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Bear or Bull: Tips to identify current phase of Indian mkt

They say it is better to teach people how to fish than to give them the fish. Speaking at CNBC-TV18’s show Investor
Camp Nandan Chakraborty, managing director-institutional equity, research, ENAM explained how one should
understand the stage in which the market is. "If you know where you are you will know where you will be going." (Click
on the attachment for Chakrabarty's full presentation)

Here is an edited transcript of his comments.

On market cycle:

The deep undervaluation stage is where there is abundant, but reluctant liquidity. This is the Stage I, where the market
just seems to go nowhere and is extremely low. The next stage is where you are going towards fair valuations. This is
usually due to EPS growth which is either due to remedial measures by the government - interest rates get cut etc or by
the industry itself. The stage after that which tends toward over valuation is the one where most of the market returns
are determined by the valuations rising rather than the EPS rising. Finally, we reach the bubble.

There is no cause for a bubble to burst, there are only triggers which make the bubble burst. What is important is that
house of cards becomes so tall that any small trigger can make it fall. Then there is a sharp correction and suddenly a
massive bear rally. This bear rally happens because the business cycle has not yet turned.

There is little bit of reflexivity in the markets. This is a phase where business cycle has not yet turned therefore the EPS
still looks healthy and multiples still look extremely cheap because the EPS has not started to fall, which is the reason
for this massive bear rally. Then because of reflexivity and because of a host of other reasons there will be a bear
phase, which is a rounded bottom stage. Finally, you are back into the abundant liquidity stage.

If you look at the curves below, there are three waves. The momentum of returns is just below the bubble phase, after
there is acceleration in corporate profits. So, the bear rally is actually at the time when you have acceleration in
corporate profits and finally there is high inflation.

What is the reason for these three curves?

What happens is that it is working backwards as the line right in the bottom shows. Inflation is a demand supply
squeeze. Essentially, there is far more demand than supply, which leads to corporate profits going up, which in turn
leads to market returns. It is the reverse of the three curves which act on each other. The acceleration in corporate
profits pre-empts inflation.

Corporates work because no inflation is coming. Similarly, there is a momentum in stock returns because you are
anticipating acceleration in corporate profits. If you can burn this cycle in your memory, a lot of your work will be easier
because you need to know where we are. When you look at it you can see the bubble is what we reached in 2008, then
we had a very sharp rally.

There are various triggers where you know where you are in the cycle. Similarly, if you look at the bottom part you will
see that the methods of valuation also keep changing across the different cycles. When you start of with the beginning
of the cycle, you are looking at dividend yield, you are looking at price to book and stuff like that which are absolute
valuation measures.

At that time, you are not really looking at outlook. That is the time when you are saying that markets are so low, I don’t
really care. If I lose 10-15%, but there is probability of gaining maybe 50-60% but I do not know in what timeframe and I
do not know the outlook, which is why it is not embedded in the price yet. What happens is that you buy dividend yield
stocks and put small portion of your portfolio then. It is only the performance of the stock price that makes you invest
more. That is the first phase - value phase.

The second phase is what you call a growth at a reasonable price i.e GARP where you talk about payback, where you
talk about EV by EBITDA, PE etc. Then when you are reaching the third stage, you are moving from the EPS stage to
the PE stage. That is the part when you are looking at the technicals, reflexivity, PE to growth etc.

Essentially, this dance of Nataraj keeps happening over cycle and continues to happen across cycle. The nature of the
sectors that move may keep changing. The length in terms of the periods and heights may keep changing, but what you
need to know is where you are in the cycle. That is the fundamental thing that drives what you should be doing.

So, each phase has no particular time period or height. It is only the symptoms, which identify the phases or at least
what just got over and what you think will happen next. It is only the characteristic that is the shape of the curve that
becomes meaningful and easier to digest.

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How should you look at a bear market:

There are millions of books written on how to identify the phases on the way up. It is only in a bull market that you get
books about the bull market. In a bear market nobody is looking at this. They are doing their own things. Therefore,
there is very little information or symptoms on how do you look at a bear market. How do you know that what stage of
the bear market are you in.

Bengal is an intellectual country, so I am sure a lot of you may have read somebody called Franz Kafka. One of his best
short stories is the Metamorphosis. This is about a family member who becomes an insect. So, slowly his eyes turn
green, scales start on his body and so on. If you look at the stages of a bear market, it is very akin to what the story
talks about. So, the first stage is where there is horror. You rush to the bank to withdraw may be money for an operation.

The second stage is pity, where you search for worms to feed your poor brother sister. The third stage is you are fed-up
now. There have been lots of uncles and aunties who basically come to you and say, you have done a lot of sins in your
past life, giving you astrological remedies, ayurvedic remedies and so on. You have looked after the person for a long
time and now you are ashamed and you are disgusted.

The fourth stage is apathy. That’s a stage where he does not look like a human being anymore. He doesn’t talk like one,
he whistles instead of talking etc. That is the stage of apathy, where you have sealed off the bedroom door and you
have made him independently – have an independent exit for him to go to the garden and consort with fellow insects. If
you look at these four stages, you will remember and lets now translate to the stock markets.

The first one, which is this horror, is unwinding. That’s not the stage when midcaps fall. That’s not the stage where India
falls in relationship to the world because India is a midcap in a global context. What happens is, you feel that you are
saved, but actually what’s happening is people are unloading their most leveraged positions, their biggest positions.

The second is greed buying. So, stage one, you look backwards at the highs and say you are about 40% down from the
high and you start greed buying. Then again you get hit because stage 2b is, now you have broken the 52 week low or
you have broken the last so many years lowest PE and therefore you say buy.

The third stage is where you are questioning, should I have remained as an engineer? Should I have worked for
Hindustan Lever or should I be in the stock markets? That’s the stage when you are looking at your entire life, your
entire portfolio and you are not looking at whether I should buy ITC or Jain Irrigation. What you are looking at is whether
I should be in India or not. Whether I should be in gold, bonds or property? So, you are introspecting on your entire
portfolio. That is a portfolio introspection stage.

The last stage which is the apathy stage is what I call the time horizon stretching stage. This is when the real treasure
hunt starts because you don’t expect a near term revival, but at current valuations you are willing to sacrifice short term
volatility and people are liquid of stocks. So, the rise starts again.

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When we are saying we are in phase six, as a summary of whatever I have said so far what can we expect? Living in
this phase six means, one is, inflation should peak out, but it is not going to happen immediately. Obviously, there are
places like – I recently went to Shirud district in Maharashtra where there is a major drinking water problem. They have
had the worst drought in the last 40 years.

Sitting here in North India, you don’t feel the pain out there, but there will be problems, there will be lot of central funds
released towards various drought affected areas. In this sort of an environment you don’t expect inflation to come down
immediately. It will take a little bit of time but it will happen. So, inflation should peak out.

Earnings growth, if you look at the last quarter results it’s been fairly steady. While there have been surprises, but you
see it has stopped falling. So, it has stopped crashing. The consensus estimates have been more or less at par leading
to interest rates should start easing off with a lag may be sometime next calendar year.

A new bull market doesn’t emerge simply because the worst is over. If you look back at the cycle, there is still phase one
to go through. It is not that you have a bust and then new bull market starts. So, be prepared for that phase one.

Thirdly, the whole characteristic of a bear rally is what I call no reason rallies because there are for two reasons. One
reason is under ownership of a sector or a stock and the other is hope. You hope that there will be reforms after the
President gets elected, after the vice-President gets elected, after the monsoon session gets over and after the winter
session gets over or may be there is a QE which will come from the West, so you constantly live on hope. That is the
nature of a bear rally. It is very sharp and swift. Each time it will tempt you that a new bull market is on, which is why you
have to keep your eye on the ball in terms of the cycle.

Markets phases in India:

We have seen 1995-1997 was a frustratingly flat period. Then we had high RoE bull run of 1997-2000. Then there was
a horrible dark period which is a bear run of 2000-2003. Then this once in a decade dream of everybody what we live for
and the whipsawing bear rally that we talked about. So, this is a perspective of what we have seen over the last couple
of decades.

If you look at the Return on Equity (ROE) bull run; we all think about IT, but essentially it was multiples of FMCG,
pharma and high RoE stocks got massively stretched and then finally ended with one narrow segment blowing off. You
did not really have to choose stocks; nobody knew that if a stock will go up by 40% or 400%. If we did then we would
have put our money in that one stock. All you had to do is be in the markets. Secondly, be in the right sectors.

In the bear market of 2000-2003 the Sensex fell by 50%, while the stratospheric PE sectors collapsed two stocks that is
HDFC Limited and HDFC Bank continued to shine despite multiples falling. The second thing was when you see there is
a problem the seeds of the problem get corrected. At that time, there was a problem of fiscal deficit, which is why there
was lot of talk of divestments, which is why PSUs started going up.

If you look at 2003-2008 massive Bull Run, in retrospect you feel like slapping yourself. If there is going to be a liquidity
driven bull run, it is obvious that what will run is things like infra, metals, banks things which depend on liquidity. Again
those were times when you just had to be in any bull run. It is more important to be in the market and in the right sector
rather than the right stock.

Then there are these flat periods 1995-1997, this is an ‘analysts paradise’ and a fund manages 'nightmare'. These are
the periods when the same sector you may have one stock going up and the other going down. You have to be
extremely stock specific in these areas.

Markets: The way forward

It is extremely important to know what base you are working on. To give an example, people talk about markets climbing
a wall of worry, there is constant bad news and yet the market is going up. When does that happen? It happens when
valuations are low. It does not happen when valuations are high. So, this is one of the greatest takeaways that you can
take from the stock market is whether your outlook is good or bad what is your initial expectation of the outlook decides
everything.

There are couples of other things which are important; if you look at the range of the PEs it has generally being between
12 and 20. Thirdly, everybody assumes that India will go up at around 15, maybe 20% per annum in EPS growth year
after year. I want to mention that there have been long periods when the EPS has been flat.

When we look at the dreaded times, you had dreaded times in ’89-90 and ’96 to ’98 and in 2000 to 2003. So you focus
on these periods – politics was bad, global events were negative; INR fiscal deficit and current account deficit were all
bad. Do not pay so much attention to interest and inflation rates because these are only symptoms, these are not
causes.

I will take only one example of a period, if you take ’88 to ’91 period – you had four Prime Ministers in four years, politics
was bad, there was balance-of-payments (BOP) crises and inflation, interest rates, it was a problem all around. So,
when you are talking about today you should look at these different periods that we had in the past. That’s the game of
the stock market.

Similarly, we had periods like that in ’96-99, where at a time in the Bull Run you think that whatever you touch turns gold
and this is exactly the opposite - whatever you touch seems not to do well. This is what summarizes entire section.

If you look at the roles; these are you current account deficit, the fiscal deficit and INR. All three seem to move together,
and you have these pink periods and green periods. In the midst of the two pink periods in the middle there is a green
period also. What is amazing about India is that all three move together and when you feel the things are the worst in
INR fisc and CAD and just within three-four years maybe sometimes within two years all three against are doing well
together. This is the crux and the nature of the Indian markets.

India’s growth is extremely closely related to reforms. If you look at Indian demographics and what you will see in terms
of the various consumer durables, it is fantastic as unmatched in the world, so you will get your time. Similarly, if you
look at the wealth effect in India in terms of realty and gold, one of the reasons people in India at the retail level have not
got into the markets is realty, gold have given as much or even superior returns to stock market.

So when you look at now versus ten years back – there are very few strikes to do with onion prices, inflation and so on
because basically people are far wealthier than before, on average.

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Tips on personal investing

There are multiple sectors which are set for high compound growth like organized retail, air conditioners, home
mortgages, cars, digital TV and so on, major infrastructure expansion plans. If I look at investing over any time period,
there are actually three conceptual boxes.

One is what are the sectors which are going to blow out in demand? Second is which are the regulatory catalysts and
third are there any companies which can scale irrespective of what happens in the environment? I have just populated
this in terms of what happens in 2015. But essentially these are three boxes to invest in.

We must not forget that the US has engaged with its problems and we have not. One of the biggest problems of India is
rupee because foreigners lose money when the rupee moves against you. Also, the better the US keeps doing in terms
of the dollar, the more we suffer.

Certain investment takeaways for personal investing, one is there is a huge speculative position being built up in so
called defensives whether it is US bonds, gold or FMCG. These could unwind with equal destruction. On the other hand,
highly levered stocks may not have the staying power till the cycle recovers. So while theoretically it seems like huge
beta, will they have the staying power till then? Because when you look at PEs, the valuation multiples, are they
masking the wrong EPS in the first place?

Third, somebody asked me should I own some gold? I learnt this from my family members, none of them are into
finance, is that you should have at least a little bit in different asset classes if you are investing for the long-term,
whether it is gold or property or bond or forex, a little part of everything for security. Diversification is a key because the
future is inherently predictable. Do not double discount problems.

When you are saying there is a problem in Japan or China or Europe, isn’t it the same problem? It is ultimately the same
problem; it is the Europe problem which is causing China or the US problem. Instead, be sensitive to the remedial
actions that emerge, which can change the cycle. Look for stocks essentially which can double by 2015. Take a 2-3 year
time frame without a very high absolute downside.

The personal investing is all about; I am taking this from Kenichi Ohmae’s triangle in business strategy - what is the
competitive edge that you have which relates to the stock in question which the market is not looking at. In terms of
what is the difference between you and a great investor, there are basically three things.

One is how long a period that you have been investing. So time period is extremely important because when you are
looking for a multi-bagger, normally it is a high risk idea. Therefore you put a very small portion of your investment in it
and the minute it goes up then after that may be 6 months, 2 years you don’t find anything else.

The second thing is leveraging your convictions. How much money you have put in your conviction and the minute it
goes wrong, you think how quickly you have taken it out. Leveraging your convictions both on the buy and sell side and
there are two basis that you need to cover before you even start equity investing.

One is your financial security. If you are not financially secured please don’t be in the markets. Number two is emotional
security. If you are going through a bad patch in your personal life don’t be in the markets. It will completely spoil your
judgment.

There are four pillars of modern life. A personal family relationship, personal health, something to keep the mind active
and minimal level of wealth base, four things if you take care, you should be fine as far as the markets are concerned.