Indian Equities Reset: Quality now matters as much as price

Over the past year, several equity investors ignored (even though they were reminded frequently, including by yours truly) almost frothy, bubble-like valuations in the Indian equity space. This mania, largely driven by irrational optimism, has now died down and many are painfully realizing that there is nothing guaranteed about stock-market returns. To top it up, the war in the Middle-East has further negated the sentiment. India, especially, has been hurt given its vulnerability around energy dependency. It is important to be mindful that this is still a temporary exogenous shock and not a structural risk to most businesses. Will this affect stock prices in the shortterm? Of course, it could especially if it leads to higher inflation and higher interest rates. In that case, would you be better off staying in cash or buying equities (that have pricing power above inflation) if multiples continue to compress (cheap can always get cheaper if war persists)?

Cash is a useful weapon in the armoury when valuations are stretched, as they were over the last two-three years. The key question going forward is have multiples reduced to levels that make it financially rewarding from the perspective of buying Indian stocks? This question is primarily aimed at long-term investors who pick individual stocks rather than those who passively invest via index funds ( S e n s e x / N i f t y 500/S&P500). The latter are agnostic of valuation/ quality of the underlying holdings. Terry Smith (an investor at Fundsmith-UK) has called index investing the ultimate “momentum strategy in which the investor buys stocks that are performing strongly”. In many ways, this isn’t very different from buying stocks that are only going up (regardless of fundamentals) as stocks are added/removed from the index based on their market value.

Just to digress a bit from the primary question (if valuations have become tempting for stock-pickers), it is important to first address the valuation question from the index pointof-view. It is now widely accepted wisdom that index investing works and the world must thank John Bogle (he launched the first retail index fund at Vanguard) as this is probably the greatest wealth generator of our lifetime. Anyhow, what many may be unaware of is that there have been long periods where index investing has underperformed cash. In the context of S&P 500, one only needs to glance through the performance between 1966-1982 and 2000-2012. This is in stark contrast to financial gurus on TV who proclaim that one’s investment time-horizon should be three-five years at most. No, if you are looking to make money via index investing, your time horizon needs to be a decade at minimum. Nifty-500 is currently trading a multiple of 22x and it was consistently trading below 18x before 2014. Make of that what you will.

Now, speaking of valuation for specific companies, there has been a “clear derating of Indian stocks” as some investors have frustratingly pointed to. There are pockets of pain & panic and some opportunities seem like lay-ups for longterm investors. At the same time, as domestic investors took the approach of “there is no alternative to India” and confused high growth rates with high stock returns completely ignoring the entry price (fortunately, capital is mobile and always finds a way to make lucrative returns elsewhere), they have now become obsessed with valuation to an extent that nothing else matters. Again, if you are a closet index investor, this might not matter to you but if you pick individual stocks, valuation should matter as much as the underlying quality of the business.

What quality means here: businesses that have structurally powerful and sustainable inter-linked moats (competitive advantages that include: high barriers to entry, low competition/monopoly, no threat from product substitution, network effects, economies of scale, brand/IP, high switching costs, irreplaceable physical assets and predictable sources of revenue). India has idolized Warren Buffett (and rightly, so) who has probably been quoted far more than even the sole figure on our currency notes: Gandhi. Buffett’s mantra of buying good companies at fair prices has resonated with many but it’s time India learns about Chris Hohn (compounded capital at close to 20% for 23 years). To quote Hohn: “in a financial world of distractions, focus on quality.”; “the sustainability of moat is the real deal”; “narrow your investable universe to 200 high-quality companies”. In other words, it is important to buy good companies at fair prices but it might be even more important to buy good companies that are actually getting better (no business is static by nature, it’s getting better or worse).

Now, consider the opportunity set in a few pockets within India: The IT space now looks fairly cheap on a traditional multiple (around 15x earnings) and maybe this could work as a trade for many. On the other hand, if you’re a “looking to invest in quality companies” (the key word being “invest” and not “trade”) would you pick the likes of Infosys, TCS over a Meta/ Alphabet (US) or a Tencent (China)? Meta, Alphabet and Tencent are all aggressively investing to defend their competitive position and could end up as massive AI beneficiaries. Similarly, consider private banks in India which have become the poster-child of low-valuation. Again, they might be statistically cheap but would you be better-off investing in payment companies (Mastercard/Visa) that have strong network effects and high switching costs? Both of these might not look interesting to traditional value investors but it is important to judge valuation with regard to quality of the business. Take another example of hotels in India. The top-tier names include Indian Hotels Company (Taj) and ITC Hotels. Both are phenomenal companies and yet trade close to 30x earnings, much higher than Hilton or Marriott (23x earnings). Both Hilton & Marriott generate higher returns on capital, benefit from brandrecognition and global presence (not just exposed to a single market in India).

The crux of the argument is that Indian investors have played this game like most Indian entrepreneurs for far too long: sticking to India and focusing on Indian revenue growth/margins. Buying the dip has worked for so-long and it might work again for Indian equities but if one has to actually form an investable universe of 200 high-quality global stocks (to quote Chris Hohn again: “most companies - 95% of them - are mediocre or bad companies”) then how many of those names will realistically come from Indian stocks? The point isn’t that Indian stocks will not do well (if stocks get cheap-enough, they can also produce great returns) and nothing here is investment advice but more Indian investors need to broaden their investment landscape (helps as a buffer to global shocks) and focus on quality as much as valuation.

THE VIEWS EXPRESSED BY THE AUTHOR ARE PERSONAL

Arihant Panagariya, The writer is a Portfolio Manager at Hundred Ten Capital in London and a graduate of Columbia University