Stock Market Turbulence - A model to follow

We live in extraordinary times. After leveraging till January 2008 and averaging till October, market participants are still gauging what hit them hard. Former Fed chief Alan Greenspan, who authored the bestseller An Age Of Turbulence, is now accused of causing much of theturbulence by keeping interest rates too low for too long and failing to check the explosive growth of risky mortgage lending. He admits he was ‘partially’ wrong in opposing the regulation of derivatives.

After years of unmonitored growth, the world is finally having to pay for the huge pile up in leverage, its casual attitude towards risk management, asset froths due to cross-border carry trade flows and step up in weapons of mass destruction (read derivatives). In a matter of months, the world has gone from a state of profound optimism to that of deep pessimism. The outbreak of US Subprime crisis in August 2007 has had a cascading effect on the world economy. Carry trade, the main liquidity driver, continues to unwind and a global flight of capital is taking place. Risk aversion has reached historic levels and even while central banks are cutting rates, financial institutions are unwilling to lend, resulting in capital turning insufficient and costly.

After nearly five years of unprecedented rise, the Indian stock market hit a roadblock in January 2008 and the Nifty’s then high of 6,350 has vanished from public memory. The tsunami of relentless selling has taken its toll on commerce. The cracks are now appearing in the profit cycle of companies. Volatility has risen sharply and it is fair to say that confidence is at an all time low. We are part of that world and theories like decoupling remain literature to be read at leisure.

History suggests that Indian bear markets last 3-4 years with up to 58% price corrections. In terms of price, we have already fallen below historical levels. Whether we will spend another 2-3 years from now in the bear zone is difficult to gauge at this point. The global economy is facing a recession and the extent of damage is such that healing could take a while. But having said that, unless one believes there is no tomorrow, economies will eventually find a way to resurface and markets will make the painful adjustment and move up again. On the brighter side, economic cycles are getting shorter.

Every dark cloud has a silver lining. There are positives to take away, even in bad times. During a slowdown, companies turn cost conscious and excesses are weeded out of the system. They get time to pause and take stock of their plans. A bear phase could often act as a healthy check and help cut down flab, which helps good companies emerge stronger. Another advantage of a bearish period is that it boosts a long term investor’s return by giving the opportunity to buy future winners at yesteryear prices. Even after the staggering fall since January 2008, Rs10 lakhs invested in Sensex companies in mid 2003 would have grown to approximately Rs30 lakhs today.

This simply re-emphasizes that equities have proved to be the best asset class in the long run.

“Most people get interested in stocks when everyone else is. The time to get interested is when no one else is.” – Warren Buffet

“For those properly prepared in advance, a bear market in stocks is not a calamity but an opportunity” – Sir John Templeton

Investors have in recent times paid the price for not being fearful when others were greedy. The reverse holds true now. The time has come to be greedy as others turn fearful. Investors with a 3-year horizon should see opportunity in these adverse times. That does not mean you rush to create wealth overnight. The best way to create wealth is to build a portfolio of fundamentally strong companies which will bounce back stronger in the years to come. When the dust settles and the world economy stabilizes, India will be among the first to race ahead. The best bargains are now available at the equity shopping mall. But deep discounts need not necessarily mean value for money in the long term.

Keeping in mind a 3-year horizon, we have built a model portfolio of 12 stocks with assigned weights. We believe IMP strikes the right mix as our chosen stocks are:

1) Companies that are adequately funded with low financial leverage and will therefore, not be severely affected by reversal in credit cycle

2) Businesses with reasonable earnings visibility even in this uncertain environment

3) Value buys that will be less damage prone to the high volatility in markets

4) Growth stories with an element of inelasticity in demand

The India story cannot be thought of without giving enough importance to rural themes. Rural India is not much susceptible to a slump in the stock market or property market. Three consecutive years of good monsoon, farm loan waiver and benefits accruing from the ‘Bharat Nirman’ and ‘Rural Employment Guarantee’ programs provide enough proof that demand will sustain even as the broader economy loses steam for some time. Some of these forma part of the IMP.

Attractive bargains often tempt people to spend more than they can afford. We advise you to resist such temptation and gradually add stocks to your portfolio. We are confident the IMP will strengthen your portfolio and outperform the benchmark (Sensex). Take your time to build a strong portfolio. After all, Rome wasn’t built in one day.

You won't get there by reading 'Now is the time to buy.’ – Peter Lynch

“Uncertainty actually is the friend of the buyer of long-term values” – Warren Buffet

A Model Portfolio of 12 stocks with assigned weights :-

1.Bharti Telecom 10.0 Market leader with high visibility; impressive return ratios

2. BHEL Capital Goods 5.0 4.2x Order backlog/Sales; well funded for executing capex plans

3. CESC Power 6.0 Capex on track; trading at 60% discount to peers

4. Cipla Pharma 4.0 Continues to outperform guidance; benefits from INR depreciation

5. Gail Oil and Gas 5.0 Increased gas supplies to drive core business of transmission

6. Hero Honda Auto 5.0 Gaining market share; riding on rural growth

7. Jindal Saw Pipes 5.0 High order book and margin improvement to drive earnings

8. M&M Auto 5.0 Rural play: Tractor and Bolero growth to remain strong; trading below BV

9. Marico FMCG 5.0 Highest growth among peers - trades at a discount; 25% sales from rural

10. Reliance Ind Oil and Gas 17.0 Commencement of KG-D6 and RPL growth drivers

11. Sun Pharma Pharma 4.0 Low risk business model in the industry; robust balance sheet

12. Tech Mahindra IT 7.0 High revenue visibility vis-a-vis peers; best play in IT