An Unselective Approach To Investing

Some of the news during the last week was good. There are several potential vaccines in the pipeline, including at least one from India. The number of daily Covid-19 cases may be close to peaking. The economy is gradually reopening.

The stock market gained, with the Nifty up by 2.5 per cent week-on-week. That takes current price-to-earnings (PE) for the index up to the 28x levels. Optimism is all very well. But these valuations are irrational. To justify a 28 PE, you need earnings growth at around the same level (28 per cent) and that’s unlikely with corporate advisories uniformly negative, or cautious. Markets eventually revert to rationality, which means we could be in for a second steep correction sometime.

June has seen a broad rally. The Nifty is up 6.5 per cent, mid-cap indices were up 9 per cent and small-caps were up by over 11 per cent. The June rise was partly sustained by Rs 21,000 crore of net equity buying from the foreign portfolio investors (FPIs), but they have turned sellers in the first three sessions of July.

Equity mutual funds have seen inflows of roughly Rs 5,000 crore which is on the lower side but positive. Domestic institutional investment was net positive but not very high at an estimated Rs 2,500 crore. Given excellent daily volumes and a wide spread of gainers, direct buying from retail investment has been a major contributor to the bull-run in June.

This could be called a premature relief rally. It comes after a long period when economic activity more or less stopped. It’s been driven by a combination of high liquidity and a lack of alternative investment avenues.

Let’s look at some high-speed indicators. The PMIs indicate that both Services and Manufacturing are still contracting but slower. Since PMI is a month-on-month indicator, this isn’t a particularly good signal since the base month, May 2020, was extremely low.

While auto sales climbed steeply in June over a base of practically zero in April and marginal sales in May, the June 2020 sales were about 50 per cent lower year-on-year compared to June 2019. This suggests big-ticket consumption remains badly below par. It may take six months or longer before we see auto sales back at reasonable levels.

GST collections recovered to around Rs 90,000 crore. That’s a good number, just 10 per cent or so less than the Rs 100,000 crore, which is considered normal. Exports and imports are down, the latter more so, which gives us the silver lining of a current account surplus. But low imports also indicate industrial demand is low. Among other indicators, the Railways are still not running most passenger services. Aviation traffic is still well below par. Power demand is down.

However, while optimism looks premature, it’s also wrong to read too much into disappointing numbers and get over-pessimistic. Starting March 20, and all through April and May, the economy was shut down. This means peculiar base effects that will last for at least a year. The current quarter (July-September 2020) could show marked improvement over April-June while still being poor compared to last year.

One thing is sure. The Gross Domestic Product (GDP) will contract in 2020-21. There is no way the economy can grow fast enough in the next nine months to compensate for Q1 loss inactivity. The IMF projects 4.5 per cent GDP contraction in 2020-21. That could be an underestimate, or an over-estimate since error margins are high.

The biggest sectoral gainers were the PSU Banks, with the index rising almost 20 per cent. However, most sectors were up. Even underperformers such as metals and pharma gave positive returns.

Institutions tend to buy large-caps and mid-caps. The small-cap rally has been driven entirely by retail and the data suggests a shotgun approach. Instead of picking specific targets, retail investors have bought everything in an indiscriminate fashion. This unselective approach may work in uncertain times when it’s difficult to pick specific businesses that could do well.

Here’s how the logic operates. Some of these stocks will turn into multi-baggers but it’s impossible to know which ones. So by buying a large, almost random selection, you will also pick up some of the multi-baggers. The danger, of course, is the stocks that don’t turn into multi-baggers will see so much capital loss, the net returns will be poor.