Sensex at 80,000! How to Approach Equity Mutual Funds Now
July 10, 2024 Mutual Fund
The bellwether, BSE Sensex hit an all-time high of 80,392.64 points last week (on July 4, 2024). This is stupendous for the Indian equity market amid rising geopolitical tensions and various other key risks, such as tightening global financial conditions and capital outflows, among others.
It is perceived that despite these risks, India’s strong macroeconomic fundamentals and financial system soundness augur well for sustaining the growth momentum and withstanding global shocks.
India is viewed as a “bright spot” – the fastest growing economy major economy — with several structural reforms being rolled out by the current dispensation, a significant rise in government spending for sustainable economic growth, the sovereign rating outlook has been recently upgraded to ‘positive’ from stable, and the country is enjoying a favourable demographic dividend.
With Prime Minister Mr Narendra Modi getting a third term — though this time not with a clear majority, but instead with the support of the alliance partners such as the TDP and JDU — hoping policy continuation, stability and a big push in the Modi 3.0 budget (which will be presented on July 23, 2024), the Indian equity market is continuing its northward journey, creating wealth for investors.
A National Stock Exchange (NSE) Report cites that higher-than-expected GDP growth and strong corporate earnings have boosted investor confidence.
Graph 1a and 1b: Performance of Nifty 50 and Other Benchmark Indices and PE Ratios
Past performance is not an indicator of future returns.
(Source: RBI Financial Stability Report, June 2024)
However, as we scale new highs, it is also important to recognise that valuations aren’t cheap. Relative to many of their global peers, Indian equities are trading at a noticeable premium.
Graph 2a and 2b: Indian Equity Market vis-a-vis Global Peers and P/E Ratios
Note: Trailing P/E Ratios taken.
Past performance is not an indicator of future returns.
(Source: Refinitiv, NSE, MSCI, as per RBI Financial Stability Report, June 2024)
The Morgan Stanley Capital International (MSCI) India Index Price-to-Equity (P/E) Ratio is over 26x, while the MSCI Emerging Markets Index and MSCI World Index trail P/Es are around 16x and 22x (as per the latest factsheets). Even on a 12-month forward P/E, India is commanding a premium vis-a-vis emerging markets and the world.
Table 1: India’s Current Market Cap-to-GDP Ratio
Based on historical values, divided into five zones.
Data as of July 7, 2024.
(Source: https://www.gurufocus.com/global-market-valuation.php?country=IND)
At present, India’s market capitalisation-to-GDP ratio, famously called the Buffett indicator (named after legendary investor Warren Buffett), is in the ‘modestly overvalued’ zone.
Now, while India’s valuation premium may seem justified since it is the fastest-growing major economy, at these elevated levels the margin of safety, particularly in smallcap and midcaps, seems to have narrowed. Clearly, there is froth building in these market cap segments (as pointed out by the capital market regulator earlier this year) with many investors chasing them for high returns.
It should be noted that in the case of smallcap and midcap, the valuations are even more expensive than largecaps. The Small Cap Index-to-Sensex ratio is around 0.7 vis-à-vis the long-term median of 0.4. Note that, previously, when this ratio hit 0.6 in 2018, it led to a crash in mid and smallcap crash in 2018-19. Now, I’m not saying smallcap and midcap will crash but you surely ought to be careful.
[Read: Small Cap Index Near an All-time High: Should You Rejoice or Worry?]
Keep an Eye on Corporate Earnings
Fortunately, in recent years, corporate profit growth has managed to surpass the GDP growth rates due to top-line growth and improvement in net profit margin. India Inc.’s profit share in GDP was at 5.2% in FY24. The Nifty 500 companies have grown at the fastest pace.
That said, it would be pointless getting carried away by over-optimistic earnings estimates. Also, don’t live under the impression that earnings would improve linearly quarter-on-quarter.
Going forward if earnings do not keep pace and meet market expectations, there is potential risk. The equity market cannot continue to scale new highs on irrational expectations and exuberance.
Watch Out for the Risks
The RBI in its latest Financial Stability Report (released in June 2024) has cited the key risks emanating from geopolitical risk, tightening global financial conditions and capital outflows, among others.
Graph 3: Potential Risks to Financial Stability
(Source: RBI’s systemic risk survey May 2024, as per RBI Financial Stability Report, June 2024)
Keep in mind that if geopolitical tensions increase, it could have a bearing on FPI flows, global financial market volatility, supply chains, commodity prices (resulting in inflation), and the returns of the equity markets.
So, as a thoughtful investor, you cannot be oblivious to these risks and the fact that India’s current valuation premium is ringing a warning bell.
In such times it’s important to pay heed to the famous quote, “Be fearful when others are greedy, and greedy when others are fearful,” shared by the legendary investor, Warren Buffett.
Hence, approach the equity with prudence by devising a sensible strategy instead of investing in an ad hoc manner or mindlessly going gung-ho and skewing the portfolio to smallcaps and midcaps.
Follow the Core & Satellite Strategy
When investing in equity mutual funds, it makes sense to follow the time test ‘Core & Satellite Strategy’ followed by some of the most successful investors around the world.
The term ‘Core’ refers to more stable and long-term holdings that could potentially multiply your wealth with stability.
At this point, largecaps seem a better option to approach Indian equities. Quite a few large cap funds have outperformed their benchmark index in the last 2 to 3 years by taking tactical portfolio calls sensing the mood and momentum.
Largecap funds make perfect sense in an overheated market. What matters is that you hold some of the best Large Cap Mutual Funds in your core portfolio. Want to know which are the 4 Best Large Cap Funds for 2024? Watch this video:
Other than largecaps, you may also consider adding some of the best Value/Contra Funds and Flexi-cap Funds as part of your core equity mutual fund portfolio.
Your allocation to the aforementioned types of equity schemes could be around 65%-70% of the equity mutual fund portfolio, and the investment time horizon of at least around 5 years in all these funds.
The ‘Satellite’ portion of your portfolio, on the other hand, could be around 30%-35% of the equity mutual fund portfolio. The term ‘Satellite’ refers to the strategic portion that would help push up the overall returns of the portfolio with relatively high risk. Thus, make sure you have the stomach for high-to-very high risk and a longer investment horizon.
In the ‘Satellite’ portion, you could have one of the best mid-cap funds and a couple of aggressive hybrid funds, and if you have a very high-risk appetite, then one of the best small cap funds. For a small cap fund and a mid cap fund, particularly, you ought to stay invested longer, at least around 7 to 8 years. A longer time frame may alleviate the downside risk if the broader markets correct in the near term (due to any macroeconomic and geopolitical uncertainty in play).
Have a Tactical Allocation to Equity, Debt, and Gold
You see, not all asset classes move in the same direction always. In some calendar years, like in 2015, 2016, 2018, and 2022, equities have disappointed investors while other asset classes, such as debt and gold have fared better.
Hence, it would be meaningful to follow a multi-asset approach when investing. In this regard, a Multi-Asset Fund would be appropriate providing you with tactical allocation to equity, debt, and gold in the wealth creation journey.
How to Invest – Lump Sum or SIP?
At a market high, it would be wise to stagger the lump sum investments. Don’t postpone your investments when planning for your envisioned financial goals.
Or even better is or even better making SIP investments, to address the envisioned financial goals. SIPs with the inherent rupee-cost averaging feature shall help handle the volatility, add investment discipline, and potentially generate wealth for you.
[Read: 5 Key Benefits of Investing in Mutual Funds via SIP]
To sum up…
By wisely structuring your mutual fund portfolio considering all the factors in play, you would potentially earn optimal risk-adjusted returns, enabling you to accomplish your envisioned financial goals.
Ensure that your portfolio is well-diversified in the year 2024 and beyond. Asset allocation is the cornerstone of investing.
Hence, considering your age, risk profile, broader investment objectives, the financial goals you are addressing, and time in hand to achieve those envisioned goals, ensure you are following the right asset allocation mix.
Asset allocation serves to be a strategy in itself and potentially mitigates the impact of uncertain and volatile market conditions.
The overall returns your equity portfolio would clock shall hinge on your asset allocation best suited for you, the type of schemes held, and the performance of their underlying portfolios. Note that at a market high, it is important to tone down your return expectation.
[Read: Are You Setting Your Risk-Return Expectations Right While Investing in Mutual Funds?]
Be a thoughtful investor.
When in doubt, don’t hesitate to reach out to a SEBI Registered Investment Advisor.
Happy Investing!
This article first appeared on PersonalFN here
