Indian equities saw a sharp run-up between 2014 and 2017 amid a host of factors such as BJP forming government at the center, reform measures, domestic and global economic recovery, and improving corporate earnings boosted market sentiment. During this period, markets scaled to new highs with the large-cap index (S&P BSE 100) delivering a cumulative return of 84.2%, whereas the mid-cap (S&P BSE Mid-Cap) and the small-cap (S&P BSE Small-Cap) indexes were up by 179.4% and 204.4%, respectively over this period. The optimism was also reflected in the market valuations as price/earnings multiples rose for all three market-cap indexes.
After a runaway bull market, volatility returned to the markets in 2018 as concerns over a global trade war and Brexit dented markets sentiment. Risk-off sentiment flowed around the world, and Foreign Portfolio Investors (FPIs) pulled out approx. $4.3 billion from Indian equity markets in 2018. Markets continue to face the heat in 2019 amid slowing domestic economy and looming global recessionary risks. From the peaks of January 2018, markets have seen a sharp correction till date as valuations looked stretched particularly for mid and small caps. The S&P BSE Mid-Cap and S&P BSE Small-Cap indexes recorded a max drawdown (peak to valley) of -26.6% and -38.7%, respectively. Whereas, large-cap index (S&P BSE 100) saw limited losses and is down 14.6% from its peak in August 2018.
With the downturn, our valuation-driven asset allocation process reflected the value opportunity in the Indian equity markets. Our valuation-implied returns suggest that Indian large and small-cap stocks are now more attractive than they were as of December 2017. With this backdrop, we have reduced our underweight position in the mid and small-cap segment across managed portfolios.
Rather, investors are relying on the benefits of future growth opportunities to stoke returns. In our view, this is not good investor behavior, and we refrain from investing in expensive assets, hoping for growth to materialize. Instead, we opt for assets that are priced below their intrinsic value and offer attractive margins of safety. This explains our underweight positions to both asset classes.
We believe investors are unaware of the cash flow generation, and the relatively low returns on equity (Exhibit 2) that these companies offer.
The recent slowdown casts doubt on the Indian growth story, and stocks have declined sharply as weak private demand and subdued investment activity has widened the output gap and dampened market sentiment. Earnings to date at a broad market index have been well below consensus estimates with headline earnings increasing by 9%, of which financials contributed the most, whereas commodities, agriculture, autos, and telecoms detracted. The US-China trade war is likely to cause shifts in manufacturing away from China. India could benefit from this, as it does not have the aging population issue as China does. As such, we have penciled real growth of 4% over a rolling 10-year period. However, our endeavor is to identify and select managers who actively look out for companies where the growth potential is higher than what the broad market index would offer. Over the long-term, we believe that India would benefit from a cut in bureaucracy and improving penetration for banking and financial services.
Our estimated 10-year valuation implied return is driven by a suitably strong trend growth and improving earnings for the Indian markets. With the return profile improving for Indian equities, we have reduced our underweight positions. We think that corporate earnings growth will improve as domestic consumer demand, export, and government expenditure increases. This, along with the implementation of better reform measures and fall in real interest rates should bode well for the economy.
We continue to monitor the portfolios closely and stay focused on helping investors achieve their goals over the long term. Going ahead, our overweight position in cash (vis-à-vis neutral position) should provide ammunition when attractive investment opportunities arise and protect ourselves on the downside.
