Greed Over Fundamentals: The Investor's Folly

In her address at the fifth SEBI-NISM research conference on March 12, 2024, Securities and Exchange Board of India (SEBI) chief Madhabi Puri Buch expressed her concerns about the valuation froth in the mid- and small-cap space. The next day the Nifty Mid-cap and Nifty Small-cap indices dropped 4.4% and 5.3%, respectively. But who cares? The correction is a buying opportunity.

The number of demat accounts has surged from approximately four crore in March 2020 to nearly 15 crore as of today. And this is accelerating, with a monthly record addition of about 46.8 lakh demat accounts in January 2024 alone. This is just the tip of the iceberg. With about 65% of the 1.4 crore population below 35 years of age, India is a nation of thriving youth believing in instant gratification. 

Canary in a Coal Mine

First-time investors with no prior experience in investing are finding it easy to open trading accounts with discount brokers that offer quick onboarding. The growth of these discount brokers has been unprecedented, with more than 60% of NSE’s active client base already captured by them. This is a welcome development for the country that is hooked to investing in gold and fixed deposits and now moving into financial assets. Rapid financialisation is great for India’s future and the growth of the 
industry; however, the problem comes when the short-termism, excessive leverage and “gamification” of investing takes centre stage.

Retail investors generally favour small-cap stocks where the risk is maximum. Looking at the past three years of staggering returns, retail investors are increasing their small-cap holdings. The overall ownership of NSE Small-cap 100 Index by the retail investors has jumped to 15.4% currently, versus 12.5% in March 2019, while the ownership of NSE 100 remained largely stable around 8% during the same period.

According to ICRA data, the margin trading funding book for the stockbroking industry reached Rs 54,537 crore in mid-January 2024, a staggering eight times higher than the pre-pandemic levels. Additionally, the Futures Industry Association reports that option contracts traded on Indian bourses reached a staggering 8,530 crore in 2023, reflecting a 52.4% compound annual growth rate (CAGR) since 2013. This dwarfs the US market, where 1,120 crore contracts were traded in 2023, with a CAGR of 10.7% over the same period.

What is even more alarming is that this unprecedented surge in equity investment is happening alongside a decline in household financial savings. Net financial household savings in India dipped to a mere 5.1% of the GDP in 2022–23, the lowest level in the past 50 years. On the one hand, consumption is faltering and formal job growth is largely stagnant. On the other, unsecured personal loan growth has skyrocketed, with the end use of these loans often unclear. Personal loans grew a staggering 141% in the two years ending December 2023, far outpacing the overall system loan growth.

This lopsided growth in risky personal loans has nudged the RBI to tighten regulations on personal loans and credit card loans by raising capital requirements. Wherever required, the RBI also barred some banking products issued by certain entities. While technology is helping to improve financial asset penetration in India and ease access to capital, regulators have also stepped up the monitoring of market activity. Recently, the Enforcement Directorate (ED) unearthed a scam where bank accounts of fictitious companies were used to manipulate the prices of certain small-cap companies. 

Optimism in India

India's real GDP growth is projected to reach a remarkable 8% in the current fiscal year, exceeding the RBI’s initial optimistic forecast of 6.5%. This unparalleled resilience, demonstrably outperforming even the most bullish forecasts, is evident in the all-time low volatility of the rupee against the dollar over the past year. This comes despite the record low difference of around 100 basis points between the repo rate and the Fed rate. The resilience of the rupee is lowering the risk perception of Indian assets for foreign investors, allowing the market to comfortably accept a forward price-to-earnings ratio exceeding 20x for the Nifty Index, compared to pre-pandemic times when even 18x seemed stretched.

The market is forward-looking. What if the headwinds it faced this year turn into tailwinds! The Federal Reserve will most probably cut rates in mid-2024, nudging the RBI to ease domestic liquidity in the second half of the year. The El Niño weather condition that impacted the agriculture sector seems to be dissipating, as per meteorologists. Industry capacity utilisation has come to a level of close to 75%, where pick-up in private capex looks inevitable. The real estate sector, the second largest employer in India, is showing signs of recovery and, this time around, it looks like a longer cycle.

This, coupled with continued government focus on infrastructure and tourism, has the potential to create much-needed jobs and boost overall economic activity. The rock-solid political stability and visibility on policies are rare in India. The reform momentum is not only bearing fruits, but it may also see further acceleration with continuity of the government at the Centre. This is how the narratives are built and bubbles are formed, ignoring risks, and the market succumbs to the herd mentality bias.

Repeatedly, these unprecedented times have shown astonishing returns for equity investors, ignoring all the emerging risks. The post-liberalisation era in the early ’90s, the dotcom bubble and the pre-crisis period [2007–08] are some of the examples where the returns were staggeringly high. However, these periods were often followed by multi-year consolidation with negative returns. When greed takes over, fundamentals are forgotten.

Call for Caution

These are indeed unprecedented times. The Fed's assertion that inflation was "transitory" has been proven wrong, and most experts have abandoned their forecasts of a US recession. China, previously touted to surpass the US as the economic superpower, is grappling with record-low valuations and significant wealth destruction. Meanwhile, the Russian GDP, despite crippling sanctions from the West, seems to have overtaken Germany’s in terms of purchasing power parity. European countries like France, Germany and the UK are teetering on the brink of a cost-of-living crisis, yet their stock markets are flirting with all-time highs.

A highly speculative crypto asset like Bitcoin has surged over 70% year-to-date, creating 1,500 new wallet millionaires daily, according to Kaiko Research. Prime Minister Narendra Modi got behind PSU stocks in August 2023 parliamentary speech, where he advocated investing in PSU stocks with his comment “Daav laga dijiye [place a bet]”. Since then, PSU stocks have been on a tear. While this is truly an India moment, and there is no doubt in my mind, past experiences suggest excessive leverage and speculative activities in India and abroad can ruin the party anytime. So, keep your canary with you. 

The author is the chief investment strategist at Kotak Alternate Asset Managers