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Put The Seat Belt On

Author: Swapnil Pawar/Thursday, May 1, 2014/Categories: Stocks

Put The Seat Belt On

If we are to believe street opinion and the surfeit of opinion polls, a government led by NDA might become a reality soon. In this article, we explore the likely fallouts of such a development on the capital markets and its implications for investors. We are not implying our concurrence with the popular view here, nor are we taking a stand against it. We are simply focusing on what might lie ahead if this does come to pass.
Why bother just now when we can wait till 16th May, find out who won and then decide our strategy? Short answer – because we are human! Should the NDA achieve majority on May 16 and form the government, most experts would start competing on how high a Sensex target they can publish, FII inflows will surge, Rupee will appreciate, bond yield would fall and a general climate of positive sentiment will prevail, at least till a few months after the event. In such a climate, the worries of policy paralysis, tapering by Fed, inflation might start to seem like a bad dream long forgotten. Very soon, a slew of new financial products would hit the market – targeted at capturing the boom that most believe to be a near certainty. Most investors, faced with all of this, are likely to make investment decisions driven by ‘recency effect’ and over-optimism. In this article, we explore some likely excesses and ways to steer clear of them.

1. Over-exposure to equities
While most product manufacturers will be right in their part in launching equity based products (including specific high growth sectors like infrastructure), investors should bear in mind that equities are a risky asset class and they should maintain their asset allocation decisions even in the face of euphoria. Just as last year was not necessarily a good time to prune equity holdings to zero, this year even after a pro-reforms government will not be a good time to take equity allocation to near 100%. Of course, many retail investors had continued to exit equities through 2012 and 2013. Hence this advice might be unnecessary for them so long as they choose to return to equities only to the extent of a prudent allocation.

2. Investing aggressively in products with long or very long lock-ins
In times of optimism, many products with long lock-in make an entry. Many of these are based on market performance over three to  five year horizon. While a limited exposure to some of these products can boost returns from long term growth, some of these products also tend to have point of time risk (say market levels as of April 2017 in particular). Closed ended mutual funds which become open ended after a lock-in are safer alternatively since they avoid the point of time risk. However, investors would do well to remember that a lot can change in 3 or 5 years – fundamentally altering an investment thesis. The investment in such products should be limited to less than 10% of the portfolio.

3. Investing in exotic products
In the last bull-run, many products like wine funds, art funds and even timber investments in Latin American countries were being offered to investors. The managers of these products were generally bona-fide and their investment theses were also usually sound when considered in isolation. The trouble lay with the investors – more specifically their lack of awareness about the product’s risks and rewards. In general, investors underestimated the risks. Similar or even more exotic product ideas will do the rounds this time as well (in case of an NDA led government and the subsequent bull-run). Not all will be inappropriate for investors. However, investors should spend time in deciding whether they accept the investment rationale or are merely getting swayed by the general positive sentiment.

4. Overdoing the sectoral re-allocation
During bullish times, sectors such as infrastructure, real estate and automotive perform quite well – both fundamentally and in terms of share prices. Often enough, the share prices tend to over-react to the good news. Considering the depressed valuations of most stocks in these sectors, that over-reaction seems far. However, the swings in the prices of stocks in these sectors tend to be sizeable enough for over-valuations to appear within a few months of being undervalued. It is quite sensible to restructure one’s portfolio in favor of these sectors if a reforms-oriented government comes to power. However, a reallocation is much more sedate response than a complete reorientation e.g. moving the weight of infra stocks in the portfolio from 5% to 15% would be re-allocation, moving it to 50% would be over-optimism and highly risky. The converse is also true. Reducing weight of defensive sectors like FMCG and IT would be sensible but taking time to near zero is akin to removing the stabilizing influence they might exert during turbulent times in future.

5. Assuming that all boats will be lifted in the positive tide
To some extent all stocks will benefit from a sweeping positive sentiment and inflow of capital into equities. However, as the euphoria settles down, the men will be separated from the boys. Those stocks that genuinely benefit from a potential economic turnaround will continue to hold up in terms of valuations. Others that turn out to fare not so well even in the newly positive environment will get beaten down eventually. It is important to appreciate that all good times are not alike. Hence a company that did well in the last bull run need not do as well this time if there is a bull run. Business environment changes in complex ways over the years and across business cycles. The winners of this bull-run might have some commonalities with the list of previous winners. But there will be additions and deletions from the list. Venturing into a stock (especially mid-cap and also not a market leader in its domain) simply on the basis of history is recipe for trouble. What are investors to do then? Either get good advice on which stocks are fundamentally sound and well positioned to benefit from revival or stick to large cap established names. In the short term, there will be many stocks that will show returns twice or more than the bigger players. In absence of fundamentals, these very stocks could plummet to less than 20% of their peak value.
All of the above points in the same direction – don’t get greedy along with everyone else! Watch your asset allocation, sectoral diversification and large-cap to mid-cap split.

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