The Indian stock market seems to be on a roll for multiple reasons. We have a strong prime minister and a political party which has a stable majority , and seems to be capable of delivering the promises which it made during the elections. Governance seems to have improved, and the government is making all the right moves as regards rationalising GST and cleaning up the cash economy.
India seems to be the one bright spot in a gloomy global economy, because of the demographic sweet spot we find ourselves in .
There’s a lot of buzz about how India’s GDP will overtake China’s in the next 20 years and is positioned to becoming a world superpower if all goes well.
Now it’s great to have all this hope, positivity and optimism, but one problem with all this hype is that the prices of high-quality individual stocks go completely through the roof. They become way too expensive and their price is completely divorced from their underlying value.
This Is True For Multiple Reasons
For one this, there really aren’t that many good quality stocks. Also, there is a now a lot of money flowing into the stock markets. Part of this is coming from overseas because many foreign institutional investors ( FII) find India to be a very attractive destination for parking their funds.
What’s new is that a lot of it is domestic money as well. Thus, provident funds are now allowed to invest in the equity markets, and many are doing so, in order to get a better return. Also, many Indians who used to invest in gold and real estate in the past no longer think of these asset classes as being attractive options. They are looking for alternatives, and the stock market has become increasingly an attractive destination.
Put these two factors together, and this means you have a lot more money chasing a limited number of high-quality stocks. This is why the price of these stocks is going to go through the roof and that’s already started to happen. Now it’s very gratifying for investors to see the value of their portfolio appreciating so dramatically.
However, once these stocks hit their plateau, the influx of money will then drive up the prices of poor quality stocks as well. These will shoot up at a much faster pace, which is why a lot of value investors are going to be extremely unhappy for the next 2-3 years, until this cycle plays itself out.
A conservative value investor will no longer be able to pick quality stocks which provide an adequate margin of safety. This means they are going to be forced to wait on the sidelines until the boom fizzles out. However, lots of aggressive investors will keep on buying other stocks, which may be of poor quality, but whose price will rise dramatically as the crescendo builds up.
During this phase of irrational exuberance, value investors will suffer a lot of heartburn because the returns which aggressive investors chalk up will leave them in the dust. The prices of risky microcap stocks will reach lifetime highs, and while the price of the high-quality blue chips which the value investor believes in will also rise, this increase will be nowhere as dramatic as that of the aggressive investors.
After a few months, his clients will start getting restless, because their friends are getting far better returns from other fund managers, who are willing to take riskier bets. At some point, he may start doubting his own sanity, because he is not investing in all the companies whose prices are doubling left, right and center. His clients may feel that he is stodgy and old-fashioned, or has lost his touch, because “this time, it’s different.” All the brash young fund managers will start outperforming him because during a bull run, pretty much all stock prices shoot up and it doesn’t require much skill to put together a portfolio which provides outsize returns. As Warren Buffet pointed out, a rising tide raises all boats.
As time goes by, his faithful clients will start deserting him, because his returns start lagging behind those of other fund managers, who are willing to take riskier bets. Their portfolio may double, while his will continue growing at 20% per year – a return which is very respectable , but will no longer be considered to be acceptable because other fund managers are doing far better.
If he does not have the courage of his convictions, he will be pressurised into changing his investing philosophy and his stock selection strategy. Interestingly, this is what will lead to disaster, because all good things come to an end, and while bubbles can last for many years, they will pop at some time.
One needs courage to manage greed and euphoria. It requires a lot of effort to watch everyone else around you make easy money, while you stick to your principles and refuse to take part in the madness. However, the right time to Think Slow is when everyone else is Thinking Fast. This is what will give you an edge and will help you outperform over a complete market cycle.
[This post by Dr. Aniruddha Malpani first appeared on LinkedIn and has been reproduced with permission.]
