In the dynamic world of investment, recognizing the nuances of market cycles is pivotal for sustaining long-term success. As every bull cycle ushers in new leaders, investors are presented with opportunities to capitalise on businesses with compelling growth potential (more than 20% growth over the next four to five years), trading at reasonable valuations (typically less than 15 PE for high growth and high RoE businesses), typically at the cycle's onset.
Navigating market euphoria and the pitfalls of exorbitant valuations
However, as the bull cycle peaks, the euphoria in the market can lead these stocks to trade at exorbitant valuations. These emerging leaders often experience a swift rally in stock prices, thanks to the discovery premium, propelling valuations to 2 times to 3 times of starting point, within three to four years. At elevated valuations, the market tends to factor in most positives, making these stocks vulnerable to external shocks or minor growth slowdowns.
Consequently, stock prices may enter a sideways phase for one to two years, waiting for valuations to cool down or business growth to resume. During this phase, the primary driver of stock prices becomes earnings growth, as ever-expanding valuation turns unsustainable. Investors must exercise prudence, even though the underlying business remains unchanged, as high valuations could be a trigger to take some money off the table.
Strategies for navigating market peaks
Historically, when valuations catch up to industry leaders or reach around the triple-digit mark, stocks tend to trade within a range. In bear markets, high valuations act as a catalyst for profit booking or triggering exit from the stocks. To navigate this terrain, the art of rotating stocks comes into play. Investors should consider letting go of stocks/ trimming exposure to businesses that have witnessed earnings and multiple expansions in the ongoing bull cycle, especially those trading at exorbitant valuations.
Trimming or exiting such positions and reallocating funds to stocks with characteristics of low valuation, high growth, and robust RoCE/RoE can rebalance the portfolio for sustained multiple expansion and consistent higher growth. Keeping an eye on your stock investments all the time might sound like a bit of work, but it comes with some benefits. It allows your investment portfolio to adjust to the ups and downs of the market and take advantage of broader economic trends.
However, there's a flip side to this strategy. You'll need to constantly be on the lookout for new stock opportunities, and when you decide to sell after holding onto a stock for three to five years, there could be some long-term tax implications.
Strategic portfolio management
Despite these challenges, the smart moves you make by keeping an active eye on your stocks can outweigh the downsides. One of the big advantages is that it helps protect your portfolio from big drops – we're talking about those times when the market takes a nosedive by 25% to 35%. By being proactive, you're essentially putting up a defence against major losses. This kind of smart management might result in more stable returns over a three-to-five-year stretch, even though it requires a bit more attention along the way.
In the contemporary financial landscape, where business cycles have shortened, agility in managing portfolios in response to macroeconomic shifts has become imperative. While downturns or bear cycles are often influenced by top-down factors related to overall market or macroeconomic conditions, the quality of businesses acts as a resilient floor against significant drawdowns during down-cycles.
The value creation playbook underscores the interplay between Growth, ROCE, and the cost of capital to evaluate return drivers. Identifying rapidly growing quality businesses at discounted valuations becomes critical in unlocking the potential for multi-bagger returns. Adopting a tactical approach to stock rotation ensures that portfolios remain resilient, adaptable, and poised for sustained success in the ever-changing market dynamics.
Prabhat Ranjan, Co-Fund Manager, Right Horizons PMS and Vijay Chauhan, Co-Fund Manager, Right Horizons PMS
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