Employed) at levels above rising cost of capital are seen as safe havens. Macro investors are selling equities and commodities and buying safe have assets of gold and investing in fixed deposits of banks. Table 1 shows the performance difference between risky and safe haven assets.
The way the markets are falling with equity indices falling by 3% to 6% on daily basis, investors are selling so called risk assets and buying safe have assets and this is causing a widening chasm between performance of risky assets and safe have assets. Investors typically look at past returns for their investments and safe haven assets have outperformed by a whopping margin over the last four months. The question to ask is whether this is a sustainable trend and will incremental investments in safe haven assets prove beneficial to investors?
Investors will have to be wary of investing in such outperformance of safe haven assets. A turnaround in sentiments will have a large trend reversal and FMCG, Pharma, Gold and Fixed Deposits will underperform the broad markets by a wide margin. Investors should not get caught into a defensive trap at current levels of the market. However, if investors do want to consider switching out of underperforming stocks into outperforming ones, they should ask themselves the following questions.
Will the broad market go down further from these levels?
The markets have fallen by over 13% over the last four months and are trading at one year lows. Sentiments are poor, economic factors such as industrial production, business sentiments and interest rates are indicating weakness ahead and investors have lost a lot of money. Given such market conditions, there could be further weakness in equities, but how much further can the markets fall? The fact that equity markets are 24% below peaks seen in 2007 and the economy has grown by an average of 7.5% over the last three years suggest that market levels are more or less realistic in its future growth expectations. GDP growth for 2011-12 is expected at between 7%-7.5% levels though RBI has projected growth rates of 8%. Market underperformance coupled with reasonable growth trend points to stability in markets going forward.
If the market falls further, when is the right time to invest?
It is always difficult to catch the bottom, as one never knows what is the bottom. However, one can take a more balanced approach towards the outlook for the future and if the outlook does look positive, one can start to invest in risk assets underperformance. The outlook for the future seems more positive now given that RBI will be more inclined to stop its monetary tightening in the face of falling growth expectations and lower commodity prices with oil prices having come off by 20% from peaks seen during this year. A pause in monetary tightening will lead to better sentiments in the bond markets and bond yields, which are trading at close to multi year highs will come off. Lower bond yields will bring down interest costs in the economy, which is positive for equity markets.
If markets are close to bottom and outlook for the future is more positive than negative, it is time for investing in underperforming equities. However, as always, there is a big difference between underperformance coming from poor market sentiments and underperformance arising out of specific company or sector related factors. Hence it is always better to avoid investing in stocks that have poor business related factors including corporate governance. Do not fall into the trap of equating a speculative driven stock with a broad market rally. The latter can work in the very short term but if the bet is wrong, it will backfire heavily. Investing in large cap stocks or the index is always better when sentiments are weak and outlook for the future is not really certain.