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The fundamental and the incremental

The market’s extreme focus on incremental developments versus fundamentals will add to the challenges of investors—(1) disconnect between price and value may sustain for a while, (2) likely underperformance, despite high churn and (3) classic top-of-the-cycle mistakes, given investments on incremental developments without any consideration of fundamentals.

Disconnect between price and value may sustain for a while

(1) The Indian economy’s reasonable macroeconomic fundamentals, with two fairly solid and two weak-but-improving parameters (see Exhibit 1), (2) the Indian market’s strong earnings growth prospects over FY2024-26E (see Exhibits 2-3) and (3) likely decline in global interest rates (see Exhibit 4) may result in the large disconnect between price and value across sectors and stocks sustaining for a while. The market may find comfort on incremental developments and ignore rich valuations across sectors and stocks (see Exhibits 5-10) for the time being, but this may lead to bigger issues eventually.

Performance may still be a challenge; chasing versus leading

We are not sure whether an ‘incremental’ strategy can generate ‘excess’ returns over long periods of time, given (1) likely wrong timing (too late at most times) of both entry and exit from sectors and stocks; presumably more money can be made from a theme when it is still undiscovered (say, housing in 2020-21 versus currently, when a lot of positives regarding the housing cycle are largely priced in) and (2) performance being similar to the market’s, while the momentum strategy is working and being much worse on any reversion to the mean.  

Investing on incremental developments will work until it does not

We note the heightened investment risks from relying entirely or largely on incremental developments as an investment strategy, given (1) the possible large disconnect between price and value being completely ignored under an incremental strategy; the ‘incremental’ argument is valid at all price points and (2) large losses to investors if and when price and value were to converge through moderate-to-severe price corrections and/or time through a period of lengthy time correction; incremental developments may have already been priced in, as is the case with several sectors (automobiles & components, electricity utilities and IT services are the most prominent cases).

So many anomalies across sectors and stocks on incremental approach

We note several anomalies across sectors and stocks on a bottom-up basis, with (1) market capitalization of sectors and discounting absurd price, volume and profitability assumptions in perpetuity; see our usual reverse DCF math on the 2W stocks in Exhibits 11-13 and (2) multiples of sectors and stocks being higher now versus ‘better’ periods in recent history on a ‘bottoming-out’ thesis; note the higher multiples of IT services companies for likely lower growth and higher CoE versus pre-pandemic levels (see Exhibit 14). We assume banks are struggling due to the ‘peaking-out’ (NIMs to decline, credit costs to rise) thesis.

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