Identifying Market Trends

Kenneth Andrade, Head–Investments, IDFC Mutual Fund talks about the components of the equity market as well as the factors that bear on overall economic growth that investors need to understand to make the most of value creation by companies in different sectors. Also with inputs from Ankur Arora, Associate Director – Fund Management, IDFC Mutual Fund.

• Over the long term, equity market returns are a function of growth in corporate profits, which in turn, is a function of the economic growth rate. This implies that equity market returns over the long term should be in line with the economic growth rate of an economy. However, in the short term, different sectors and themes have led the stock markets and have delivered above average returns. There hasn’t been any particular sector or company that has done well at all times.
• Due to the inherent ever-changing dynamics of the equity market, active management becomes very important for investors. Passively following an index mostly helps investors in participating in the growth of an economy. However, wealth creation is a function of choosing the right subset of the economy and investing accordingly.

With the markets delivering marginal returns over the last five years, investors ponder over their judgment of investing in the equity market and seek answers to questions that have come to the fore. Like, how much value has the equity market created for investors over the long term? As an asset class, has equity generated returns which compensate investors for the risk that they have taken? Has it amply reflected the rapid economic growth of the country post the liberalisation of 1991?

Over the last 21 years, the Nifty has delivered annualised returns of 11.9 per cent (1992-2012). Considering that India’s nominal GDP growth in the same period has been at around 13.5 per cent, the returns delivered by the equity market can be considered a little sub-par. However, averages can be misleading as they never portray the complete picture.

Over the long term, equity market returns are a function of growth in corporate profits, which in turn, is a function of the economic growth rate. This implies that equity market returns over the long term should be in line with the economic growth rate of an economy (adjusting for listing and survivorship bias). However, in the short term, this is not the case.

In the short term, different sectors and themes have led the stock markets and have delivered above average returns. There hasn’t been any particular sector or company that has done well at all times. In 1998-2000, the markets were driven by the IT sector. 2002-2007 was all about infrastructure, while 2008-2012 has been dominated by consumption-driven companies. Thus, an investor needs to understand the components that are moving positively in the equity market and then invest wisely to derive maximum returns.

In order to make informed decisions, investors also need to understand the factors that play a crucial part in economic growth. There have been multiple factors that have impacted the markets at various times to provide investment opportunities. In fact, one cannot undermine the role played by the government in the returns generated by the equity market. The economic liberalisation of 1991 and abolition of the License Raj led to increased private sector participation in various businesses. This, in turn, helped in improving efficiencies and contributed in improving the growth rate of the economy.

Currency depreciation in 1991 and later years provided a huge impetus to the exports of goods and services. The IT sector in particular grew rapidly in size and became an important part of the economy and the equity market. Outsourcing was one of the key themes towards the end of the 20th century, and that was amply reflected in the composition of the equity indices at that time. Most companies in the IT sector grew rapidly and delivered supernormal returns towards the latter half of the 90s. Infosys, the flagship company of the IT sector, scaled up its revenues from USD 18 million in FY1995 to USD 414 million by FY2001, a growth of almost 23x. The equity market rewarded this stupendous growth, and the stock was up almost 70x in the same period.

Infrastructure was another sector that gained significantly due to government policies. In early 2000, the government decided to invite the private sector to participate in the infrastructure space. Given the lack of funds as well as the inefficiency of the public sector, Public Private Partnership (PPP) became the preferred route for most public infrastructure. During this period, the government’s focus on creating a huge amount of new infrastructure provided a great opportunity, which the private sector took great advantage of. Almost 15000 km of roads projects were awarded by the NHAI to the private sector under its National Highways Development Project by the year 2009.
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Similarly, the power sector saw greater participation from the private sector. In the last decade, almost 80 GW of capacity was added in the power sector and a significant portion of that was driven by the private sector.

The banking sector also took part in the growth story and expanded its balance sheets rapidly to keep pace with the huge demand for funds from the infrastructure sector. The total advances by the banking sector grew from Rs 7 lakh crore in March 2002 to Rs 31 lakh crore by March 2009. As the companies grew in size by capitalising on the opportunities, the equity market returns ballooned. The banking sector index (Bankex) went up by 10x from 2002 to 2007. Similarly, many construction companies delivered returns of almost 20x in that period.

In more recent times, since 2007, government policies coupled with favourable demographics like higher per capita income, underleveraged consumers, etc. led to a huge boom in the consumption sector in India. Government support in terms of NREGA, farm loan waivers, higher MSPs, along with continuous double-digit growth in per capita income of the country led to a tremendous increase in the spending power of the ‘common man’. This burgeoning middle class was the main reason behind the consumption boom in the country over the last four to five years. Consumer sector companies, obviously, were the main beneficiaries of this growth and delivered annualised revenue growth in excess of 20 per cent. These companies delivered extraordinary stock market returns in that period inspite of a muted overall market.

However, government policies are not the only reason for a sector or stock to do well. Many companies have done consistently well over a long time in spite of limited support from the government. Many IT and pharma companies continued to do well after the year 2000 as well despite currency rising between 2002-2007 and very few policy-level incentives. Similarly, many private sector banking sector companies have done consistently well over the last decade or so without any support from the government. The performance of these companies has mostly been a function of their efficiency and the overall demand by their end customers, and they have mostly delivered better returns for their shareholders.

Due to the inherent ever-changing dynamics of the equity market, active management becomes very important for investors. Passively following an index mostly helps investors in participating in the growth of an economy. However, wealth creation is a function of choosing the right subset of the economy and investing accordingly.

The components of any Large-Cap index at various instances mostly reflect the performance of a particular sector in the preceding few years. The big boom of outsourcing in the late 90s resulted in IT and pharma companies becoming a significant part of the index. At its peak in early 2000, IT and pharma companies together made up almost one-fourth of the Sensex. Post Y2K, however, stocks corrected significantly and many IT stocks have not yet reached the peaks they had seen in the year 2000. Similarly, infrastructure stocks, which had a stellar run between 2002 and 2007, witnessed a change in fortunes after 2008 and have been languishing at the bottom for a long time now. Any investor who based his/her investment decision on the basis of the benchmark only and invested a disproportionate part of his/her portfolio in any of these sectors at their peak would have been hurt severely by the fall in the sector later.

Thus, it is only by identifying the trends playing out in the market space and investing in the right sectors and themes that one can truly create value in the equity market.