Four reasons to cheer the market fall

Attribute it to the Finance Minister imposing a long-term capital gains tax on equities in his budget. Or blame it all on the US Fed and hostile global cues. Whatever the reason, the Indian stock market has launched into a long delayed correction in the week following the budget. Mid and small-cap stocks, in fact, had started to decline much ahead of the Nifty and the Sensex. While the fall has triggered quite a few rants and memes in the social media, if you are a long-term investor in Indian equities, you should really be cheering if the market sustains this fall. Here are four reasons why.

Blowing off froth
Fund managers may not put it in so many words. But Indian markets in the past year had gone into a bubble zone. The 10 year average price-earnings multiple for the Nifty 50 is about 18.5 times on a trailing basis. But in the last week of January 2018, just before the budget crashed the party, the Nifty 50 PE had topped 27.8 times (26.4 times on the Sensex 30). That's the kind of valuation at which previous bull markets like the one in 2007-08 and 1999-2000 topped out. The problem was even more acute for mid-cap stocks because their PEs were at over 33 times at January end.

Now, fund managers and market players keep coming up with a variety of creative explanations for this super-expensive market. But irrespective of what the reasons are, a high market PE poses a risk to equity and equity-fund investors because when you buy into stocks at a high entry valuation, it sets a very high bar on profit expectations and sets you up for disappointments in the long run. Indian markets have just completed their 10 year anniversary of the previous bull market peak. It is no coincidence that investors who had entered equity funds in January 2008 at a Nifty PE of 28 are sitting on 10 year category returns of just 9 per cent on large-cap funds and 11 per cent on multi-cap funds.

Therefore, you should be glad that, at the time of writing this, the market correction had levelled the Nifty PE to 25 from 27 times. The lower the PE goes, the more you can be sure that your investments, from here, will deliver a reasonable long-term return.

More value from SIPs
Volatile or falling markets are far better for investors running long-term SIPs than relentlessly rising markets. After all, SIPs deliver their best results only when fund NAVs fall after the investors' start date and recover in the later years of the investment holding period. If a market is steadily heading only one way and that is up, SIPs actually make less sense than lump-sum investments because every instalment ends up averaging your cost higher!

A bearish market, marked by falling stock prices, allows your SIPs to work as they should. They reduce your acquisition costs by averaging your investments at lower NAVs over time. This ensures better long-term returns from your investments.

More buying opportunities
For the last couple of years, the rising high tide of new money flowing into funds has posed a problem of plenty for fund managers. The universe of listed stocks in India has certainly not kept pace with expanding equity-fund assets.

When too much money chases too few good stocks, the result is a dilution on either quality or valuations. This problem is made more acute by the fact that most AMCs in India frown upon high cash positions and like to be fully invested.

Of course, some micro-cap, small-cap and mid-cap funds have thrown in the towel, admitted to the lack of good opportunities and stopped accepting fresh lump-sum or even SIP investments. The other diversified-fund categories are still reluctant to do so because they can rove the entire market-cap range in search of good stock picks. But they have also faced the problem of bloated AUMs for their best funds, which reduces their agility and ability to take focused bets.

If markets correct substantially, some of the good small and mid-cap schemes that have gated their flows may decide to reopen for new subscriptions. The jumbo-sized funds may return to slightly more manageable levels. And both value and quality conscious fund managers can go back to applying stricter filters for their stock picks.

Speed and greed
One of the main characteristics of a frothy market is that every punter appears to be genius. Under normal market conditions, unearthing good stocks that really deliver returns is a difficult task, requiring a lot of homework on business fundamentals. Therefore, only patient and diligent investors are rewarded. But in a market that is teetering on the edge of a bubble zone, speed matters more than diligence. As one well known fund manager told Value Research, in a bear market, fundamental research reports on companies run into 50 pages. In bull markets, they just take up four lines on your computer screen.

With stocks running up on the flimsiest of excuses, obscure companies turning market darlings, and fancy new spins and theories driving up age old operator stocks, frothy markets can look fundamental and diligent investors look like fools because they are too slow to buy into a stock. Given the short-term performance pressures on fund managers, those who aren't seasoned over market cycles can be lured into temptation to chase momentum over endurance. When the tide finally turns, you will find many naked swimmers.

These temptations hold good for fund investors, too. When NAVs are leaping ahead every month, the temptation can be high to abandon your long-term performer and hop on to the fund that is topping the charts for a quarter, six months or a year. Given that the toppers of a frenzied bull market often end up at the bottom of the pile in a bear phase, this behaviour can be extremely detrimental to wealth creation.

Overall, if the breathless bull run that's been on for the last one year pauses for breath and if there's a correction that resets valuations, the wheat will soon be separated from the chaff, both on stocks that have been running up and the equity funds that have been coat-tailing them.