Its real risk that matters, not perceived one

Dated: 1st January, 2018

General optimism with a hint of its excess buoyed markets up in mostly all parts of the globe. While  at the face of it, it might seem that an equity investor could not have  missed making money in 2017, but for me, it has been anything but easy.  The optimism seen in equity markets, especially in Indian equity  markets, roiled me with conflicting emotions throughout the year. The  price movements seen in most stocks that were held in the portfolio were  anything but par for the course. For example, Maruti Suzuki, my  favored auto stock in the portfolio, moved up about 30% in a span of  four months, mostly based on multiple expansion. Somehow when a dynamic  like such plays out in most stocks in a long-term oriented portfolio,  buy and hold becomes a difficult proposition as stocks reach their  assessed fair value or even become overvalued at an extremely rapid  rate. I clearly don't think that Maruti Suzuki should be valued at 40x  TTM with its close to 15% annual sales growth, even when its margin  expansion is taken into the equation. Extrapolating current trends  insanely into the future is a routine mistake that equity participants  in markets are prone to make, especially when majority of equity market  performance is a factor of optimism rather than fundamental earnings  growth. 

Almost everyone in India is  talking about the impending earnings growth that is likely to come in  the near future. Likewise in the United States, equity market optimism  is based on healthy earnings growth seen, although from what I assess,  it is not spectacular by any means at ~20% if we take into account the  buyback factor that has been in place for some years now. With oil no  longer in its 20s or 30s and yield curves in the US nearly flat (0.5%  odd differential), and the Fed and other central banks on an upward  cycle on base rates, it is but hard to see how equity markets can keep  going up as it has till now. By the looks of it, if the trend does  continue, we would be in a completely new territory that we have  probably never witnessed in the past. History will be rewritten and  cycles will break.

Till some months  ago, as I had alluded to in my past monthly updates, I have been  cautious in the later half of 2017 yet did not take action on it for the  most part. The portfolio now has cash at above 60% with mostly  opportunistic event driven names as holdings. None of them (RCom, JP  Infratech, and Bhushan Steel) are compounding machines but are  restructuring/ reorganization, cigar butt bets. My analysis concludes  that the risk of derating owing to factors I have not yet foreseen in  well-managed compounding businesses is much above the risk of almost  binary outcomes in the event driven names. Added to that, the allocation  to event driven names is at a significantly reduced level to control  overall portfolio risk. I believe that the risk-reward equation is much  better in my portfolio now than it was days back when the portfolio was  fully invested in good overpriced compounding stories.

Lately,  equity market experts have tried hard to discredit that notion that  equity markets may be expensive. They mostly cite the relatively lower  multiples we have witnessed than in 2008. Somehow, I see those arguments  akin to saying that previously, a 100-ton trailer went over a 90-ton  capacity bridge without harm, so a 95-ton trailer passing through would  be safe. On a relative plane of reasoning, this argument might make  complete sense but is crazy on an absolute reasoning plane. Even more  absurd is to judge the relative creditness of the system that existed in  2008 and now and somehow come to the conclusion that the markets are  safer than in 2008. 

It  may not be completely sane to think that valuations, creditness etc.  will have to reach previous levels before we see a revaluation of  equities. Explanations to why something should go up or down can range  from 'new normal' or 'my chicken has laid five eggs rather than four'  but ultimately if we try and assess from first principles as to whether  we are on overvalued territory or not, the best place to start is to  understand the current level of perception of risk.

The  rise in this phenomenon called bitcoin, markets not even pausing to  take a breather when there is a rise in fed rate, not discounting for  the fact, up or down, that oil price is going up again all point to an  environment where market participants, in general, have somehow gotten  past the era in their memory lane when markets could be decimating. That  in my view, is the real risk because it is then when equity markets may  start showing up its bloody head again. 

Timing  the market is impossible and I am not trying to, but to be cautious  when people show greed may be a useful mentality to have.