A pressure gauge sits on pipework at an underground gas storage facility (Photographer: Vincent Mundy/Bloomberg)  

Investors Should Temper Return Expectations. Here’s Why

Volatility has returned to haunt investors this year after getting handsomely rewarded in 2017. What to expect from equity investments now?

They should temper expectations from both short- and longer-term perspectives, Aashish Somaiyaa, chief executive officer at Motilal Oswal Asset Management Company Ltd., said on BloombergQuint’s Mutual Fund show. There’s a reason for that.

Earlier, inflation used to be 6-8 percent and bonds and deposits returned 9-11 percent. That’s when equity compounded annually at 15 percent while mutual funds returned more, he said. That has changed now. With the Reserve Bank of India targeting inflation and interest rates coming down, there is no reason for equity as a riskier asset class to deliver a substantial premium, Somaiyaa said.

If inflation is at 4 percent and interest rates at 6-8 percent, then return expectation from equity should be 10-12-percent. For mutual funds, it should be slightly higher as they have the luxury of choosing stocks.
Aashish Somaiyaa

Short-term volatility entices people to enter the market, Gautam Sinha Roy, senior vice president at Motilal Oswal, said. “However, participants forget that equity is an asset class meant for the longer term.”

Here are edited excerpts from the interview.

We smile when people talk about investing in funds or equities for six odd months thinking that why they are thinking to invest in short term when they are investing in equities?

It’s human nature. When you start planning, when you decide that you want to invest then you have a particular goal or a thought process. But the fact that prices change every microsecond and NAVs change every day, it endangers the response which is not really needed.

If you tell me that I want to change my strategy or profit margins by 5 percent, how much time do you think I will take, how many quarters or may be two years. So, businesses change their course over quarters and years together.

Companies declare their results once in 90 days. Sales number in certain sectors and companies comes once in a month. So, fundamentals come up once in a quarter and they change directionally over few quarters and years. Equity is the manifestation of what the business is doing.

From all perspectives we know that it is absolutely irrelevant to react to what has been happening over a week or month, but it is human nature. There is a reason why Nobel prizes in Economics goes to those who study human behavior and not actually core economics.

How difficult does it becomes as a fund manager running large funds, if indeed the behavior of investors in the fund turns volatile? Would fund managers would be able to deliver better returns if investors come with a bent of mind that I am putting in the money from a 3-5 years perspective?

Absolutely. When any money comes to me in with a lock-in, that’s why I keep telling that my favorite fund to manage is ELSS funds which comes in with a three-year lock-in. Obviously, at any time some money is getting locked out. But lock in is brilliant because equity is a compounding instrument and long-term asset class and in the short time it is just volatile. People come in for the short term because the volatility is very enticing. It is like you will get that pot of gold in six months, get a multibagger in six months.

Many people get caught up in that volatility aspect of investing in equities forgetting completely that it is really a 10-year asset class and 20-year asset class which is more of compounding in nature. Fortunately, or unfortunately we can only play that game or a 10-20-year game. We chose not to play 3-6 months game. There are also one day plays. This is an asset class where you find people who have come in for a day to a lifetime like Mr Buffett does. It is complete spectrum of investors or traders that you find coming to equities. Funny part is the concentration is more in the short term. Shorter the term, more the number of people trying to play that game.

As you increase the horizon of investing, the lesser number of people are competing. But they are much sharper people. So, competition is not less but the number of people who are competing with you are lesser. Another important aspect is the more cerebral part of investing which we enjoy like strategic understanding of business, how they will pan out in long term, that is a very long-term thing. That is what differentiates people like us who try to think the long-term course of businesses and hence take calls accordingly. That’s where we specialize in.

Hence, if we get that quality of money it would be like, in banking parlance you call it asset liability matching. If our liability is matching our asset, if the money that we are getting matches the capabilities we have, then it will be the perfect utopia for us. But real life is not like that.

What is it that people can realistically expect after enjoying what we have enjoyed in the last couple of years or at least in 2017? Any thoughts on whether people should temper down there return expectations in the short term and why that’s not bad?

People need to temper down their return expectations, short term perspective or even on a directional longer-term perspective. Everything in an economy and in a capital markets is a derivative of certain base rates. Like if you see interest rates are a compensation for inflation.

We are coming from a scenario where inflation was perpetually be 6-8 percent, and government bonds and deposits used to be 9-11 percent. For many years, equity CAGR is 15 percent and mutual fund CAGR is even higher if you take the past data. Now, you have gone in a scenario where your inflation is more like 4-6 percent. RBI’s stated objective is 4 percent plus minus 2 percent. So, RBI is targeting inflation now and inflation has been 4-5 percent.

The government bonds and deposits rates are now in last 3 years, is 6-8 percent. So, why should equity which is risky asset class has to have a premium for sure but when your inflation and interest rates have settled 3-4 percent lower, then why should equity keep giving you 15-20 percent return. If interest rate is 4 percent, interest rate is 6 percent then equity should be 10-12 percent. Then mutual funds should be slightly higher because they need to beat the index and they have the luxury of choosing stocks and they are not buying the index.

The real return might be 3-4 percent, but you need to temper down the nominal return. You see any data now, people say that the market has corrected. But the fact is one-year return is still double digit. From last 3-5 years, everything is excellent returns. When all time horizons look like double digit CAGR, then people think this is my birthright and I have to get this. But it doesn’t always come in a straight line. Don’t extrapolate what you have seen in the past.

Have a reasonable time horizon, you will make the return and there is no doubt about it. if companies are delivering profits, if economy is growing 6-7 percent and now expectedly 7.5 percent, there is no way you will not make money. But nobody can promise you like a straight-line journey. That’s the point.

Can you please explain the data provided by you?

From 1995 to 2016-2017, if you take the CAGR of the Sensex it is about 10 percent. Sensex consists of all types of companies. We know that the mutual fund return is higher. Equities is the manifestation of the earnings of the companies.

Over a long period of time, the return on the Sensex is absolutely same as the growth rate of the earnings. If I corroborated this with volatility data, while the average returns of Sensex and the earnings is same, the difficulty is the standard deviation or the volatility of Sensex 2.5 percent more than the volatility of the earnings itself.

Investors Should Temper Return Expectations. Here’s Why

If there are two swimming pools and if I tell you that they are very safe because the average depth is only 6 feet, does that tell you anything? It means that the deep end could be 6 feet and the shallow end could be 2 feet. Now, in the same example you should keep in mind that the Sensex 10 percent CAGR is like Olympic size swimming pool where the shallow end is 1-2 feet and the deep end is 12 feet and you can actually drown.

But instead of Sensex if you look at the EPS, it’s like our society’s swimming pool where the average might be 5 feet, but the shallow end is 3 feet and the deep end may be 5.5-6 feet. So, the EPS doesn’t fluctuate as the share prices fluctuate. In 2008-09, it was the worst phase of the market. In FY09, Sensex fell 40 percent. The earnings of Sensex declined by only 2 percent. In FY10, Sensex bounced back by 70-80 percent, the earnings recouped only 2 percent. So, in 2 financial years the change in EPS was nothing. Market behavior for one year was like that the market has come to an end and the next year it was like blue sky. So, volatility of Sensex is 2.5-3 times the volatility of the earnings.

All ups and downs, all leads and lags, finally the return you will enjoy is the return is the growth of the earnings of portfolio that we actually own. Don’t bother about where NAVs are going or share prices are going, just make sure that you are in a good quality fund which has companies which are delivering and allow the portfolio manager to hold on your behalf. If investors keep moving in and out, you are taking the life that much difficult.

We didn’t have the earnings growth in calendar year 2017 but the returns have been staggering. Is it possible to predict what 2018 could throw up on the earnings front and returns?

Whenever in the short term, your PE ratio go up and markets move faster than earnings, it has to come back. It’s like the pendulum. So, PE ratios are like the pendulum. They swing around the average and right now they are on the extreme top, especially for the broader index which is Nifty 500. It is actually plus to standard deviations above the long-term average for the Nifty 500.

So, I will bet my last dollar which has to come back. It will happen probably over 1-2 years, nobody knows that, and nobody could predict that. But that’s the law of market and law of nature that anything which goes to an extreme has to come down to average. Basically, it is mean reversion. So, that is the most important thing that one has to keep in mind from a short-term perspective.

From 1-2 years prospect, one should expect PE contraction and there is always hope that earnings come back but that is like Karan Arjun story. We have been waiting for it for 4-5 years. It has not come. So, the predicative factors for that is cyclical recovery of few sectors and stocks including Tata Motors Ltd., Tata Steel Ltd. which did well last year from earnings perspective.

More importantly, the capex cycle coming back and hence PSU and corporate banks are recovering some their lost money in terms of NPA. These things are happening, some are happening while some are not. But the expectations that the earnings will rebound in very fast pace have been belied and could again be belied. There is a chance.

While earnings will improve from where they have been from last couple of years, but then it won’t be massive recovery then. So, there is a chance that you might have cool off in the Sensex and Nifty 500. But the risk lies more in small and midcap as that is where the over valuations are lot more. There are sectors which are much more richly priced and hence might see some PE contraction. But investors as coming in today, one should have muted return expectation from a 1-2 year perspective.

Watch the full interview here.