An Asset Called Self-Preservation

When wealth managers in India talk about asset allocation, they invariably suggest sticking to equities and real estate. Other assets like commodities, fixed income and alternative investments such as art are discussed, but in no way rival shares in their appeal. Even for many above the age of 60, wealth managers are keen to have them invest in equities, provided they are well taken care of by their family and have the required risk appetite.

But the global financial crisis has changed our view of investment profoundly. Equities may continue to command the attention of Indian investors, but conservatism will be in.

Illustration: Abhijeet Kini

Conservation of capital, absolute returns and liquidity will be the theme for the long term investor in 2010 as against high risk, benchmark-driven returns and locked-in investments like structured products that were the themes until 2007, says Amitava Neogi, executive director at Morgan Stanley India.
“I think 2010 will be the time for stock picking, rather than just investing into pivotal stocks. We believe that with 30 percent in cash, much of the investment should be in high quality equities and some in gold,” he says.

India’s stock markets rose 78 percent in 2009 and investors are rightly worried about their investment in this asset class. With the global economy behaving like Humpty Dumpty over the last two years, there is a distinct sense of unease. Like a summer storm, the financial crisis ravaged most asset classes and led to a scary spike in volatility. All assets, from stocks to gold, commodities to currencies, fell and rose together, breaking the age-old wisdom about positive and negative correlations between asset classes. There were interest rate cuts across the world and governments started pumping in money. Bond house Pimco went so far as to describe a “new normal” implying that the developed world will be in stagflation while emerging markets like China call the shots.

The corporate sector had a few surprises. Crisil data shows that the gross profit margins of 2,040 manufacturing firms fell to as low as 15.3 percent in the quarter ended December 2008, before bouncing back to 20 percent plus in the April-June 2009 quarter. It wasn’t rising revenue that brought the profits back as much as fall in raw material prices.

But as the world starts to repair itself, commodities across asset classes are gradually reverting to higher levels. Initially, commodities used in manufacturing, like fuels and metals, are expected to be pricier. Once again, corporate profit margins will be under threat and that will reflect in stock prices.

Emerging markets have had a good run since March 2009 but are overvalued now. So their volatility will only be higher. A Motilal Oswal research paper says that market capitalisation is at 109 percent of GDP, the highest in history.

If we compare earnings yields (the inverse of the P/E ratio) and government bond yields over the last seven years, Indian markets appear overvalued. Long-term government bonds are giving a yield of 8.10 percent while earnings yields are at 5.39 percent.

The market looks like it is in bubble territory when we compare asset prices (book values) to market prices in the context of the returns these assets have created for their firms. Over the last one year, the return on equity for Nifty companies has fallen from 27 percent in 2007 to just 16 percent currently, yet investors remain willing to pay higher prices for these low yielding assets.

Price as a multiple of book value has gone down from 5.31 times to 3.5 times. For the markets to revert to normal levels of valuation, this number needs to come down to 2.8 times.

However, the long-term investor has less to worry about given that the Indian economy is riding on domestic demand fired by the expanding bottom-of-the-pyramid market, increased urbanisation and an acceleration in infrastructure spending. The investor must sit through the volatility to realise its full benefits.

The world equity markets have opened to the Indian investor with the Reserve Bank of India liberalising the norms for investing abroad. Brokerages and wealth managers have been tying up with foreign partners to bring those opportunities to India. In particular, this opens up vistas for playing the other big theme in global growth: China. The country offers completely different opportunities from India and its growth rate and fundamentals are also different. Recognizing this opportunity for Indians, JP Morgan has started a Greater China off-shore fund.

As the debate on where the financial crisis stands is yet to be settled, investors will look for capital protection. So fixed income will be vital in asset allocation.

“People have understood the importance of conservation of capital the hard way. After the crash of 2008, investors who were diversified in fixed deposit or even post-office schemes, were amongst the least-hurt investors,” says Vicky Mehta, senior analyst at Morningstar India.

In India, most investors have a chunk of their savings in fixed deposits, but that space is increasingly being taken by fixed income funds. Their returns have been superior at 10 percent annually in the last three years vis-a-vis bonds that yielded only 6 percent (Crisil Bond Index). But as things stand at the start of 2010, India is moving towards a high interest rate regime, to counter inflation. This means, income funds with long-dated securities will prove less attractive once the rates go up. A better strategy may well be to invest in liquid funds or short-term bond funds for now. There is also a section of fund managers that advocate putting 10 percent of one’s resources in long gilt funds, irrespective of the rate scenario.

Historically, the best way to combat inflation has been to invest in gold. The yellow metal was an alternative asset just a few years ago, but now has gained the status of a mainstream option.
But gold prices are notoriously difficult to predict. Every time analysts talked about a correction, gold prices simply moved up. The general consensus is that gold will settle at $700 per ounce but nobody can say when. “No gold prediction has stood the test of time and most have gone awry in three months time, because the price is very volatile,” says bullion analyst Sanjeev Arole. “Last year, the punters in India took a beating. So speculators are keeping quiet,” he says.

Over the last two years, Indians have been attracted to gold bars and coins rather than jewelry. Jewelry demand has fallen to 70 percent of total demand, from the earlier level of 85 percent. This shows that gold has become a serious investment.

If the US dollar remains weak, gold is likely to appreciate even more. Generally, gold has a negative correlation with equity to the extent of 17 percent. But now with the crisis, the correlation has become positive. Both gold and equity went up together for the first time.

Real estate is a great opportunity for investors who are ready to wait for a longer period. Those who want to buy property directly may have to take some risk on liquidity as well. The real estate market is interest-rate sensitive. So if interest rates rise, it might affect demand to a certain extent. But overall, this is a fundamentally strong sector that still has a lot of steam.

To investors who want to park their funds in real estate, the only decent performance metric they can use is the rise of real estate stock indices vis-a-vis the broad market index, the Sensex. In the last one year, the Sensex has more than doubled from its lows whereas the real estate index is up about 70 percent.

“The demand of the residential and small offices spaces will drive the sector in the short term,” says Abhishek Lodha, director at Lodha Developers. According to him, cities like Mumbai will see a shift as the market moves towards an upper middle class society. Data shows that households with income more than Rs. 5 lakh per year will more than double from 17 percent in 2008 to 36 percent in 2015. “A lot of Mumbai will get re-developed in the next couple of years and there is always an opportunity to deploy capital in such a change,” Lodha says.

For those who like to take risk on liquidity and are fully invested, there is another avenue for investment in the alternative asset class — art. (Though the best of wealth managers avoid their clients’ money from getting into this asset class due to the lack of transparency or liquidity.)
Art is certainly not a retirement plan, unless, of course, the purpose is to gaze at a Hussain or Raza with a sundowner in hand in the twilight years. In that sense, it certainly would be an asset. Incidentally, good art also gains in value as the years advance. Old money has always been buying art for decades, quietly, as is its wont. But as individual wealth spreads, it becomes almost de rigueur. The fast-growing economy spawns hundreds of millionaires and a relatively smaller number of billionaires every year. The numbers are not important. It is that heap of money that is.

“The whole concept of patronage is just beginning to take root in India,’’ says Deepak Shahdadpuri, founder and managing director of BCP Advisors Private Ltd., a Mumbai-based alternative asset advisory firm. Although Shahdadpuri agrees that art can generate positive returns, this is usually over very long holding periods, often decades. He does not consider art as an alternative asset class that can be packaged and sold per se, and argues it is something for people who have a genuine interest and understanding of art and art history. Otherwise, they may be misled into buying what is intrinsically a very illiquid product.
“It is certainly not for the masses,’’ says Shahdadpuri, a collector who owns works of many contemporary Indian artists apart from the masters.

After hitting rock bottom early this year, the art market has bounced back somewhat. London-based art market research firm ArtTactic’s confidence index for the Indian market has risen from its all-time low of 20 in May to 49 in October. But ArtTactic’s founder and managing director, Anders Petterson, writes that the market is wary of speculators and prices could still fall. That might be a good time to enter the market. One way to invest in art is to buy units in art funds. However, art funds are unregulated in India and at least one fund that was floated a few years ago has been saddled with unsold stock and is still struggling to repay investors.

The next few years will not be like the past few years. Those investors who are expecting higher returns will surely be taking higher risks. But this is India. And as Pimco says, that may prove to be the new normal.

(Additional reporting by Dinesh Narayanan and T. Surendar)