The market has run up over the last two-three months in spite of a fall in earnings and an uncertain outlook. Which pockets currently offer value? How can one differentiate between a value opportunity and a value trap in general and in the current context in the aftermath of the pandemic?
COVID-19 pandemic hit the world abruptly at the beginning of the year bringing economic activity to a grinding halt. The subsequent market meltdown offered some of the best conditions that allow for possible value investing opportunities to emerge in the marketplace. The world has now moved beyond lockdowns and is in the unlock mode, whereby economic activities and mobility indicators are on an improving trajectory. Central banks across the world have responded to avert liquidity shocks and related business failures, and reduced policy rates to spur growth.
In India, like elsewhere in the world, markets have therefore celebrated the first phase of return to normalcy in economic activity. A good part at this stage, however, appears to be the restoration of supply-side normalcy, which is easier to judge as factories start humming again. The picture on demand, however, is only partially clear in certain sectors and will likely take time to recover and become more broad-based. Riding on liquidity and improving activity indicators, the stock markets have staged a sharp recovery and quickly priced in quite a lot of the available value in the system. The benchmark valuation multiple has moved beyond the long-period average and in the short-term, the performance can even be termed as 'too fast, too soon'.
'Value', in the more traditional sense of the term, is commonly seen when industries or businesses are going through a period of stress or, less typically, when there is a severe dislocation in the overall market (as was the case recently during March-April 2020 at the height of the COVID-led crisis). At times like these, market prices of assets move materially below their long-term intrinsic value, thereby creating value-investment opportunities. During such periods, markets tend to considerably over-emphasise the short term and significantly disregard the long-term earnings power and value of a franchise. Under normal economic conditions, value opportunities are more business- or industry-specific and in a growth economy like India, generally result when a business or industry suffers from an adverse growth cycle.
Normally, we come across two types of value investing opportunities: (1) when markets take a dim view of the medium-term growth prospects of any enterprise or (2) when there is pessimism on continuity of even the present cash flows of a non-growth business. Inexpensive valuations do become a good starting point while seeking value but in doing so, one must guard against franchise or balance-sheet risk.
Value opportunities can degenerate into a value trap when there are conditions that result in a more permanent impairment of the earnings power of any business or industry or the perception thereof. Value-oriented strategies or contra bets do run with the risk of delayed turnaround or value traps. Delays in turnarounds are easier to deal with by (1) buying at valuations that provide the necessary downside cushion in the event of such delays and (2) ensuring that one avoids taking balance-sheet risks of the investee companies, even while assuming P&L risks. Changes in the competitive landscape, technology-led disruptions or product redundancies generally precede value traps. Many of these are identified and filtered at the stage of initial investment due diligence with the help of our investment process. However, one must acknowledge that value traps can become evident at a later stage of ownership of a business as well and the speed of response of fund managers in mitigating their impact on the portfolio is crucial under such circumstances.
The initial round of market recovery has disproportionately belonged to sectors where earnings recovery has been faster to visualise, such as staples, healthcare and technology, besides businesses geared towards the rural-consumption theme. In phase 2, it stands to reason that it will be the tier 1 locations that would now begin to emerge from the lockdown. As that unfolds, in our view, sectors such as banking and financials, parts of consumer discretionary and industrials would be from where the next set of value opportunities may likely emerge.