Maximum Pessimism Means It Is Time To Invest
One principle that I have used throughout my career is to invest at the point of maximum pessimism. That is, the time to be most optimistic is at the point of maximum pessimism. –John Templeton
There has been a continuous flow of bad news on the macro-economic front, the corporate earnings front and the fund flows to equity markets. All of this has resulted in a huge sell-off in the markets with various research reports showing a drop of more than 50% from the peak prices in more than 50% of the stocks in the market. Many smaller stocks have dropped 70% to 90%. This huge drop in stock prices clearly shows that we are in a bear market. And this is not just any bear market, but a very severe bear market.
However, the headline indexes, such as, Nifty 50 and Sensex do not show a bear market. For example, Nifty 50 (index of the largest 50 stocks) shows a return for the last 1 year of -4.35%, while Nifty 100 (index of the largest 100 stocks) shows a return for the last 1 year of -5.83%. These numbers do not show a bear market, defined as a drop of more than 20% from recent highs.
However, if we look at Nifty Next 50, some interesting facts come to light. Nifty Next 50 shows a return for the last 1 year of -14.48%. This is the index of 50 stocks following the largest 50 stocks included in Nifty 50. The Nifty 100 is the index of these 50 + 50 = 100 stocks. The question is why is there so much difference in the returns of these 3 sets of stocks?
For that one has to under that the index is market-cap weighted. So the larger stocks have larger weights. So Nifty 50 and Nifty 100 have the same set of top10 largest stocks. However, Nifty Next 50 has a much smaller set of the top10 largest stocks. It is very clear that the smaller stocks in Nifty 100 have fallen close to bear market territory while the largest 10 stocks are showing a much stronger performance. This is the divergent performance in the markets.
The Nifty Midcap 100 and the Nifty Smallcap 100 are showing last 1 year returns of 20.63% and -28.24%. These are definitely in the bear market territory. However, even these indexes are not showing the true picture since, as mentioned above, there are more than 50% stocks which have fallen more than 50% based on various research reports.
This is one indicator of reaching the point of maximum pessimism.
The next indicator is the fund flows. The FPIs are consistently showing a net outflow for the past 1 year or more.
Another indicator is the macro-economic data. The real GDP growth rate has fallen to 5%, which is not a shrinkage but one of the highest growth rates for any major global economy. However, the reaction to that number has been hugely negative.
Certain sectors, such as, Automobiles, textile, residential real estate etc. are in actual shrinkage. The reaction to these numbers is extremely negative.
Finally, the most bullish, research analysts or fund managers, including pro-government commentators are also reacting negatively.
We are not discussing whether they are right or wrong in their reactions and sentiments. The point is that the most bullish and positive commentators are also showing negative sentiments.
When one cannot find a single positive commentator, it is clearly the point of maximum pessimism.
At this point it is natural to ask the question as to why one should also not have a negative sentiment and participate in the probably correct attitude of maximum pessimism.
We as scientific investors steeped in the value investment philosophy should remind ourselves that we are not there to follow Mr. Market but to take advantage of Mr. Market. Further, remember the 3 characteristics of the Scientific Investor, viz., Originality, Character and Patience.
Originality refers to an original method of stock selection, valuation & analysis and portfolio management and rebalancing. Character refers to the strength of character to execute the trades suggested by the original method. And Patience refers to the patience required for Mr. Market to recognize the value of your portfolio once Mr. Market comes out of the Maximum Pessimism phase to a more normal sentiment and eventually to a Maximum Optimism or Euphoria.
With this we would like to show a few numbers which show that there is huge opportunity in the market. We will use our Scientific Investing process and eliminate the Capital Destroyers, Capital Eroders and Capital Imploders from the markets. What is left is the SuperNormal companies. For each market cap we will look at the SuperNormal companies and their valuation ratios.
Take the largecap space of the largest 100 stocks. While the PE for the full universe is around 27, for the SuperNormal universe of 33 stocks it is 15.
For the midcap space of the next 150 stocks following the 100 largest stocks, the PE for the full universe is around 36, it is 17 for SuperNormal universe of 32 stocks.
For the smallcap space of smaller stocks below the 250 large and midcaps, but above INR 1000 crore market cap, the PE of the full universe is 25 for the more than 350 stocks in the universe. However, for the 142 stocks in the SuperNormal universe it is 14.
For the microcap space of stocks smaller than INR 1000 crores marketcap, the PE for the full universe of nearly 1400+ stocks is 19, while for the SuperNormal universe of nearly 300 stocks it is just 9.
It is clear that the SuperNormal universe stocks are available from PE of 9 to PE of 15 with more than 200 stocks to choose from in the INR 1000 crore+ marketcap and around 300 more stocks to choose from in the microcap space.
Let us close with a quote from Buffett.
You want to be greedy when others are fearful. You want to be fearful when others are greedy. It’s that simple. — Warren Buffett
Dr. Vikas V Gupta, CEO and Chief Investment Strategist, OmniScience Capital
Disclaimer:
Past performance is not necessarily indicative of future results.
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