ATM :: Still time left to invest in equity MFs?

Kayezad E. Adajania | First Published: Mon, Dec 01 2014. 07 15 PM IST | Live Mint
Markets may have gone up a lot this year, but there is steam left for investors to benefit from  
Talk about how equity markets can jump and leave everyone behind. After returning a dismal 9% in 2013, the S&P BSE Sensex has returned 35% so far this year. Since 1 April 2013, Sensex has returned 28%. Diversified equity schemes have returned 41% on an average so far this year. Does this mean it’s too late to invest in equity funds? We don’t think so. Given a few caveats, we feel this is still as good a time as any to put money in equity mutual funds (MF) if you haven’t already done so. Here are four reasons:

Corporate profitability…
As business conditions and India’s macroeconomic indicators improve gradually, analysts and fund managers are expecting companies to make more profits. A Kotak Institutional Equities report dated 29 October 2014 has predicted that Sensex companies’ net profits may go up by 13.1% in financial year (FY) 2014-15, by 17.1% in 2015-16 and by 13.9% in 2016-17. Simply put, if companies make profits, market prices of their equity shares will go up, as will the net asset values (NAV) of equity funds.

There’s another way to look at it: through corporate profitability to gross domestic product (GDP) ratio. GDP is the market value of all the products and services manufactured in India. If you think of India as a corporate firm, GDP is its sales figures. In 2006-07, when equity market was rising furiously, and in 2007-08, when it peaked, this ratio was 7.27% and 7.76%, respectively, according to Motilal Oswal Research. Past 25-year average is 3.72%. For FY14, the corporate profitability to GDP ratio was 4.30%. “We are coming from a period of slow economic growth, and high inflation and input costs. As the GDP growth improves and input costs decline on the back of the recent fall in inflation, interest rates, oil and commodity prices, we will see not only GDP growth but also a higher percentage translation of that growth into corporate profits. GDP will improve and corporate profit to GDP will improve even further, resulting in dual tail wind and, hence, a significant re-rating of the markets,” said Aashish Somaiyaa, chief executive officer, Motilal Oswal Asset Management Co. Ltd.

Yet another way to look at it is through the return on investments. According to a Mint report, the return on capital employed (RoCE) for S&P BSE 500 companies was at a low of 14.6% in 2013-14—the lowest among all financial years since 2009-10 for which data is available.

“RoCE has definitely bottoming out, but market looks at future projections and not past data. Most companies in BSE 100 have been discounted as per their FY16E (estimated) earnings. Growth of companies is still at its nascent stage as the past five years were tough, with dimming global scenario—stagnant growth in the US markets and de-growth of the European markets. With a positive outlook emerging, Indian firms are bound to get back on the trajectory of growth. We believe the worst is over for the Indian markets,” said Yogesh Nagaonkar, vice-president, Institutional Equities, Bonanza Portfolio Ltd.

…will lead to rise in stock prices
Improved performance should lead to higher share prices. But sometimes, equity markets outpace corporate performance. Is that the case this time? Have the markets risen too much already?

Let’s look at the market capitalization to GDP ratio to find the answer. Market cap is the market value of a company’s outstanding shares. Rising markets lead to rise in market cap also. The historical numbers of market cap-GDP ratio show that we are not at the peak. (Market cap of all listed companies of BSE has been considered.) For the December 2007 quarter, this ratio was 163%, and 103.03% for September 2009 quarter. On 31 March 2014, the market cap to GDP ratio was 71%. “Typically, if this ratio is above 110, it means that the markets are in the expensive territory,” said Huzaifa Husain, head-equities, PineBridge Investment Asset Management Co. (India) Ltd.

Meanwhile, foreign institutional investors (FII) have been investing in Indian equity as well as debt markets. So far in 2014, FIIs have invested a little over $40 billion. To be fair, a significant chunk of these inflows has come in Indian debt on account of higher yields and an expectation of falling interest rates. Strong inflows over the past five years have also resulted in FII ownership in Indian companies reaching a high. A Bank of America Merrill Lynch report dated 14 November said that as of June 2014, FIIs collectively held 22.5% of the market and 46% of the free float (shares available to the public to buy or sell, keeping the promoter’s holdings aside). This is much higher than the 15% of total market cap and 36% of free float in March 2009.

“The hurdle rate for foreign investors have fallen significantly since many foreign countries aren’t doing that well. The cost of equity for foreign investors has fallen dramatically. For instance, German bond yields, which were 4.6% in 2007, have come down to 0.7%. This makes even stocks at 40 times price-earnings ratio, cheap. The outlook for the Indian economy is positive, although, of course, much of the growth is yet to happen at the ground level,” said Gopal Agarwal, head-equities, Mirae Asset Global Investments (India) Ltd.

Will reforms happen?
Expectations are high from the six-month-old National Democratic Alliance government to deliver on reforms. So far, it has made the right noises, but significant progress is yet to be seen. The deregulation of diesel prices (petrol prices were already deregulated in June 2010) has been hailed as one of the bigger measures that it has taken so far. The caveat here is that a fall in crude oil prices helped and it remains to be seen how the government would react if and when oil prices go up. A Citi Research report dated 31 October says that the government’s fuel reforms (including diesel subsidies) will reduce the fuel subsidy by 0.5% of the GDP.

The government also appears to be easing red-tapism and, at the same time, creating accountability by setting deadlines and monitoring progress. Abolition of the Empowered Group of Ministers and Group of Ministers (inter-ministerial committees formed to resolve conflicts and come to a consensus for decision making) was one such step—there were about 80 such committees at one point.

Further, a two-week deadline was set up for inter-ministerial consultations. Liberalization of foreign direct investment (FDI) in railways and defence is another key measure that the government has taken.

“If harnessed appropriately, the three trends of urbanization, demographics and technology in combination can put India in a higher orbit of growth. These would require appropriate policies at the centre and state. Geographically speaking, industrialization is more dense near coastal areas whereas population density is higher in the northern belt. A simpler and easier-to-administer indirect tax regime can optimize production and movement of goods, which should benefit all,” said Husain.

But are we reading too much into what the government has done till now? In a recent interview to Mint, Christopher Wood, managing director, CLSA Ltd, Asia’s leading equity brokerage and investment group, said, “The single biggest risk is if something happens to Mr. Modi. The market would be down 20% in dollar terms very quickly.”

A lot rides on how the government acts in the next few years. “Last time, the Indian economy’s growth was supported by a growth in the global economy. But this time, the ball is in our court. Growth here is yet to happen and we have to take certain steps on our own,” said Agarwal.

What should you do?
The main question for a retail investor remains: is there still time to invest in equity MFs, or are we too late? A look at how investors have invested in equity MFs, unfortunately, tells a sorry tale—of chasing past returns.

In two of the past nine financial years, equity MFs saw either a minuscule net inflow or a net outflow in the years following years in which the Sensex gave negative returns. But in both these cases, the following years saw equity markets go up.

“The returns are sub-optimal when investors simply chase past returns. This tendency leads to higher investments when past returns (and, therefore, valuations) are high, and vice versa. Instead, investments should be guided by valuations; i.e. invest more at low P-E ratios, and vice versa,” said Prashant Jain, executive director and chief investment officer, HDFC Asset Management Co. Ltd.

But then, shouldn’t we be selling our equity funds now, instead of buying more when the equity market has already returned about 30% in the past year-and-a-half? “Even though it is difficult to forecast markets over short to medium periods, one is likely to be disappointed if one expects past one year kind of returns to get replicated. Usually, the first leg of a market rally is the sharpest. However, given the mediocre returns of equities over the past six years (even after the high returns over past one year), reasonable P-Es, cyclically low margins of companies in aggregate and improving growth prospects, reasonable returns may be expected from equity funds over 3-5 years, even from current levels,” added Jain.

What this means is that there is still time to invest in equity MFs. Opt for diversified funds, preferably those that tilt towards large-cap stocks. Avoid sectoral or thematic funds if you are a first-time investor.

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