[Investor Memo] Wise to Optimise Expectations & Review Asset Allocation


In April 2022, we published an important subscriber memo titled ‘Wise to Optimise Expectations & Review Asset Allocation’

While the two pillars of the bull market: Liquidity & Growth are slowing, Export is the bright spot. Following are some edited excerpts from the same.

After crashing in March 2020, markets have been on steroids ever since, which implies the ongoing bull market is now two years old. The last six months though have been tepid for markets, but thanks to some outliers in our portfolio like Usha Martin & Gujarat Ambuja among others, the portfolio has continued to show outperformance even during this tepid phase. Extra-ordinary periods like this are generally followed by some pullback or a decent time correction (sideways market). Accordingly, instead of extrapolating this into the future we should keep our expectations in check and be prepared for some turbulence this financial year. After enjoying a heavy & delicious meal, the focus should be on ensuring we digest it well; implementing many learnings from the previous cycle, we made exits where risk-reward seemed unfavorable –  APL Apollo (5x) & Dhanuka (2.7x) to move money to better opportunities i.e. some neglected businesses where underlying changes are strongly positive but not yet appreciated by markets, so as to position the portfolio for next cycle.

We usually stay focussed on bottom-up investing (company-specific) while giving little weightage, if any, to macros like inflation, interest rate, politics or the global news, as the latter always has something to worry about. In fact last month (Mar 2022), when markets tanked on the news of Russia attacking Ukraine, we released a memo saying, good news & good prices don’t come together, so wise to ignore the news and deploy idle cash in buy-rated stocks.

As an exception, this note carries some thoughts around crucial macro developments and why we should stay a little cautious about markets. Though that does not impact our decision-making around selling or raising cash, rather, as reflected on the dashboard, we continue to be almost fully invested and carry reasonable confidence in our portfolio to deliver above-average earnings growth and maintain outperformance over markets across cycles. However, the same inputs should be used to reset future return expectations while optimizing asset allocation – there are times like March 2020 when stocks crash by 60-70% leading to a steep fall in our equity allocation, and such times are best leveraged to buy more equities by shifting capital from other asset classes like fixed income (FD) or real estate. The old subscribers would remember how we kept nudging everyone to add or at least stay the course using the example of farmland with a loss of just one harvesting season.

On the other extreme, are times like the current where equities have massively outperformed (in the last two years) versus other asset classes which would have led to a significant rise in its share of our net worth. We take this opportunity to nudge you to revisit your asset allocation. Given strong returns in equities over the past two years along with negligible returns on other asset classes (FD at 3.5% post-tax), some of us might’ve deployed more capital in equities than warranted. If you have put any sum of money which you might require within the next three years for predefined and time-bound purposes – be it a down payment for a home purchase or a kid’s education, this could be a good time to start taking that money off the table. In some extreme cases, one may have borrowed against property or taken an unwanted home loan so as to invest existing savings into equities. In such a case, one can consider using some of the gains made in equities to prepay the debt i.e. optimize asset allocation.

Stalwart Advisors’ job as an independent equity research outfit is to put together equity portfolios under any given circumstances. This equity basket should ideally be fully invested at all times as long as we find investable opportunities as opposed to trying to time the market within this basket (by holding cash). The risk appetite and liquidity requirement gets taken care of at your asset-allocation level i.e. how much of your net worth gets invested into equities, fixed income, and other assets. It’s you (or your financial planner) who would have a complete view and a better assessment of your individual goals, finances, and asset allocation. We urge you to revisit the same and ensure you are comfortable riding forward with the current equity exposure. We reiterate you should at least have a three-year horizon for equities, the longer the better.

Why should we reset return expectations from Equities for near term?
At the core, there are really just two factors that drive the equity markets – 1). Liquidity & 2). Growth. Both these factors have been pretty favorable in the recent past but are now showing some signs of draining out.

1. Best of Liquidity Behind?
The interest rate cycle in the west has finally taken a turn. The real interest rate in the US is steeply negative and is expected to rise in a fast and furious way given the unprecedented spike in inflation. While the jury is still out whether the inflation is transient or not, what’s certain is that with rising interest rates, all assets, including equities, will be repriced – theoretically higher interest rates lead to higher discounting of future cash flows which leads to lower present value. FIIs have already withdrawn big from emerging markets including India. So far this has been countered well by strong domestic flows via Mutual Funds, but for how long that continues is anybody’s guess.

2. Is Inflation Really Transient?
The inflation worry is no different for India. From energy (gas, fuel & coal) to metals, textile, telecom, and Agri products, the inflation has worsened across the board. The reported consumer inflation number of 7%, although at a 17-month high, fails to capture the full impact given the lag effect as well as somewhat outdated basket mix. If we track our monthly household expenses or speak to the house help/driver, we will realize the true inflation is far higher. Households could see a substantial drop in their discretionary income as expenses on necessities go up. To align with higher prices, consumers would be forced to reduce consumption as well as down-trade (go for cheaper variants). Consequently, both volume growth and sales mix for producers would come under pressure. In such an environment, it would not be easy for the producers to fully pass on the input cost hike which shall put a dent in their margins, making it a double whammy. This could temporarily impact the earnings of many sectors and put pressure on the second engine of markets ‘growth’.

Some market participants opine that given the markets have continued to climb multiple walls of worries from a pandemic, crude crossing $100, Russia-Ukraine war to Fed tapering, only shows that we continue to be in a strong bull market. Even if that argument is valid, the valuations for most of the sectors today are reasonably fair to high*, pricing in most of the positives and leaving little room to absorb any shock. Russia-Ukraine war and the consequent turbulence in global trade, especially in the most essential ‘energy & food’ basket, has impacted the geopolitical environment in a big way. Vulnerable countries like Argentina, Turkey & Sri Lanka are going through a major crisis amidst depleting foreign exchange, sliding currency, and a shortage of essential goods for their citizens. China’s zero COVID policy and the strictest possible lockdown are only going to hurt global supply chains further, impacting all industries that rely on China for their raw material. A lot of this would be known better over the next few weeks, as investors dial into the Q4FY22 earnings call and listen to management commentary and guidance around this.

The Brighter Side – Export Opportunity
With global supply chains being reset, the export opportunity for India is only getting bigger & better. The last few decades were all about globalization which made China the manufacturing hub of the world. Outsourcing brought efficiency but also made importing countries vulnerable to external shocks which have become too obvious in recent times of pandemic and the Russia-Ukraine war. It could take decades to reverse this but the process has surely begun. China + 1 has anyways been happening in select sectors like Chemicals for the past few years led by the pollution crackdown in China. This could now spread to other sectors that rely majorly on China. A corporate that was okay getting all its goods from one large factory in China could now start preferring to de-risk its supply chain by having a few additional, even though smaller, factories outside China – India could be a major beneficiary of this given cheap and skilled labor backed by a democratic government that is offering tax sops & incentives for new manufacturing setups.

As it is nearly impossible to beat China on cost, the alternate supply chains would also add to consumer inflation taking a further beating on global growth. Net net India could still be a beneficiary with a rising share of the existing global trade which can ensure Corporate India continues to grow volumes and also absorb any intermittent pressure on domestic demand. A significant part (~45%) of our portfolio is positioned to benefit from this megatrend – Usha Martin, Gujarat Ambuja, Suven Pharma & five other portfolio businesses are large exporters out of India, have leadership in their chosen niche along with cost competitiveness and they continue to invest in fresh capacities to tap into newer opportunities.

To sum up, equities continue to be one of the best asset classes to beat inflation. Although there are some near-term challenges that can create turbulence in the market and hence we should revisit asset allocation to ensure its optimized. From a long-term perspective, the portfolio continues to be well constructed with attractive businesses, in which we are co-invested with you.

Should you have any queries or feedback, please let us know at support@stalwartvalue.com

Jatin Khemani, CFA
Manish Chopra, CFA
Stalwart Investment Advisors LLP

*When valuations go overboard in any of our stocks, we downgrade them from the buy-list to the hold-list. This ensures that any fresh capital being deployed in our portfolio does not enter those stocks at elevated levels. The hold-rated stocks either get upgraded back to buy based on price correction, time correction (stock stays flat while earnings grow), or they get replaced with newer opportunities. So, unlike Mutual Funds where your capital gets deployed at one shot on that day’s NAV irrespective of the valuation of the individual portfolio stocks, at Stalwart we ensure tailor-made portfolios for our subscribers based on the timing of their entry or fresh capital addition. This ensures the risk is well managed and your capital gets deployed in a sensible way.

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Initiating Coverage Report along with all subsequent updates (AGM/Plant Visit/Management Meet/Quarterly Result etc) on some of our portfolio companies like Usha Martin, Suven Pharma & Gujarat Ambuja can be accessed without a paywall on the Guest Dashboard – new users need to submit a short sign-up form. We hate to get spammed ourselves, so rest assured we wouldn’t do that to you. By signing up as a guest user, you would occasionally be notified of new posts and stock updates, with an option to opt-out with one click whenever you change your mind.

Disclaimer: This is not a recommendation to buy/hold/sell. Please consult your financial advisor before acting on it. Read the complete disclaimer here.

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