How to check if markets are too high
Valuations have run ahead of fundamentals in some sectors. But pockets of value do exist
Equity markets sped through the last 12 months, defying expectations of many investors. The benchmark CNX Nifty 50 index jumped 20% during the period; and a large part of that rally happened in the last three months of March, April and May. In May itself we saw a 10% rise before the benchmark took a breather and corrected around 2% in the week ended 30 May 2014. But data from Association of Mutual Funds of India shows that in the one year from March 2013 till March 2014, retail folios in equity-oriented mutual funds declined by over 12%.
This indicates that just when the markets, after a five-year sideways movement, were getting ready to rally, some retail investors were moving out. Not all missed the bus. Data from National Stock Exchange shows a jump of around 30% in March 2014, 20% in April 2014 and nearly another 30% in May 2014 compared to the previous month in the daily average turnover from the non-institutional non-proprietary segment. So activity from individual investors seems to have picked up recently. While those who moved out would not have been able to make gains from the last one year, those who entered the market in the past two to three months may be wondering what next.
In case of equity markets, valuations are often known to run ahead of fundamentals, both on the upside and the downside. The key is to gauge the probability of fundamentals catching up. Let’s take stock of where things stand at present in terms of corporate finances and stock valuations so that your decision to buy now or not is more informed.
If you want to judge whether markets are under-, over- or fairly-valued, it may not be enough to look at just the price-earnings multiple (P-E) of benchmark indices. You must also consider valuations for broader markets. Data will tell you that both for the BSE Sensex and the broader S&P BSE 500, although P-E valuations are not at the peak, they are higher than the respective 10-year averages. In January 2008, when markets touched a lifetime high, P-E for BSE 500 was at a peak of 24-25 times. In September 2009, when the market saw a steep recovery from its lowest level earlier that year, P-E reached a level of around 22 times.
On a broad level, the current market valuation of around 18 times is no longer cheap, but pockets of value exist. You also need to be cautious where valuations have run up too much too fast. This is particularly true for segments such as capital goods, where valuations are higher than the long-term average while the fundamentals are yet to change. This makes the short-term risk-return dynamics unfavourable.
…but earnings lag
One must note that the current rally has come at a time when earnings are depressed. During the previous market peak in January 2008, the earnings growth trajectory was upwards; now it’s downwards. What this means is that if all goes as expected and economic growth for financial year (FY) 2016 is in line with the economists’ upgraded targets of 6.5%, corporate earnings, too, will move up. This can then lead to more upside in stock prices. “A lot of the anticipated improvement in earnings is priced in. Sectors where earnings are below the historical mean still need to catch up. If all goes as per expectations, P-E is at 15-16 times forward earnings and we could see similar growth in market returns as well,” said Surana.
Caveats must also be put in place. At the moment, these are just expectations and if they don’t come through, prices can correct sharply.
“While we can’t control external risks, what could go wrong is the reform agenda (of the new government) and getting inflation under control. We are also extremely leveraged with banks having financed many unviable projects, which may need to be written off,” said Vikas Gupta, fund manager, ArthVeda Fund Management Pvt. Ltd.
When you look at the current value of any index, the absolute level shows a lifetime high or nearby. But when you look at the financials behind that you will find that even for the broader market, companies’ financial health is worse than what it was during the previous peak in January 2008. For example, for the companies that form part of BSE 500 (excluding financial and oil and gas companies), return on capital employed (RoCE) and return on equity (RoE) are both on a declining trend as opposed to the expansion we saw between 2003 and 2008. Debt-equity levels are at a multi-year high. Markets have rallied despite these conditions on the hope that the change in government will bring in an uptick in economic activity and infrastructure spending, which will trickle into corporate earnings. This, coupled with the widely awaited interest rate easing, can also help strengthen corporate balance sheets.
While some of this is priced in, there is room for higher prices as the improvement actually takes place. According to Gupta, “The book values for companies have increased annually by 15% or so. But the RoE on that book value has fallen from a peak of around 25% during FY07-08 to around 15% in FY13. For RoEs to improve, we could see an earnings upside of up to 60% but that can take another 3-5 years. Somewhere during this period, we are looking at an accelerated earnings growth and that can push multiples up at a faster pace.”
There is a lot of expectation built into markets at the moment, but the delivery is yet to happen. While there is no reason yet to believe that economic conditions will not improve, it’s also too soon to confirm that they will.
Experts say that investing is also about timing the markets, and investing when valuations are less than attractive may be a sure shot way to lose money. But that really depends on your equity allocation and your investment horizon.
If you want to remain invested only for, say, a month or even six months, then yes, short-term valuations do matter. But over a longer period of five years or more, it’s quality that really matters.
At the moment, however, valuations have run far ahead of fundamentals in some sectors. Therefore, you have to be selective in what you choose to invest in. Some sectors, capital goods in particular, have run up too fast and are no longer cheap; at the same time, their underlying fundamentals are yet to become supportive.
The long-term case for defensive sectors such as fast-moving consumer goods, healthcare and information technology seems stronger as these businesses have adequate cash flow, earnings visibility and, at the same time, valuations haven’t run away.
The bottom line is that if you are going to buy stocks directly, then pay attention to the underlying company’s financial health and earnings visibility. For an investor who has a horizon of five, 10 or more years, investing in equity now is a must. You don’t want to miss the bus again, do you? Buy good quality companies and equity mutual funds without worrying too much about market or index valuations. After all, 10 years ago, in May 2004, the Sensex at around 5,500 was near its (then) lifetime high of 6,000, and the P-E multiple at 15-16 times was not cheap.