Charanjit Singh, Fund Manager, DSP Mutual fund

23 Dec 2024 , 01:34 PM

1. What is Business Cycle Investing and How Can It Mitigate Risks in Turbulent Markets?

Business cycle investing has been a well-established concept in developed markets for years, focusing on macroeconomic cycles. This strategy involves selecting sectors based on economic phases such as expansion, slowdown, recession, and recovery. However, our research suggests that it’s more effective to focus on market cycles rather than just macroeconomic cycles because market cycles often lead economic cycles. Markets tend to react even before economic data is released. Additionally, actions taken by central banks and governments can significantly influence the macroeconomic landscape. We define market cycles through sector rotations based on several factors: the excess returns of a sector compared to the Nifty 500 index, sector valuations relative to the Nifty 500, earnings growth of the sector versus the index, and ownership levels across mutual funds compared to index weightings. Business cycle funds act like flexi-cap thematic funds but with lower risk than traditional sectoral and thematic funds. By concentrating on sectors with better returns or eliminating those with lower returns, these funds can enhance overall performance compared to standard flexi-cap funds.

2. Which Sectors Are Likely to Outperform in the Current Business Cycle?

In the current phase of the business cycle, we see promising opportunities in the banking sector. This sector has underperformed over the past four years, and its valuations are now reasonable. With low growth expectations for earnings, there’s less room for disappointment. We are also optimistic about sectors like pharmaceuticals and healthcare services, manufacturing, and power. These sectors have strong fundamental drivers that should support superior earnings growth compared to the broader market. Additionally, emerging sectors such as electronics, energy transition, and battery storage have minimal representation in major indices but are poised for significant growth in the future.

3. What Role Does Diversification Play in Managing Risks During High Market Valuations?

Diversified strategies like business cycle funds are better positioned than sectoral or thematic funds during volatile markets. Since 2019, investments in sectoral and thematic funds have surged from 2.5% to 15%, but these funds often carry high concentration risks. Having a diversified portfolio of 45 to 50 stocks is crucial because liquidity can be an issue in many sectors. A well-diversified portfolio allows us to build substantial positions based on stock liquidity and adjust as market conditions change.

4. What Is DSP Mutual Fund’s Approach to Business Cycle Investing?

At DSP Mutual Fund, we employ a two-step approach to manage our business cycle fund. First, we use a sector rotation framework to determine which sectors to invest in and which ones to avoid. This framework considers four key factors: excess returns, valuations, earnings growth, and sector ownership .Next, we analyze each stock’s business cycle by examining three-year sales growth CAGR and margins compared to historical highs and lows. This blend of top-down and bottom-up analysis helps us build a robust portfolio.

5. How Does DSP Mutual Fund View Current Market Valuations?

Currently, valuations are stretched in mid- and small-cap stocks due to strong market inflows; however, large-cap stocks still offer reasonable valuations. Therefore, we must be selective in choosing stocks that either provide valuation comfort or have strong earnings growth drivers—this is akin to a barbell approach. The market is trading at around 20 times earnings—close to its long-term average—which suggests that significant rerating may be challenging moving forward. We expect medium-term market returns to moderate as they align more closely with earnings growth projected at about 12% for FY26.

6. What Challenges Should Investors Prepare For in Turbulent Markets?

Investors should be aware of several challenges in today’s market: slowing urban demand, weak government capital expenditure so far in FY25, declining tax collections, and high valuations. Additionally, global factors such as a strengthening US economy could lead to foreign institutional investor (FII) outflows from India. Changes in US government policies could also pose risks for certain sectors. However, India’s overall macroeconomic outlook remains strong compared to other emerging markets, making it a preferred choice for investors.