Practice a structured risk-reward balance in your investment thinking. Weigh the choices between overvalued mid-caps and undervalued cyclicals in recovery mode
Investment scenarios are always unique and we can’t respond the same way to every scenario. Each scenario is a function of the broader equity market and calls for a customised response. An investor must align her response keeping in mind the risk-reward balance in each scenario. One’s investment strategy must not be fashioned solely on the judgement of either the reward or the risk. Year 2014 was a very different scenario from the present. Then, investors were viewing the markets as a hope trade. Rewards were the sole driver after the historic election verdict. A new government raised expectations of change. We were betting on an aggressive approach to liberalisation. Speedy resolution was expected of issues faced by several industries, most of which were core industries. These issues were weighing heavily on the banking sector. We were betting on the resolution of the pain in banking. We were also betting on the speedy resolution of challenges to growth. We were happy to sidestep the risks that a top-down trade faced then. Large institutional monies chased headline growth. Money poured into the indices. Foreign institutional investors (FIIs) added top-up fuel to the indices exactly when fundamentals were not supporting them. Fund houses sold large-cap and diversified schemes heavily. There was a scurry to put money into equity as people scampered to get in. Predictably, that bet proved short-lived.
By early 2016, the index-hugging funds were struggling. Performance was eluding them; the top-down approach wasn’t working.
So, were investors wrong in their strategy? I think, investors could not rightly evaluate the magnitude of the problems faced by the economy. And, near-term returns were becoming a huge challenge. We had not adequately evaluated the risks attached to a top-down trade. When rewards are the sole driver of investment decisions, risks always come back to play spoiler.
Professional investors and the savvier high net-worth individuals (HNIs) handled the scenario much better—they got their risk call right. They avoided a top-down direction and approached the markets bottom-up. The risks were in favour of that. So, they followed a stock-specific approach and bypassed the top-down opportunities. They rode the earnings momentum that was already built up in companies that did not suffer headwinds.
Much later, when it became evident that it would take significantly longer for the-top down approach to deliver, fund houses and retail investors started aggressively focusing on the themes that had worked well for the HNIs and professional investors. This created a rush of flows, which soon turned into a flood in mid-cap and small-cap themes. The flows simply refused to ebb. This became the reward hour for HNIs and professional investors. Now they are going to town advocating their bottom-up approach’s invincibility. The fund industry is also participating in this parade as it helps them gather assets. Anything that’s good for asset gathering will never be stopped in its tracks. So money keeps pouring into the wrong tank.
Importantly, the top-down approach has almost fallen out of favour among retail investors. The professional investors and HNIs are now making exactly the same mistake that large institutions and funds had made earlier. They are sidestepping the risks posed by valuations. They are focussing mostly on the residual rewards that this extended trade has to offer. They see little risk in going down the quality ladder to find newer ideas. Clearly, reward is sidestepping risks now.
What we see now is an expedient approach to risk. The current investment premise is that the top-down approach will take too long to deliver, and growth is expected to remain elusive. This assessment seems to have become almost routine and habitual among both institutional and retail investors. For a moment, think what will happen if this expedient and habitual assessment is proved wrong.
The money that is overflowing in the wrong tanks will want to move quickly into the top-down investing tank. This could potentially cause a valuation breach in mid-caps and small-caps. And that could be just as painful as the hope trades from the past. A more pragmatic approach will be to bet now on a broader economic recovery. One must wait and watch. A better, structured risk-reward balance needs to be practised in our investment thinking. The choice needs to be weighed carefully between cruising overvalued mid-caps and undervalued cyclicals that are in recovery mode.
Investors must evaluate what makes more sense to them. We need to carefully recalibrate our portfolios. Risk-reward alignments must match the playing conditions. Even a master batsman who has just scored a double century takes a fresh guard before he bats on—a cricketing lesson that applies to investing as well.
Shyam Sekhar is chief ideator and founder of iThought