The Hindu Business Line : `Time to reassess asset allocation'

In his note @12,000: Time to Reassess Priorities, Mr Prashant Jain, Chief Investment Officer, HDFC Mutual Fund, opines that the investor focus should be now more on assessing, reducing and managing risk and taking only that much with which one is comfortable.

Extracts from the note:

On earnings power

"Equities are slaves of earnings" is an apt description, but only over long periods. Over short-to-medium time-frames, equities have a mind of their own and can significantly under-or out-perform corporate earnings.

In the recent past, the markets have raced beyond the catching up stage and have in fact now outpaced the profits themselves. The pendulum now appears to have swung somewhat beyond the equilibrium point and, in fact, the markets are discounting fairly healthy earnings growth over the next two years and reasonable growth thereafter.

This increases the risk in the markets, because, if the expected growth rates (emphasise rate and not growth itself) do not materialise, then the punishment for any disappointments should be sharp and swift.

The risk is also higher because of the time factor at current levels of P/E multiples, there is now a relatively long period of two years (as two years growth is discounted) for things to go wrong unlike shorter periods at lower P/E multiples

Economic growth and profit growth

Economic growth and profit growth are not always synonymous.

Though the Indian economy is on a secular growth path, economic growth need not always flow through to corporate profits in same measure and particularly for all sectors and companies.

For example, during the period 1990 to 2000 the economy grew consistently, but several sectors did not grow or in fact where profits eroded.

This can happen for any number of reasons — commodity prices, rising interest rates, currency movements, increasing competitive intensity, slow down in growth due to higher penetration, regulatory changes, etc. Therefore, to simply translate economic growth to profit growth is not entirely correct.

In view of the large capex that is underway and a likelihood of a rise in interest rates, it is not realistic to assume any significant acceleration in growth rates beyond fiscal 2008.

Impact on investor returns

Clearly, the big returns are over. Potential returns are less attractive and the risks are higher than in the past (partly driven by higher valuations, partly by some risks to corporate profit growth and partly by a likelihood of higher interest rates).

This implies that the potential reward for the risk that is assumed is less than in the past. Therefore, probably this is not yet the time to sell equities completely; it is definitely a time to reassess one's asset allocation and to take restock of the situation.

In view of the significant deterioration in the risk-reward equation, the focus, in my opinion, should be now more on assessing, reducing and managing risk and taking only that much with which one is comfortable. There is lesser merit in taking high risk in portfolios, as the risk is not being matched by a corresponding potential of returns.

Extracted from the HDFC Mutual Fund web site

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