Markets Still have Steam Left
One should not be swayed too much by near-term news flows but use them as opportunities if there is a market fall to pick high-quality companies.
The Sensex has touched 30,000 and the Nifty 9,000, and they are now tracing back towards 27,000 and 8,000. A lot of market participants seem nervous. Everyone is wondering that markets were probably overvalued and a fall was imminent. So is the market really overvalued?
As a value investor we do not pay attention to the headline Sensex and Nifty numbers. It is immaterial what the Sensex’s value is today. What matters is: Are the fundamentals of the companies intact? What is the valuation? Are companies available at a discount to their intrinsic value?
The Sensex was at 21,000 in January 2008. It reached 21,000 again in January 2014. So, for nearly six years the markets went nowhere. It had reached the same level at the end of 2010 and January 2011, after which it had fallen again. From January 2014 to January 2015, the Sensex rose about 32 per cent, the BSE midcap index by 58 per cent and the BSE small cap index by 74 per cent. So, are the markets ready for a fall?
Take a look at how the fundamentals have evolved from 2008 onwards. The total market cap of companies rose 50 per cent from 2008 to 2015, with most gains in the last one year. During this seven-year period, book value and sales have tripled. This indicates growth in market cap lags growth in book value and sales. The only concern is debt, which has surged nearly 400 per cent.
Let’s switch our attention to the fundamental and valuation ratios. The Return on Equity on a “Smart Alpha” portfolio of “investment grade equities” is 19.3 per cent, versus 17.3 per cent for the benchmark. The net debt-toequity of this portfolio is a negative 0.04 (i.e. it is cash surplus to that extent) as compared to the benchmark’s 0.38. Interest coverage is more than 40 times as opposed to nine times for the benchmark. This means there are still a lot of companies where one can invest without worrying too much about losing capital if one has a long-term investment horizon.
Of course, anything can happen in the short term. And, if one invests with a margin account or using leveraged instruments like options, then one can lose money with these equities as well. Also, investors should keep away from companies that have increased their debt way out of proportion to their fundamental growth.
The valuation of the benchmark is at a price-earnings (PE) trailing ratio of 21.24, which looks very high. However, our Du Pont analysis shows earnings are cyclically depressed given their “normalized earning power” and so the PE ratio gives the wrong picture. A better valuation ratio would be Price to Book Value (PBV). This is at 2.63 for the top 500+ companies that we have analysed. This is below the median PBV of about three while the peak PBV goes to nearly 5.8-6. On that basis, the market is not crazily overvalued. But we would caution investors to focus on low-debt companies with strong balance sheets that are undervalued.
One should not be swayed too much by near-term news flows but use them as opportunities if there is a market fall to pick high-quality companies. Invest in them for the long term and rejig your portfolio every year or so with quarterly reviews with an eye on maximising long-term tax-free capital gains. Our market outlook report for the next five years clearly shows that, barring some unforeseen black swan event(s), the Indian economy and markets are poised for an earnings CAGR of 20 to 30 per cent. This should be accompanied by similar growth in market caps and, hence, investor wealth.
(The author is Executive Vice President – Traded Markets and Investment Research, Arthveda)