How economic cycles influence returns

Indian investors need to wake up to the reality of economic cycles, and the risks and returns that they entail, says Uma Shashikant

    Several investors worry whether the optimism of the 2003-7 period will return. The hope about emerging as the next big economic miracle has been replaced by despair. Everything that seemed to be a good thing feels like a burden now. Investors refuse to see some of the issues as cyclical and agree that a downturn will unleash the very factors that shall take the economy back to an up cycle. The reluctance to build economic cycles into an investment strategy comes from a dominance of structural factors that have influenced returns for a long time. 
    Economic cycles represent the correction of excesses that take place over periods of time. During an up cycle, there is an overall optimism. Economic activity expands with assumptions about revenues, costs and profits riding on growing consumption and demand. Inevitably, these assumptions tend to be too sanguine to convert into reality over sustained, long periods. The up cycle collapses and businesses soon reach the bottom, trying to protect against failure, while cutting investment and costs, and looking for demand for their products and services. 
    The investors in emerging markets such as India take time to align their portfolio strategies with economic cycles. This is because a dominant number of structural factors influence their returns, sometimes overshadowing the logic of economic cycles. The real estate market in India is structurally insulated from the developments in the economy by a blanket of black money. It is a parallel asset market funded at high rates by cash, used dominantly by investors who want to acquire and hoard the asset. Several of these people are not impacted by the interest rates set by the RBI, the tax regime, the processes of the banking system, or the rules of law. When such an asset defies the laws of the economic cycle, it begins to attract ordinary investors, who see it as a safe haven during difficult times. The problem with this approach is that the real estate market may not remain insulated completely if the money being invested here is sought for other purposes, or if the players have stretched themselves by overestimating the demand. The cyclical factors inevitably come into play, perhaps with a lag. Small investors in real estate hope for the structural inefficiencies in this market to continue forever, and that is the risk they take. 
    Leaning on structural factors does have its advantages. It is a tough, long road to correct structural imbalances and problems, and every policy correction offers investors the opportunity to make abnormal profits. The first large set of retail investors in equity in the 1970s came from investing in the IPOs of multinationals. These were share sales by blue-chip companies, which were mandated to reduce the stake of foreign parents and offer shares to the Indian public at a price decided by a government agency. Subscriptions to these IPOs made several small investors very rich. This was a structural gain. What this triggered, however, was the tendency of companies to go public too soon, making venture capitalists of the retail investor. There were windfall gains in some cases, but many other companies simply vanished. What the investors failed to see is that they neither have the skills of an early investor, nor the ability to take on the risk of several failures and a few sparingly available successes. 
    Several equity investors base their investment thesis on structural factors. In the early days, they would bet on what the government would do in the budget. Then came the structural advantages offered by a now open economy. These structural gains were the themes of the winning investments in the post-liberalisation period. Add to it the consumer boom that was unleashed when incomes moved up, and aspirations of a young population skyrocketed. Investors in the markets in 2007 felt so confident about the structural advantages of India that the popular theory was that the country was ‘decoupled’ and, therefore, would not be impacted by the developments in the rest of the world. 
    The past five years have grounded these risky and overtly optimistic views about investment returns. The problem now is that making structural changes to the economic environment has become tougher than before. It is obvious to many that sustained economic well-being is possible only if we carry out structural reforms in several things—electoral process, education system, infrastructure, governance, health and institutional structures. These alterations will take a painfully long time. 
    A shift is needed in the investor mindset. First, investing cannot always be about making opportunistic short-term gains. Second, return expectations should be realistic as windfalls cannot be a regular, sustained event. If some gains are made by sheer luck, it cannot be the basis for what might happen in future. Third, the risk in investing needs to be acknowledged. Every opportunity to make money has a hidden risk that needs to be dug out. It is time investors learnt to look out for economic cycles, instead of waiting for the next unexpected windfall.