Recap of the last three years
The last three years (2020, 2021, 2022) were highly eventful for the markets. In March 2020, the global economy came to a standstill and markets crashed when nationwide lockdowns were declared to counter the spread of the coronavirus.
Governments and central banks, particularly in advanced countries, responded with massive fiscal and monetary stimulus measures to support and safeguard individuals and businesses from the devastating effects of the lockdown. Central banks reduced interest rates steeply towards zero and injected massive liquidity into the system through its bond purchase programs.
Towards the second half of 2020, economies started to reopen gradually, but the resultant pent-up demand overwhelmed the global supply chain. That along with labour shortages created a huge demand-supply mismatch causing the rise in prices of certain goods.
However, the initial price rise in a few goods started broadening to more goods. As a result, inflation, which had remained low for most of the last four decades, started rising in the middle of 2021. Central banks initially considered the rise in inflation as transitory, but later had to backtrack once high inflation remained entrenched.
Consequently, the central banks had to shift focus from stimulating growth towards bringing inflation under control; the asset purchases were gradually reduced and came to an end; policy interest rates were raised at the steepest rate in forty years. This pivot of policy stance by central banks had adverse effects on markets and the economy.
Stock prices fell, bond prices fell, the dollar strengthened, and money moved from riskier emerging markets toward safer advanced markets.
Now, as we stand at the start of 2023, inflation remains high, even though there is a slowdown over the last three months. The US and other advanced countries are expected to enter a recession in 2023 (some say, they already are in a recession).
The last three years, undoubtedly, were one hell of a rollercoaster ride for the markets. And how did markets perform during these 3 years in terms of return?
The 3-year annualized return of major stock indices were:
| Country | Stock Index | 3-year Return (%) |
| United States | S&P 500 | 6.9% |
| United States | Nasdaq | 8.3% |
| United Kingdom | FTSE 100 | 2.1% |
| Germany | DAX | 5.3% |
| Japan | Nikkei 225 | 5.7% |
| Hong Kong | Hang Sheng | -4.8% |
| China | Shanghai Composite | 4.3% |
| India | Sensex | 14.3% |
As obvious from the table, Indian stocks outperformed, while Hongkong, Chinese, and British stocks underperformed. Sensex was the only major index with double-digit returns during the 3 years. But these returns were calculated without considering the currency movement during the period.
For example, Indian Rupee depreciated by 14.3 percent against the US dollar during the period, i.e., at an annualized rate of 5.00 percent. If the currency depreciation is taken into consideration, the Sensex return will be down to 8.56 percent. Still, it is among the best performer within major markets.
This has made Indian markets relatively quite expensive, and as a result, it has low prospective returns. As China has reopened after a gap of three years, in the short term, there will be a shift of capital toward China from other markets. Consequently, Indian markets may underperform in the near term.
The New Investment World
The high inflation that emerged over the last one-and-half years and the central bank’s effort to bring it within its target range through steep policy interest rate hikes signifies a turning point for the investment world.
As of now, the central banks’ stance is to do whatever it takes to bring inflation to their target range. But the adverse effects of rising interest rates on the economy are apparent. In such situations, it is doubtful whether central banks will stay the current course as the economy stumbles and suffers under their tight monetary policy.
The inflation level remains elevated, even though, the rising trend and volatile nature of inflation seem subsided for now. Many experts believe that we may have to stay content with higher inflation and higher interest rates. And that would be the new normal.
For the past 40 years, i.e., starting from the early 1980s, interest rates had been in a declining trend. The US Fed fund rate fell from 15 per cent in the early 1980s to zero per cent in 2020. What enabled this was that during this period inflation mostly remained low and anchored. And what enabled inflation to remain low and anchored was globalisation. Globalisation enabled the frictionless flow of capital and labour to places where they could be used most efficiently.
But, over the last few years, we are witnessing a slow dismantling of this system. Globalisation is seen with scepticism. Populists believe it benefited only a few, while many suffered as a result of loss of income and jobs. Protectionism is slowly being adopted by different countries to varying degrees. The political system has turned favourable toward protectionism over globalisation.
The key takeaway is that the old rules of low inflation, and declining interest rates period has become obsolete. The new investment world characterized by high inflation, and high-interest rates will have a new set of rules, and assets that perform in this environment will be quite different from the last 40 years.
Investing will shift from passive to active. Value investing will gain prominence over growth investing. Lenders will prosper, while borrowers will have hard times.
The Role of Valuation
Valuation has an important role in the investment process. It plays a big part in determining your investment return. The stock of a quality company if bought at a very high price relative to its fundamentals may deliver inferior returns, even if the company grew at a high rate. And valuation is going to gain greater prominence in the high inflation, rising interest rates market.
Growth investing rewarded investors well in the last few decades when we had low inflation and low-interest rates. Meanwhile, value investing underperformed growth investing. Growth investing was about buying companies with high growth; a large part of these companies’ earnings lies in the future. Value investing is all about buying undervalued stocks, i.e., stocks trading below or close to their intrinsic value. Value investing is expected to outperform growth investing in high inflation and rising interest rates market environment.
Aswath Damodaran is considered the foremost expert on valuation. His books – Investment Valuation, The Little Book on Valuation, Damodaran on Valuation, and Narrative & Numbers – are investment classics.
According to Damodaran, there are two types of valuation: intrinsic valuation and relative valuation.
Intrinsic valuation tries to determine the value of an asset using the cash flows the asset is expected to generate in the future. The Discounted Cash Flow (DCF) model is the most important intrinsic valuation model.
The DCF model defines the present value of an asset as the sum of all cash flows that the asset is expected to generate, over its useful lifetime, discounted for the time value of money and the uncertainty of receiving those cash flows.
We need five inputs to use in a DCF model: 1) the cash flow of the business from its existing assets and its growth rate; 2) the expected growth rate of cash flow of the company; 3) the cost of capital; 4) we need to calculate the discount rate. The calculation of the discount rate requires us to determine the risk-free rate, equity risk premium, and relative risk; 5) and finally, the terminal value, which is the value of the company at the end of the forecast period.
The second type of valuation is the relative valuation method. Here we compare the valuation of similar firms. The usual relative valuation tools of P/E ratio and EBITDA/EV ratio can be used. These values need to be normalized for the differing growth rates of the companies. It would be misleading to compare the P/E ratio of two companies from the same industry but have different growth rates. For comparison purposes, we must normalize the P/E ratio to account for the different growth rates.
Despite all these efforts, Aswath Damodaran states that all valuations are biased, most valuations are wrong, and the simpler your valuation method, the better your valuation.
AMN CAPITAL 