An Asset Called Self-Preservation
hen wealth managers in India talk about asset allocation, they invariably suggest sticking to equities and real estate. Other assets like commodities, fixed income and alternative investments such as art are discussed, but in no way rival shares in their appeal. Even for many above the age of 60, wealth managers are keen to have them invest in equities, provided they are well taken care of by their family and have the required risk appetite.
But the global financial crisis has changed our view of investment profoundly. Equities may continue to command the attention of Indian investors, but conservatism will be in.
Illustration: Abhijeet Kini
Conservation of capital, absolute returns and liquidity will be the theme for the long term investor in 2010 as against high risk, benchmark-driven returns and locked-in investments like structured products that were the themes until 2007, says Amitava Neogi, executive director at Morgan Stanley India.
“I think 2010 will be the time for stock picking, rather than just investing into pivotal stocks. We believe that with 30 percent in cash, much of the investment should be in high quality equities and some in gold,” he says.
India’s stock markets rose 78 percent in 2009 and investors are rightly worried about their investment in this asset class. With the global economy behaving like Humpty Dumpty over the last two years, there is a distinct sense of unease. Like a summer storm, the financial crisis ravaged most asset classes and led to a scary spike in volatility. All assets, from stocks to gold, commodities to currencies, fell and rose together, breaking the age-old wisdom about positive and negative correlations between asset classes. There were interest rate cuts across the world and governments started pumping in money. Bond house Pimco went so far as to describe a “new normal” implying that the developed world will be in stagflation while emerging markets like China call the shots.
The corporate sector had a few surprises. Crisil data shows that the gross profit margins of 2,040 manufacturing firms fell to as low as 15.3 percent in the quarter ended December 2008, before bouncing back to 20 percent plus in the April-June 2009 quarter. It wasn’t rising revenue that brought the profits back as much as fall in raw material prices.
But as the world starts to repair itself, commodities across asset classes are gradually reverting to higher levels. Initially, commodities used in manufacturing, like fuels and metals, are expected to be pricier. Once again, corporate profit margins will be under threat and that will reflect in stock prices.
Emerging markets have had a good run since March 2009 but are overvalued now. So their volatility will only be higher. A Motilal Oswal research paper says that market capitalisation is at 109 percent of GDP, the highest in history.
If we compare earnings yields (the inverse of the P/E ratio) and government bond yields over the last seven years, Indian markets appear overvalued. Long-term government bonds are giving a yield of 8.10 percent while earnings yields are at 5.39 percent.
The market looks like it is in bubble territory when we compare asset prices (book values) to market prices in the context of the returns these assets have created for their firms. Over the last one year, the return on equity for Nifty companies has fallen from 27 percent in 2007 to just 16 percent currently, yet investors remain willing to pay higher prices for these low yielding assets.
Price as a multiple of book value has gone down from 5.31 times to 3.5 times. For the markets to revert to normal levels of valuation, this number needs to come down to 2.8 times.
However, the long-term investor has less to worry about given that the Indian economy is riding on domestic demand fired by the expanding bottom-of-the-pyramid market, increased urbanisation and an acceleration in infrastructure spending. The investor must sit through the volatility to realise its full benefits.
The world equity markets have opened to the Indian investor with the Reserve Bank of India liberalising the norms for investing abroad. Brokerages and wealth managers have been tying up with foreign partners to bring those opportunities to India. In particular, this opens up vistas for playing the other big theme in global growth: China. The country offers completely different opportunities from India and its growth rate and fundamentals are also different. Recognizing this opportunity for Indians, JP Morgan has started a Greater China off-shore fund.
As the debate on where the financial crisis stands is yet to be settled, investors will look for capital protection. So fixed income will be vital in asset allocation.
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