We are in the midst of an economic shock.  India has not been able to flatten the curve and the number of infections continues to rise. There is no visibility of a vaccine or a cure.  SMEs are in distress. Neighbourhood shops are doing very little business, if any at all.    Yet stock prices seem to ignore market conditions and have reached the levels of February 2020.   

What is going on? Are markets ahead of themselves? Should Solidarity be taking a cash call at present to preserve some of the gains?

While I have no view on what course stock prices may take in the short term, I would like to re-iterate our perspectives on this issue. 

Our minds have been conditioned to equate market direction with short term Earnings growth.   However, there are other factors that affect estimation of fair prices. 

a)      Interest rates

b)      Terminal value: Change in competitive positions – of sectors, and of players within sectors

Additionally, we must not forget that Solidarity does not buy the market but select sectors/companies we believe will outperform the market

Declining interest rates

Fair value of stock prices reflect estimated future cash flows discounted to the present.  As interest rates fall – and if future estimates of cash flows do not change significantly – lower discount rates justify higher stock prices.   Short term interest rates at present are the lowest they have ever been in India and long term interest rates very close to all time lows.    And as I explain below, in many of our positions, future estimates of cash flows have not significantly changed, and in some instances improved.  

The other implication of declining interest rates are they encourage more risk taking and participation in Equities due to lower yield being earned on debt instruments.  One can observe this phenomenon with the rise of Retail participation in the market.

Covid-19 is creating winners and losers across sectors.

• The geopolitical chess board is being realigned.  The US is explicitly trying to weaken China’s economic might and influence.  The coming shift of supply chains from China means Indian companies have the opportunity for market share gains in some sectors.  Hence, companies that serve global supply chains in essential sectors (Pharma, Agro, Food) should continue to show strong earnings.

• Rise of Digital: Covid-19 has resulted in consumers experimenting with Digital.  While it is intuitive, research also seems to suggest that many first time users of Digital services don’t go back to old ways. This means rising terminal value of some business models and rapid erosion in others.  It also offers the opportunity for many companies to realign cost structures.

• Businesses affected by social distancing norms- India has been unable to control the spread of Covid19.  The fear of getting infected will reflect in an erosion of trust and hence unwillingness to frequent venues which can be avoided.  Businesses that cannot be profitable with social distancing measures in place will be challenged. You may observe we have acted on some names here.

Market share gains and differing resilience

• Trust. A crisis causes consumers to migrate to brands they trust.  Private Banks (eg HDFC Bank, ICICI Bank) and Insurance cos (eg HDFC Life) continue to gain market share

• Inability to compete – In July, non AAA NBFCs (Edelweiss, India Bulls) announced plans to sell down their developer loans leaving more room for existing leaders like HDFC

• Institutions which have a higher share of SME Loans, loans to builders, loans to the urban poor, and have been pursuing riskier credit will be more affected than others Results published till date show differing levels of loans on moratoriums.  For eg, as of 30 June, PNB Housing Finance has 39% of its book on Moratoriums vs 9.7% for Axis Bank.

Hence, while the economy has a whole may struggle, individual companies may be resilient in the short term and emerge stronger from the crisis medium term.  It is our endeavour to align the portfolio with such winners

Should we be taking a cash call to preserve some of the gains?

The challenge we face every day is to balance Greed and Fear.  One of our core operating principles at Solidarity is we choose to exclusively play the long game.  As I have shared with you earlier, a calmer mind can think more clearly.     

Take the example of Specialty Chemicals. We believe the industry can create giants like those in the IT and Pharma Industry because of the opportunity and the competitive edge that India and many companies have.   Some companies could grow profits at 15-20% CAGR for a decade.   Moreover, when a sector’s earnings seem secular and strong relative to other opportunities in the market, valuations could stay above fair value.   It would be foolhardy to not focus on the long term prize, but try and over optimize for short term moves.

However, we also realize that we are custodians of third party capital and do not have the luxury of decadal views.  Hence, we will find the right balance of taking some money off when valuations are euphoric.

How can we be calm amidst pervasive fear and anxiety? 

Being a high strung personality myself, I cannot claim expertise on this subject, but I will share 3 thoughts for you to consider

• These emotions cannot be avoided as they are the pain for the premium one expects to earn in Equities over Debt.  A healthy dose of fear and anxiety are good as they keep us alert and question status quo.  But if you find yourself asking the same questions frequently, consider reducing your exposure to Equities.  The most important thing is to be comfortable with risk exposure and there is no certainty associated with returns on Equities.

• Measure acceptable Equity returns not on an absolute basis, but to the closest substitute – so for example, if Equities can return 16% absolute returns in 3 years from here (5% IRR), they will match returns one can make by investing in a FD at present.   The right metric to measure returns is the spread you will make over a risk free instrument. 

• Find a process to filter signal from noise.   It is hard to stay on course when being constantly bombard by opinions of people who are playing a different game from you and have different time horizons.  I have found myself calmer when I have stopped watching all news and particularly business channels.   They tend to sensationalize stories and the balance in reporting is missing.  Inevitably, they enhance fear which subconsciously shorten time horizons of decision making.