Christmas, err… Diwali just came early! Be patient now

The meaning of the phrase ‘Christmas came early’ is rather straight forward — that is to depict when something good happens to you unexpectedly, and it feels like Santa brought you an early present. In India, we are a little more than a month away from Diwali, and the string of announcements by the Finance Minister Nirmala Sitharaman brought a round of cheer in the equity markets, with Nifty 50 Index rising 5.3%, Nifty Midcap index rising 6.5% and Nifty Bank Index rising 8.3%. It certainly looks like Diwali did come early.

In brief, the FM announced that the base income tax rate for all corporates be cut from 30% to 22%, and newly formed companies making fresh investments in manufacturing only pay 15% base tax rate. There are certain conditions attached to the above, but it is a step in the right direction. The taxation gets calculated entity-wise and not on a consolidated basis, so the accountants of different companies will burn the mid-night oil to calculate the exact impact, but it is widely understood that the reported net income of the entire market will rise between 5-7 percentage points -- quite a meaningful gain.

Certainly, someone pays for the presents, and the cost of this cheer is Rs 1.5 lakh crore in foregone taxes. The 10-yr G-sec yield rose 16 basis points to account for the higher borrowings that the government will need to do to bridge the fiscal deficit.

The math is relatively simple here: The bank liquidity had turned into a surplus four months ago and reached a high of Rs 16 lakh crore. Banks have the ammunition to lend but was wary of lending it in the face of the high non-performing assets. What these announcements do is to put money in the hands of companies and individuals in the form of lower taxes and government is the one borrowing from banks.

Markets were looking for higher credit off-take with money moving away from banks and towards companies and individuals.

The announcements require just an additional step: money will still move from banks to companies and individuals, but with the government as an additional stop. With inflation and interest rate at their lows, the fear of government borrowing crowding out private investments is not material, in my opinion.

The key question now is—where the market goes from here? After the stellar 5% rise on Friday, the frontline Nifty 50 index is down just 5% from its all-time high, but over 70% of all listed stocks are down 30% or more and more than half the stocks have halved from their all-time highs. This is the space one should focus on.

The BSE Small-cap index is down 35% from its all-time high and it is the fourth time it has happened this century (in 2004, 2008 and in 2010 before now). It is certainly possible that a business that one thinks is mispriced today, would not immediately revert to fair valuation tomorrow itself.

Nevertheless, that does not mean we cannot formulate an investment strategy around it. In each of the three instances mentioned above, if one had started systematically investing a constant sum each month from the first time the index hit a 35% draw-down, one would have ended up generating between 18% to 39% compounded annual growth rate (CAGR) over the next three years – truly superlative returns.

This is despite the fact that in the 2008-09 global financial crises, the index, having fallen 35%, fell another 68% over the next fourteen months; and yet, if one had continued the SIP through the fall, one would have generated 18% CAGR over a three-year horizon. The same study, when extrapolated over a seven-year SIP time frame yields between 13% and 17.5% CAGR – again a stellar performance over longer time frame.

Choose the mid/small-cap fund of your liking, but don’t forget the cardinal rule that I had mentioned even in my last article. Be patient and be disciplined; returns will follow.