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The first six months of 2022 have been very difficult for the markets. The market indices hardly reflect the real damage across the asset classes. The largest losses have been in the crypto market. The total estimated loss to this segment is estimated at a whopping USD 2 trillion! The NASDAQ index has lost over 28% from its peak. All equity markets across the globe have got impacted.
In such an environment, It is very natural for investors to ask the question, “ Is the worst behind us?” or “Is there more pain ahead of us?” The Indian markets have done relatively well during the period with the Nifty 50 dropping 14% (in USD terms) which is much lower compared to the global indices. So, will Indian markets behave differently from rest of the world? Let’s explore these issues further.
So, what triggered the significant corrections in the global markets? The reason is known to all of us. Inflation fears have been lurking around and these got exaggerated with the war in Ukraine. Food and energy is the lifeline for every citizen and it is natural that as food and energy price started to rise, central banks reversed their stance on easy liquidity. And this triggered a meltdown across global markets. Is there more to come or will the anticipated demand contraction bring down the inflationary impulse? The markets are likely to remain volatile.
From an equity market perspective, It has been observed that bear markets usually start with a PE de-rating, followed by downwards earnings revision and final capitulation. The markets have seen the initial phase of multiple compression. Will there be a recession or a soft landing? If it is a recession, it will be one of the most anticipated one.
Copper to Gold ratio
Dr Copper is supposed to be the indicator of health of the global economy and gold the hiding place in case of crisis. Falling copper to gold ratio indicates nervousness regarding theeconomic outlook.
So, what about the Indian markets?
Indian markets have followed the global play book so far. The Nifty is down year to date by 14% in USD terms. Sectors with high valuations have seen sharp correction. There have been earnings cut for sector like metal and cement (driven by global factors)but overall market earnings outlook has not changed much. Valuation contraction has been the key driver for market correction.
The macro picture for India is reasonable relative to other emerging economies. India did not print excessive money during the COVID pandemic, inflation is a worry but driven by commodity prices and supply side dynamics. If the global commodity prices correct, inflation should start coming under control. High oil prices have resulted increasing current account deficit. The sharp currency depreciation is also a result of the rising USD. The fiscal situation will deteriorate given the higher fertilizer and oil prices but still not at alarming levels relative to other countries. Consumption growth is holding-up, government capex is likely to remain on track. However, private capex which is yet to pick-up meaningfully. Global factors more than domestic factors will be the key for downside risk to the Indian economy.
The Indian markets from a high of 24.5x have corrected to 17x forward earnings, slightly above the median valuations. India is unlikely to follow a different trajectory. In a recessionary scenario Indian equity indices can test the 12-13x multiples. If India were to see earnings down grade cycle it will be driven more by global factors.
So, how are we managing our portfolios at East Lane?
While we keep the macro framework in mind, our focus remains on bottom-up stock picking. We believe the current environment is giving us ability to patiently evaluate businesses which we would like to own for long-term. The macro environment is likely to remain volatile giving us opportunity to deploy capital in the right businesses at a reasonable price.
During the quarter we added to our position in Hikal Ltd (HKCI IN Market Cap US$400m). Hikal is a chemical company supplying active ingredients and intermediates to pharmaceutical, agro and animal health industry. The company has strong relations with global majors in each of the segment and is a strategic partner for several products.
Last 6 months has seen the stock price correct by 50%. The key reason being 1) Company had an unfortunate incident, where it was alleged that the company did not follow proper procedure regarding discharge of bi- product from one of its agro chemical plant, resulting in death of over 20 people in Gujarat, company refuted these charges stating that they had followed all proper procedures and the alleged incident was not caused due to any negligence or wrong doing on part of the company.2) Rising price of raw materials 3) Price correction in one of the key products Gabapentin.
Worst seems to be over for the company. 1) Company has had a favourable judgement from Gujarat High Court absolving it of any wrongdoing regarding the environmental issue, none of the customers have terminated contracts, 2) Pipeline of products over the next 2-3 years looks strong and 3) raw material prices have started correcting.
Company did suffer in the last 2-3 quarters given the above-mentioned issues and near-term could still be challenging. However, after the sharp price correction valuations at 13x FY24 earnings are attractive. Our longer-term thesis on the company regarding increased supply of ingredients to the multinational majors has not changed. As the earnings growth remerges, we believe the stock can re-rate back to 18-20x earnings.