Investing in a tightening cycle

A few weeks back, unexpectedly, the RBI hiked the repo rate by 40bps, catching the markets by surprise. This tightening cycle, combined with rising inflation, has managed to keep the broader markets on tenterhooks. Nifty has been range-bound this calendar year with a peak of 18,308 and a bottom of 15,782.

The key issues that typically an investor faces in these inflationary times are:

1. Return expectations increase: As inflation rises so do the return expectations. An average investor would today expect nothing less than a low double-digit return, irrespective of the instrument and tenure of investment. The issue is that, in these times, nothing other than equities will give you that. So, as bearish as the sentiment may be, one thing you would do well is to realize that equities remain one of the best and most sustainable means of wealth creation.

2. Multiples contract: Since PE multiples are a derivation of DCF, as interest rates rise so does the discounting rate, and consequently the valuations compress. So, de-rating of stocks is a very realistic possibility in these times.

3. Leverage: Any company having leverage, irrespective of the sector will likely face profitability issues. Again, something worth taking note of in these times.

So, the key question is: what should be your strategy as a retail equity investor in these tough times? Here is a quick guide to investing in a tightening cycle:

• Be patient: The markets will typically try and test your patience, stay put. As long as you have invested in quality stocks with a clear thought, do not panic. The idea is to be thorough in your diligence, investing only in companies with great corporate governance practices, the typical “Good & Clean” companies. Also, at the same time making sure that growth prospects are intact from a medium & long-term perspective.

• Be greedy: If liquidity permits, invest more with every fall. Remember, great companies are best bought in the worst times. Market movements are transitory but the mission to create wealth is eternal. So rather than getting worried by a fall, if business fundamentals are intact, invest more. Human beings always tend to overestimate the impact and hence always get caught by the speed and intensity of the market bounce back.

• Focus on growth: as long growth is in line with the above expectations, PE multiples do not compress significantly. In this scenario a growth focus is important. If you believe that the invested company in question shall not incrementally disappoint, then go ahead and invest, from a medium-term perspective your investment shall be fine.

• Leverage: focus on companies that do not have massive leverage. The tightening cycle is now coinciding with a re-leveraging cycle. Businesses across sectors are starting to face capacity issues, Capex cycles can be calibrated or delayed but will not be shelved completely. If already leveraged, then the probability of a debt issue emerging in the future can’t be ruled out.

Keep these simple steps in mind and see your wealth grow exponentially with time.

Happy Investing!