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Business News/ Markets / Stock Markets/  The two sides of the equity pendulum: Opportunity in adversity vs problem of plenty
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The two sides of the equity pendulum: Opportunity in adversity vs problem of plenty

When there is abundance, many companies add greater capacities than required and some become lax on financial prudence. As a result, good times lay the seeds of tough times.

Nearly 40% of the Nifty 500 stocks delivered over 3x returns in the post bust periods.Premium
Nearly 40% of the Nifty 500 stocks delivered over 3x returns in the post bust periods.

Business cycles are generally defined as intervals of expansion followed by a recession in economic activity. Keynesian economists generally argue that aggregate demand is volatile and that, consequently, a market economy often experiences inefficient macroeconomic outcomes i.e. a recession, when demand is low, or inflation, when demand is high.

A Recession is an economic contraction that is due to a contraction in private sector debt growth arising from tight central bank policy (usually to fight inflation). Once a recession has set in, central banks ease monetary policy and induce an Expansionary Economic Cycle. This process is part of a Short Term Debt Cycle which according to Ray Dalio of Bridgewater Capital lasts 5-8 years. Some commentators say these cycle times have contracted, given the speed of information flow and resultant action by regulatory authorities.

The short-term debt cycle is what comprises the business cycle and this is primarily controlled by central banks’ policies that a) tighten when inflation is too high and/or rising uncomfortably due to high capacity utilisation, low unemployment rates and strong credit growth; and b) ease when the reverse conditions exist.

This cyclical trend is depicted in the Profit After Tax/ Nominal GDP chart below. In boom periods, profitability & corporate abundance rise, while in bust periods, profitability and abundance compress.

Corporate PAT/ Nominal GDP
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Corporate PAT/ Nominal GDP

Opportunity in Adversity - Bust Cycle

In periods of recession, corporate balance sheets contract, businesses lower costs to become lean, they bear an economic cost of washing away systemic excesses created during boom periods and they gear up for the next boom cycle to commence. In order to become lean, businesses operate below optimal levels. While some of this is due to company specific reasons, many times companies react to the larger stress in the environment. For example, if there is over-capacity in the system, competitors cut prices and ease credit periods extended to customers. In such a case, companies have a choice of 1) either straining own balance sheet by continuing to bid for the unhealthy business, or 2) letting business pass, in order to maintain own financial health. Many companies choose the latter path and grow below capacity. Since valuations are a function of growth patterns, as growth slows down, valuations tend to become attractive. Hence it is in these times that opportunity arises for investors.

One period when this recessionary trend played out in India was the 2010 to 2013 period. We witnessed macroeconomic worsening with inflation hitting 11%, twin deficits being over 5% and India being classified under The Fragile Five moniker (five countries with weak economic conditions) by Morgan Stanley. As interest rates peaked out in 2013 and the bust cycle was at its peak, stock markets witnessed a significant sell-off. However, when the markets realised that stress had peaked and that the cycle was likely to turn favourable going forward, between September 2013 and Dec 2017 (4 years), the Nifty 500 stocks delivered the following performance:

Nifty500 as on 31st Dec, 2017
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Nifty500 as on 31st Dec, 2017

A similar uptick in equities was witnessed post the Covid-led recession in 2020:

Nifty500 as on 30th Sept, 2023
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Nifty500 as on 30th Sept, 2023

As is evident from the above tables, widespread opportunity arose once recessionary trends peaked during these bust cycles. Clearly, markets offered opportunity in adversity. Nearly 40% of the Nifty 500 stocks delivered over 3x returns in the post bust periods!

Problem of Plenty - Boom Cycle

The mirror image of the recessionary cycle is the boom cycle; it is here that companies create excesses. Warren Buffett says, “A full wallet is like a full bladder; you may have the urge to pee it away!" When there is abundance, many companies add greater capacities than required and some become lax on financial prudence. As a result, good times lay the seeds of tough times.

The last large investment cycle that India witnessed was in the 2003-2007 period. Given the abundance this cycle created, the system witnessed many excesses at the corporate level. While excesses, in essence, strained balance sheets, these strains were caused due to various approaches. Some instances are as under:

Acquisitions: A prominent auto component manufacturer acquired 22 companies in a period of 9 years starting 2005. Many of these acquisitions were overseas. The company was witnessing strong growth in the boom period and had ambitions of becoming large globally. Since the company used debt financing for its acquisitions, as growth tapered down during the slowdown, the company found it difficult to service debt. This company went bankrupt around 2017. Acquisitions-for-growth was widely followed strategy in this period and many companies, included some larger respected business houses, engaged in the same. Numerous ill-conceived acquisitions at the peak of the cycle, either permanently or temporarily stunted growth of companies.

Financial Engineering: A leading textiles manufacturer and exporter, having large forex receivables, entered into complex derivative contracts to cover Euro/ USD receivables. It so turned out that this transaction was at worst a financial engineering transaction (not a hedge) and at best a lack of appreciation of risks inherent in the derivative instrument. The result was, as currency markets went against the company, liabilities from this transaction ballooned to as high as 170 crore on revenues of 900 crore This severely strained the company’s balance sheet and pushed it close to bankruptcy. Many other companies engaged in similar transactions and faced the brunt.

Unrelated Diversification: Riding on a real estate boom and the resultant strength in cash flows, a leading real estate company diversified into the unrelated business of telecom (with a global partner) in 2008. The company is known to have secured loans of Rs. 5000 crore from various banks to fund this venture. Due to changes in regulation and legal hurdles, many circles of this telecom company were cancelled. This in turn caused a financial strain on the company’s stretched balance sheet and the company defaulted on commitments in its core business as well. The result was that the company went bankrupt. This was not a one-off occurrence; many companies, across sectors witnessed this phenomenon.

Capital Intensive Expansion: Many road engineering procurement and construction (EPC) companies generated handsome cash flows due to the infrastructure boom witnessed in this period. EPC business is an asset-light, high-ROE business. However, with strong balance sheets, these companies got enamored by the possibility of owning road assets through the Build Own Operate and Transfer (BOOT) route. This model required investment of capital, hence, the companies went from being asset light to asset heavy. They levered balance sheets and as traffic expectations turned out to be aggressive, these companies witnessed diminution in value of their road assets. Many companies went bankrupt as a result.

Credit Assessment Lapses: Corporate banks, many of which had government ownership, gave extensive project credit in the boom years. When the tide went out, they were riddled with NPAs. It turned out that lending to cyclical sectors like steel, textiles, real estate, etc. were the bane of their problem. These sectors saw significant over-capitalisation during the boom years and projected demand much ahead of actual numbers. Systemic NPAs ballooned to as high as 12 lakh crore; in many instances 10%-20% of bank assets. Significant write-offs were taken, PSU banks were merged and equity was raised to ensure solvency.

While this is not an exhaustive list but holding back future expectations, a shade, in boom times allows for error minimisation. Errors take long periods to come to the fore and they definitely show up in bust periods. As mentioned earlier, boom periods lead to abundance which sow the seeds of excesses and hence create the problem of plenty.

In line with lowered economic activity, bust periods, which follow booms, witness stock price declines, as shown below:

Source: Bloomberg & Emkay Research
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Source: Bloomberg & Emkay Research

It is a near consensus view that India would witness an extended boom period this decade. Time will tell whether corporate India has learnt lessons from history or they are prone to similar errors. However, signs are the whole system i.e. regulatory authorities, banking and corporate India, are approaching this cycle with far more calculated manner than in the 2003-2007 cycle.

It is within these two ends of the pendulum i.e. Boom & Bust, that opportunity arises. Hence Buffett’s phrase – “Be Greedy when others are Fearful and Fearful when others are Greedy", has decades of wisdom condensed into a few words!



Anshul Saigal is Portfolio Manager & Head - PMS, Kotak Mahindra Asset Management Company. Views expressed are personal.

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Published: 04 Nov 2023, 10:32 AM IST
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