The Art Of Identifying Future Winners During Sideways Phase In Markets And Economies

Up, down, and sideways—this has been the story of India’s economy and share markets in the last three decades. While up and down phases don’t last long, successfully managing the sideways phase is key to wealth creation.

Let us learn how to do that. But a brief recap first.

Through most of the 1990s, even as the global economy went through a period of exuberance, only to crash land in the dot-com bubble, India had a period of extended sideways movement.

Ironically though, it was in this sort of ambling sideways phase of the late '90s and the early 2000s that some of the iconic businesses and great leaders were taking giant strides, both in India and elsewhere. And this happened despite scarce capital flows.

Smart business folks knew that building businesses that are robust and profitable were not antithetical to building scale. In fact, scarce capital flows made internal accruals and profit redeployment key tools for growth.

This form of growth capital looked rather alien, at least until very recently, as I sit and observe from the vantage of 2022. Though I must say that life has come back full circle and companies banking only on ‘doubling valuations every six months’ as the bedrock of their growth strategy are looking at an uncertain future as capital flows dry up.

History tells us that the best businesses have been built when the external environment is neither overexuberant nor one of excessive pessimism.

The first 10 years of the new century had a rather long period of up phase—nearly four years between 2004 to 2008. But the decade still had six years of sideways movement along with two brutal busts of 2000 and 2008.

Nearly eight of the 10 years between 2010 to 2020 happened to be one of stagnant global economy.

In India, the sideways movement was best exemplified by the real estate sector. Property prices remained the same for almost a decade. The credit bubble and exuberance of the 2005-08 era took a toll on the banking system and kept it in suspended animation for almost a decade. It took a pandemic to create a sharp ‘up’ in capital flows and funding. 

But it has proved to be ever so short-lived. We have already seen a ‘down’ phase as I write this, and this is really something that was coming. Liquidity-driven money printing by central banks was bound to push inflation.

Everyone thought that the world has changed. But it has not. The excuse of the Russia-Ukraine war was a trigger to take the world back to the most familiar phase it knows, but doesn’t accept—that of sideways movement. 

I will try to make sense of the key elements of sideways phase, so that investors are able to identify such businesses which are not built on extreme pessimism or optimism and therefore are able to create long-term wealth.

To begin with, let us take a much longer view, not just of decades but of centuries. 

I would begin by borrowing from Thomas Piketty, the French economist known for his work on economic history and inequality of wealth distribution. Let me clarify at the outset that I am not in agreement with him on many of his prescriptions. 

The crux of his argument is that the growth rate of output at the global level, referring primarily to the most industrialised nations, has already seen its best days. Though he talks about this in the context of rising inequality in wealth distribution and the resultant turbulence it will cause, I would like to use this prognosis in a different context. 

Growth refers to population growth and economic growth. Population growth was close to zero through the most part of world history. The boom started after the First World War and accelerated post the Second World War. In fact, global population has nearly doubled in the last 50 years.

The rate of growth has, however, slowed down considerably now. While global population climbed from 4 to 8 billion in 48 years, it will likely reach the peak level of 10 billion by the 2080s, according to latest United Nations projections. 

The rapid economic growth of recent years was primarily a result of productivity gains that led to accumulation of capital, thanks to new technologies that dotted the landscape of the 20th and initial years of the 21st century.

The countries like India and China have been playing the catch-up game. The two large economies have benefited from growing working age populations and substantial productivity gains. China, however, has already seen its best days of population as well as productivity growth. India is perhaps a decade or two away from that.

Global economic growth has averaged 1.5 to 3% per annum in the last 50-70 years.

The world is perhaps trending back to this bend primarily because of the convergence of the two factors—slowing demographic dividend and lack of substantial additional productivity gains due to new technologies to generate alpha of consequence over the population growth rate.

This is a humbling proposition for most of us who have grown in the milieu where very high growth numbers have been considered a given. I am not in the business of predicting global economic growth scenario for the next few decades. All I am saying is that slowing growth may not be a passing phase.

This is not to suggest that every nation or corporation or individual is staring at secular growth deceleration. I believe that this phase will see consolidation, some sort of sideways movement in most markets at macro levels but big moves beneath that.

Corporations that are big may get bigger, talent and capital will get even more concentrated in the hands of the entrenched incumbents. The challengers may struggle to stay afloat. Governments will raise taxes and credit will get expensive.

As an investor in existing businesses or new ones, a business leader of a thriving company or a founder of a new venture, one must be able to envisage a scenario like this. It is important to also study from history, how businesses have been built and improved during these phases of sideways growth over extended periods. This environment of modest growth may become a permanent reality going forward.

The Indian stock market has been one of the world’s big success stories. Many would argue that the bull market that started in the '80s still continues with minor upheavals and sharp upmoves in an overall secular rising trend. Compounded annually, it has delivered over 15% return over a 30-year period!

Such a secular uptrend, however, has had periods of underperformance. 

Let me elaborate with some examples. The period between 1979 to 1986 is considered a rather exciting phase of returns. The Sensex went up from 125 to 650 in a span of seven years, a CAGR of over 20%. But just extend this date from 1986 to 1988, another two years, the BSE Sensex was back to around 390. Add another two years and the average drops further. 

Does this mean that a decade was lost? Not really. This was a decade of liberalisation by stealth, as some economists and policymakers would describe it. Though the markets remained flattish for a decade, it was a period of emergence of some companies that made their mark later on.

In that sense, extended sideways phase proved to be a precursor to the emergence of future winners. Identifying such winners during such phases requires abandoning the bulls and bears narrative. 

On the economy front, GDP growth averaged a little over 5.5% between 1980-90. This happened on the back of relatively ‘minor sounding’ reforms or reforms by ‘stealth’, as many including Arvind Panagriya described—in his working paper of 2004 for the IMF.

They included relatively liberal capital goods imports regime, a relaxed industrial licensing policy and some tax rationalisation. They seemed to have unleashed animal spirits as a few enterprising businessmen took advantage of these policy moves and the resultant growth—even in the pre-liberalisation decade of the '80s—was not bad at 5.5%.

The decade of the 1980s saw a flattish share market movement, but the underlying economy had shown promise. The Sensex could capture this only with a lag. 

If one were to analyse the decade of the 1990s using the economic growth as well as Sensex data, the trends mirror the 80s. Average GDP growth in the decade was 5.6% and the Sensex did not do much. 

But solid underlying growth created some of India’s future winners, and a few of them even achieved global scale. The IT industry was born and nurtured during this phase, besides a host of businesses in diverse areas such as banking, engineering, consumer durables, FMCG, IT services, and automobiles. 

This decade of seemingly flat share market movement created some of the best and most resilient Indian businesses and brands. And what followed was a phase of spectacular share market returns. Sensex turbocharged from 3,000 in 2003 to 21,000 in 2008, a return of more than 45% CAGR!

But this was a period of some of the worst excesses of unrelated diversifications, leading to bad loans, that took more than a decade to clean up. The economy did grow fast, over 7% for four years.

The disconnect between Dalal Street and the main street remained. What followed was years of sideways movement as the Sensex stayed in the 21,000-30,000 range, delivering less than 7% in the decade. But here again, in a relatively dull phase of the Indian equity markets, the Indian entrepreneurship story improved. 

Many of the excesses in the banking system got cleaned up. Credit became more disciplined and enterprises with robustness in their business models got stronger and some new opportunities thrown up by newer technologies also led to creation of good businesses. 

India’s economic history, therefore, tells us that share market booms may not mean creation of solid businesses. And phases dotted with long sideways movements of markets have thrown up companies which eventually became future leaders. It is important to identify businesses that are built and nurtured during boring phases.

What are the indicators to identify winners during the sideways phase of markets and economy?

Data crunching and the benefits of hindsight tell me that companies that retain/increase profit margins, while increasing market share during extended sideways phases, are the likely winners.

Very few have been able to do this on a consistent basis. Titan Co., HDFC Ltd., and Asian Paints Ltd. are some companies which have done that in the past.

Given below are some of the names that have passed the test of increasing market share without compromising on profit margins. I have listed only a few from among leading sectors here. 

Among the financials, ICICI Bank Ltd. stands out. The bank has transformed itself into a profitable growth story. In every category, it has increased market share without compromising on profit margins- be it in retail, home loans, investment advisory-led services and assets, corporate, or SME banking.

The technology-driven expansion in new areas like FASTag and UPI payments, besides online broking, has also been consistent. Its tech stack is the best in the business. Its net profit has grown rapidly in the past five years and so have profit margins.

Another success story in the making is Axis Bank Ltd. It, too, has surprised on the upside on most parameters. Both ICICI Bank and Axis Bank have also increased their net interest margin and reduced their non-performing assets.

In the information technology sector, KPIT Technologies Ltd. stands out as one interesting play of increasing market share in embedded software while increasing profit margins.

KPIT’s net profit has grown from almost nothing to around Rs 350 crore while retaining a profit margin of over 20%.

In manufacturing, Hindustan Aeronautics Ltd. continues to dominate the aerospace manufacturing play and has been a near monopoly, making recent strides in the international markets too. Laurus Labs Ltd., United Spirits Ltd., ITC Ltd. and Aarti Industries Ltd. have been other such examples.

The share market, too, has been generous in rewarding these companies. The share price of ICICI Bank, for instance, has nearly tripled in the last four years. Shares of KPIT have been a bull run of its own, having gone up more than five times in the last three years. Such impressive runs at the bourses show that positives of these companies have been acknowledged and perhaps factored in too.

The reasons may be varied and sectors in vogue or out of vogue, but the quantum of profits, its growth trajectory, broad improvements in market share and retention/improving profit margins are perhaps good indicators to gauge future winners.

Some of the above examples show that this may prove a handy tool in identifying inherent strengths of companies.

Disclosure: The author owns most of the stocks discussed in the article and, hence, may be biased. Individuals are encouraged to use the above only as reference points and case studies and do their own due diligence as well as talk to qualified financial advisers before making any investment decisions.

Ajay Chacko is a long-term investor and a student of economic history. He co-founded the digital content platform Arré, and has authored two fiction books. He is also the former COO of Network18 Group.

The views expressed here are those of the author, and do not necessarily represent the views of BQ Prime or its editorial team.