February 28, 2024

The Kotak Institutional Equities’ analysts wrote that they are not sure if an ‘incremental’ strategy can generate ‘excess’ returns over long periods of time.

The market’s extreme focus on incremental developments versus fundamentals may backfire badly, with “large losses”, if price and value were to converge through a price or time correction, warned the analysts at Kotak Institutional Equities.

They wrote, “Investing on incremental developments will work until it does not.”

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According to them, there are heightened investment risks from relying entirely or largely on incremental developments as an investment strategy, given several factors. One factor is the possible large disconnect between price and value being completely ignored under an incremental strategy. Secondly, investors may see large losses 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).

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This “incremental approach” is causing several anomalies across stocks and sectors, when seen from a bottom-up basis, they added.

One of the anomalies is in the market capitalisation of sectors and discounting absurd price, volume and profitability assumptions in perpetuity. To illustrate with an example, the analysts showed using reverse DCF math how Hero Motocorp would have to sell 14 million two-wheelers by FY34 and 23 million two-wheelers by FY39 to justify the current stock price, when the company sold 5.3 million units in FY23. Or how TVS Motor would have to sell 15 million two-wheelers by FY34 or 31 million by FY39 to justify the current stock price, when the company sold 3.7 million units in FY23.

The second anomaly was that the multiples of sectors and stocks were higher now versus ‘better’ periods in recent history on a ‘bottoming-out’ thesis. They added IT services companies are trading at higher multiples even thought there is likely lower growth and higher CoE versus pre-pandemic levels.

The large disconnect in price and value will sustain for a while–with Indian economy’s reasonable macroeconomic fundamentals, the strong earnings growth prospects over FY24-26E and likely decline in global interest rates–and the market may find comfort on incremental developments and ignore rich valuations for the time being. But “this may lead to bigger issues eventually”, they wrote.

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They wrote that they are not sure if an ‘incremental’ strategy can generate ‘excess’ returns over long periods of time due to several reasons, such as likely wrong timing (too late at most times) of both entry and exit from sectors and stocks; or performance being similar to the market’s while the momentum strategy is working but being much worse on any reversion to the mean.