Market dip makes large-cap stocks reasonably valued

Market dip makes large-cap stocks reasonably valued

 

Investors are not grabbing these opportunities and are not resetting return expectations either

If stock market returns of 2014 are an indication, should it mean that similar returns are going to be possible every year?

Is investing in equity always supposed to give double-digit returns year-on-year? No. This sky-high expectation is built on a wrong assumption, and it’s illogical to expect year-on-year returns in the high-double digits from the market.

Stock market returns in 2014 were a combination of deep undervaluation, which has since risen significantly to fair value levels. The year made investors mistakenly believe that stock market returns have to be positive every month, and high every year. This expectation has to be reset.

Realistic outlook

One cannot get positive returns from the stock market every year, let alone it meeting return expectations of 25-30% per annum. Stock markets are known to hit investors with negative returns every now and then. The derivatives market is another place where people believe that they will get more than 20% returns. Consequently, whenever there is an unwinding of speculative positions, markets correct. And whenever such corrections take place, investors see only gloom, which is not logical at all.

Having said that, equity assets are good investments to make for the longer haul, such as for three to five years, especially with economic reforms taking place. The economy is now recovering slowly and there are some signs of a pickup in investments along with the government increasing its spending.

However, investors are not taking advantage of these opportunities that an unwinding of speculative positions sometimes offers. By investing during market dips, investors can get more mutual fund units, for instance, for the same amount of money as opposed to when markets are at higher levels.

One such opportunity passed by recently. Due to a series of negative news, including the Greek debt repayment crisis, globally, stocks took a small breather and corrected, presenting a good opportunity to invest. These investing opportunities may not come all the time. But whenever they do, stay alert for a quick investment—whether small or big—in equity assets.

Don’t bank on leveraging

While the outlook is good, equating the structural growth story to the 2002-07 cycle is irrational. We started the 2002 cycle with very low leverage, and we over-leveraged to the extent that deleveraging is still continuing in infrastructure and real estate. It is a known fact that during a deleveraging cycle in infrastructure and allied sectors, growth cannot accelerate.

Currently, the rest of the economy may be leveraging, but that may not lead to a situation where you could see significant returns from the market. This is because you need infrastructure and real estate to begin the de-leveraging cycle. That appears to be at least two-three years away.

Valuation gap in large caps

There may be a few opportunities in the mid-cap space, but if you are looking for undervalued stocks, there are more opportunities in the large-cap space. Over the past few months, plenty of funds entered into the mid-cap category, as a result of which, these stocks appear to have crossed the rich valuation zone. Some of these funds are likely to move into large caps now and begin the switch from mid caps purely from valuations perspective .

I am from the camp that believes mid-cap stocks are relatively expensive; even today. In fact, about six months ago, we had a similar view that large-cap stocks were quoting on the higher side. But since then, some large-cap names have corrected. A few notable quality names have corrected in the consumer, pharmaceutical and information technology sectors. So, investors have an opportunity that is ripe for the picking in the large-cap diversified equity funds space.

One point worth a mention is that while the market is up significantly from the levels where the bull run in equities started back in October 2013, we are still distant from the overvalued or bubble territory. Sure, equity valuations are above average, but only marginally above the mean.

We have been seeing over the past few months that the market is quick at pricing quality companies at higher levels. This could make it difficult for investors to get better price bargains in quality large-cap stocks sometime down the line. So, perhaps a prudent strategy for now may be to invest in good quality companies whenever there is a valuation gap, as we are seeing at the moment. One may reap the benefit of this by investing in large cap funds for wealth creation in the long-term.

Happy Investing