Equity Markets - Where We Are, Where We Could Be

Getting some very basic points out of the way. Please excuse us if it is base level basics but we thought it will be useful to put them out first:

• When we buy equity, either shares or through mutual funds, we are essentially taking a part ownership into someone's business. As long as the business is being run well, the value of the business should go up.
• When instead of equity, we give a loan, there can be a zero-or-one situation: if the business goes bad, we might not recover our money or we get into long litigation to recover. In equity, there are always possibilities of the business getting revived. New management can step in.
• Now all these companies are listed on the exchange. Which means we can enter or exit any time. While that's great, when you are listed, you get integrated with an entire eco-system called equity markets. Good promoters don't bother about markets per se. While they are conscious and must be towards their shareholders, they don't usually let extraneous factors, like country specific issues, geo-politics, or some global factor like the yen unwinding, which will impact their stock price, bother them. They look at all this as par-for-the-course, that all this is expected when you are listed.
• But there are some who go out of the way to influence their share price. We have had so many such instances where promoters have engaged market operators. The regulator has been off late, urging investors to be mindful. It is evident when you consider the valuations of many stocks which are in bubble territory. While you might consider these as opportunities, it is important to know when to exit. Specially when friends talk about jackpots they have hit, it could play on your mind.
• Manipulations can be done in many ways. There is no end to human ingenuity. Some can be done in highly sophisticated ways in violation of all market norms. If, as and when, these come out, and they have, naturally those stocks take a huge knock. Importantly, if the underlying business is good, has cash flows, things can always recover. A new management team can step in. Satyam Computers is a classic example.
• However, depending on the scale and size of operations, such companies can also pose systemic risk, which can have much wider ramifications on the markets.
• Usually, most equity mutual funds and PMSs avoid getting into such stocks. They may not look good in terms of returns for some time, but professionally managed funds prefer to be consistent with their philosophy and focus on quality. And at Serenity Wealth, we prefer working with such funds.

With the Above Backdrop, What Is Our View?

• It is well accepted that market valuations are expensive.
• Interestingly, markets usually do not correct because of valuations. They correct because of an event. Post which, the argument over valuation follows. Until then, markets can become more and more expensive. World history is replete with such examples.
• The broader markets in India, barring certain stocks or sectors, are yet below to upper end of the valuations. So while expensive, we are within the historical bands.
• The critical part is the E, the denominator of the P/E ratio where P is Price and E is Earnings. Companies which we own, directly or indirectly through mutual funds, should keep growing if they have to justify high valuations or the future should look promising. Honestly, jury is out on this point. We believe that in most parts of the market earnings growth is inadequate to justify the current valuation.
• It is important to note that mutual funds are almost always fully invested. Even if they cannot find companies which fit their parameters, they would still buy, as the assumption is that the investor has given them funds meant to be deployed in equity. And that the investor has done their math.
• The math of how much equity they need. At Serenity Wealth we use various risk parameters like Risk Need, Risk Tolerance, Risk Ability, Risk Awareness to help our clients arrive at the decision of how much equity they need or they wish to have. We like to submit that our risk framework is amongst the most comprehensive in the industry.
• Classic human behaviour in times, such as what we have seen last year or so, is to lower their guard, take more equity than what they need to or what they can tolerate. Which if the situation reverses, can lead to avoidable panic.

Specific Action We Suggest

• Establish whether you need to have the equity exposure you currently have, or establish how much drawdown you can tolerate.
• We try and ensure that every client has a clearly defined investment policy, which itself sets the rules specifically how much equity one should have.
• So the action is simple - the excess should be pruned. We are no soothsayers. So we are not saying that markets will fall. That is also not the right question to ask. What needs to be asked is: are we ok holding the amount of equity we are?

The right starting point is not whether the market will fall. It is whether your current equity exposure is aligned with your actual need, tolerance, and ability to stay the course.