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Who has run the Extra Mile: Ferrari or Sedan? - Outside View by PersonalFN

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Who has run the Extra Mile: Ferrari or Sedan?
Dec 27, 2012

The fuel prices in India have been heading northward so as the markets this year. We are likely to close year 2012 on a positive note with decent gains at index level. Despite difficult economic environment globally as well as in India; markets have remained strong and have rebounded sharply from the dips. Sedans and Ferraris have also been driving in top gear. Now it is crucial to see whether they can continue their run on the fast track or are they soon going to run out of fuel.

Who's the front runner?

The year 2012 clearly belonged to mid & small caps. As depicted in the chart below, BSE Mid Cap and BSE Small Cap dominated the show right from the beginning of the year. After the initial spike up witnessed in first quarter of the year, markets underwent a phase of consolidation. While on the downside, midcaps performed in line with the large caps; in each upmove they outpaced the large caps. A decisive rally in midcaps has escalated since mid-September which still continues.

Smaller Companies: Flavour of the season

(Source: ACE MF, PersonalFN Research)

Every Rs 100 invested on January 2, 2012 in BSE Sensex, BSE Midcap and BSE Smallcap; would have returned Rs 124, Rs 136 and Rs 132 simultaneously as on December 21, 2012. Midcaps have gone from strength to strength especially since September.

What helped markets post these hefty gains?

There have been several factors which triggered a rally in broader markets this year. On the onset of the year, global markets were reeling under the pressure of Eurozone crisis. Germany was on the verge of slipping into another recession and France was downgraded by S&P. However, there were some India specific positives which helped market shrug off the bad news disseminating from developed economies. The double digit inflation which was a cause of serious concern throughout 2011 eased remarkably towards the end of 2011 and trajectory of inflation lowered significantly in 2012. However the pace of economic growth slowed considerably and industrial growth as well as investment cycle showed no signs of revival. As a result, monetary policy of Reserve Bank of India (RBI) became more accommodative and pro-growth. RBI, in first 4 months of the year, slashed CRR twice and quantum of reduction (1.25%) was significant. Furthermore, it surprised markets by lowering Repo (Rate at which banks borrow from RBI) by 50bps or 0.50%. While the Midcap index - BSE Midcap had advanced by nearly 23% within first 4 months of 2012, the rise in large cap index - BSE Sensex, was a moderate 11% over the similar timeframe.

Ride wasn't very smooth thereafter.....

Those who missed the initial rally and got carried away by the blissful mood in the market, experienced a rude shock when markets started weakening in the month of May. S&P lowered India's outlook to negative from stable pointing its concerns towards deteriorating state of economy and laxity in fiscal management of the centre. Markets were long waiting for an action from the government on lowering the burden of fuel subsidy by hiking prices. The government repeatedly postponed the decision on fuel price hike. This was the time when markets were still adjusting themselves to unfavorable tax treatment proposed in budget for foreign investors. The Budget 2012-13 hinted at adoption of new tax rules, General Anti Avoidance Tax Rules (GAAR) from the new fiscal. If implemented, the new set of rules threatened to make investments in India unfavourable for foreign investors. The picture was still foggy and markets started melting under the pressure. What's more, the global markets too turned unsupportive following the resurfaced worries in the Eurozone. Spain and Italy witnessed deterioration in economy. Rising bond yields made the borrowing activity difficult for these nations and they were on the brink of needing bailout funding. Under such difficult conditions the Indian rupee tumbled and RBI had to heavily intervene in the forex market to stabilise Indian currency.

And then came the slog overs...

The Indian government woke up at the eleventh hour and took some hard decisions only when they were left with very few options. Nonetheless, actions on important issues taken by the government (which actually should have been taken much before) did not only encourage investors but also sent strong signal to foreign investors, that it is efficient to deliver on its commitments.

Cooking fuel Prices (LPG) were rationalized and petrol and diesel prices hiked. Furthermore, announcement of allowing 51% Foreign Direct Investment (FDI) in multi-brand retail and raising the cap of FDI in aviation to 49% cheered the markets. The reforms were further extended to financial sector as the government also agreed on amending the Pension Fund Regulatory and Development Authority Bill, 2011, Insurance Laws (Amendment) Bill, Banking Laws (Amendment) Bill, 2011; The Enforcement of Security Interest and Recovery of Debts Laws (Amendment) Bill, 2011 and The Prevention of Money-Laundering (Amendment) Bill, 2011. There was a scope of further overhaul of legal frame work by amending acts and passing bills. Competition Act, 2002, and the Foreign Contracts (Regulation) Amendment Bill, 2010, were among many other such bills.

Winter session of the of the Parliament was very crucial this year as there were as many as 25 bills to be passed in both houses (Lok Sabha and Rajya Sabha) while 10 new bills were to be introduced. Despite interrupted sessions the government could manage to get through some important bill successfully. There were 7 bills passed in Lok Sabha while 8 were cleared by the Rajya Sabha.

These reforms came at the time when central banks in developed world adopted a loose monetary stance by providing more fiscal stimulus as a last ditch effort to prop up rapidly sinking economies. However, as usual, this money instead of going into the domestic economies (of their respective nations) fluxed into emerging markets and other risky assets in search of higher returns. This provided a nitro boost to market rallies in India. The step taken by the new finance minister Mr P. Chidambaram to differ GAAR by 3 years was the icing on cake.

Did Mutual Funds benefit from the rally?

Although the broader markets went up considerably; the rally was more pronounced in select sectors such as Banking, Real Estate and other interest rate sensitive sectors. Shares of retailers and aviation companies also buzzed on reform announcements. On this backdrop it is interesting to see how mutual funds have performed during this year.

How Mutual Funds Have Fared?
  Returns -Absolute (in %)  
  03/Jan/11 To 30/Dec/11 02/Jan/12 To 21/Dec/12 Absolute Change
Category Average of Large Cap Funds -23.1 27.1 4.0
BSE SENSEX -25.1 24.0 -1.1
Category Average of Mid & Small Cap Funds -25.9 40.5 14.6
BSE MIDCAP -35.1 36.4 1.3
BSE SMALLCAP -44.0 31.8 -12.1
Category Average of Flexi/ Multi Cap and opportunities Funds -24.7 30.3 5.6
BSE-200 -27.5 29.3 1.7
(Source: ACE MF, PersonalFN Research)

The chart above shows that broadly, all categories of mutual funds have outperformed their comparable indices. In line with broader market performance; category of mid cap funds has outperformed its large cap peers. Ferraris have, till now, run the extra mile. Interestingly midcap oriented funds have given highest real returns over last 2 years although they were the biggest losers last year. This goes to show that midcaps bounce back when risk appetite is high while large caps are much more stable. Another important consideration is market valuations. Let's look at it now.

Are Midcaps Overheated?
Price to Earnings or P/E multiple of the market is commonly referred as a measure of market valuation
(Source: BSE, PersonalFN Research)

Chart above denotes how the market valuation has fluctuated since January 2011. It brings out two important findings. First, we started the year 2012 on low midcap valuation. This when combined with other factors such as record Foreign Institutional Investors (FIIs) inflows and sentiment booster in the form of reforms announced by the government, triggered a magnificent rally in midcaps. Large caps too have rallied albeit at slower pace. The second finding has been alarming. Since January 2011, valuation of large caps has steadily gone down while that of midcaps has been seesawing. Moreover, valuation differential between midcaps and large caps in past 2 months has been highest over last 2 years. In other words, midcaps have become dearer than large caps. This usually happens when markets are ripped for correction. However, technically there is another possibility that earnings growth would catch up soon and to the extent that should justify the higher valuation. Over last few months midcaps have rallied a lot and hence unless they report sharp rise in earnings; they would be more vulnerable than large caps to a market fall.

Road Ahead

We are in a range bound market and even current spate of good news is unlikely to immediately take markets to a new all-time high. Unlike last year, we are entering the New Year with reasonably high valuations in the midcap space. Though large caps appear to be less expensive they are not inexpensive either. This limits any significant upside in the markets based on valuation and risk reward matrix becomes increasingly unfavourable for further investments in midcaps.

Monetary policy action of RBI, growth numbers and Inflation data remain the important determinants of market direction going forward. Unless these factors turn supportive, incremental earnings growth is difficult to come. On the global front, the sovereign debt crisis in Eurozone area seems to be far from over and in fact has worsened in 2012. This still remains the biggest threat to global markets. Any negative development in Eurozone would have a negative impact on equity markets across globe including markets in India. US Economy has been relatively strong till now but any weakness going forward would negatively affect markets. However, on the back of monetary easing in developed markets and assistance in the form of stimulus would keep global markets liquid.

In a Nutshell...

We believe that markets may continue to remain range bound and unless some unforeseen negative comes up; markets may not crackdown. As mentioned earlier, scope of further rally also appears limited. This makes us believe that the time has come to rebalance your portfolio across asset class. As remains the question of rebalancing your mutual fund portfolio; you should also consider realigning to the initial allocation you made towards funds focusing on various investment style and market capitalisations.

Market rally that happened during 2012 reinforces the basic principal of investing in mutual funds. Risk taking ability is the single most important factor which should be considered as a starting point while zeroing on category of funds. Midcap as a category is riskier than large caps but reward potential of midcaps is higher than that of large caps. Midcaps outperform large caps when the bulls are strong. On the flip side, when markets tumble, midcaps witness sharp sell offs. However, at the moment it would be imprudent to completely shun midcaps and reduce its exposure to zero just because valuations are high. It reduces your chances to benefit from further upside, if it takes place due to any unforeseen reason. A flexi approach may work well in 2013. Therefore, we believe investment in flexi-cap and multi-cap funds would pay off. Let the expertise and conviction of the fund manager identify the prevailing opportunities and accordingly allocate your money across market caps.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.


The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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