As we enter into the New Year, it is time for stock taking. Our markets have delivered a return of around 13.13 per cent this year (till December 17 closing). This is not all that bad, especially when seen in the light of 2009, a blockbuster year when the Sensex delivered a return of 76.33 per cent. Looking ahead, my bet would be that returns from equities are likely to be muted for some time. Here are my reasons:
Earnings and valuations: If you took note of the recent Q2 results, revenue earnings continued to be strong (17.8 per cent y-o-y for the Sensex), but bottomline growth was muted (9.6 per cent y-o-y for the Sensex) as cost pressures (interest costs, raw material costs and wage costs) mounted. In Q1FY11 y-o-y growth in Sensex PAT was even poorer —a meagre 0.5 per cent.
With inflationary pressures (on account of the global run-up in commodities) remaining strong, interest rates are more likely to move up rather than down in the near future. Rising commodity prices will increase the raw material costs of corporates further. With the kind of earnings growth that we have seen in the past two quarters, sustaining the current market PE of 22-plus appears to be a tall order. Thus, the odds favour a contraction rather than an expansion in valuations.
Fund inflows: Another driver of the markets in 2010 was the net purchase of about Rs61,000 crore worth of equities by foreign institutional investors (FIIs) during the year. Will a similar level of influx of funds occur in 2011? Already, economists are predicting around 3 per cent GDP growth in the US in 2011. Given the US Fed’s ultra loose monetary policy of recent times, inflation, and hence interest rates, are likely to rise in the US in the latter part of 2011. If both GDP growth rate differential and interest-rate differential between the developed world and emerging markets narrow down, the case for heavy capital inflows into emerging markets such as India becomes weaker.
No doubt, India’s long-term growth story remains strong, but for the present most of that growth appears to be priced in. In the near future, expect the markets to take a breather.
If you invest in individual stocks (as we assume all readers of our magazine do), then irrespective of where the markets go continue hunting for attractively-priced growth stories. For the value-oriented investor, 2011 may well throw up more interesting opportunities than 2010 did. In this quest, the entire team at Wealth Insight will continue to assist you.
The value investor’s dilemma
Value investors would have been better off keeping their powder dry during a greater part of 2010
2010 may have been a good year for momentum investors but for value investors the going was anything but easy. As valuations soared on account of the relentless influx of FII (foreign institutional investor) money, finding undervalued stocks became difficult.
This year the Sensex recorded its lowest (12-month trailing) PE of 19.09 on May 25 and its highest of 24.47 on October 13 (data till December 17). The five-year median PE of the Sensex is 20.44. On 190 days out of the 242 total trading days so far (that is 78.5 per cent days), the Sensex was trading at a higher valuation than its five-year median — which tells us that valuations were indeed expensive this year.
High valuations caused us difficulties when selecting stocks for the Stock Insight section of our magazine. When hunting for stocks, we follow a simple set of criteria: we look for stocks that have a low PE (compared to historical levels; compared to industry peers; and compared to the PE of the 10-year treasury bond, which we calculate using the formula 100/t-bond yield). We like our picks to have a low level of debt. We also like them to have consistently high return ratios (say, over the past five years). In addition to attractive valuations and a sound track record (as revealed by these numbers), we like our picks to have sound growth prospects. This we try to assess by reading industry and company-based research reports and by speaking to the company’s management and stock analysts.
While the market as a whole was expensive in 2010, in particular stocks with sound track records were trading at highly elevated levels. Those that we truly liked (say, those in our Blue-Blooded Bluechip selection of Stock Ideas) were simply too expensive. On the other hand, those stocks that met our stringent valuation criteria often did not have the kind of track record and prospects that we desired.
If you invest in stocks at expensive valuations, it becomes more a case of relying on the ‘Greater Fool Theory’: you buy the stock not because it is available at below its intrinsic value but because you expect a bigger fool to come along and take that stock off your hands when valuations rise even higher. The danger herein is that if you buy at these high valuations your portfolio may suffer a steep erosion in value if, for some reason, the markets correct sharply.
On the other hand, if you invest in qualitatively poor stocks whose valuations are to your liking, it is likely that these stocks will continue to perform indifferently even in future. Hence even if you stay invested in them for three years, you may not be compensated with a satisfactory rate of return.
As the markets rose higher, one heard novel reasons being advanced in favour of investing in stocks even at elevated levels. The argument was that India is a high-growth market, so PE is not a good way of evaluating stocks in this market. Instead, we were told, go by the PEG ratio (which has the PE ratio in the numerator and the three- or five-year earnings growth rate in the denominator). If the PEG ratio of the stock is below one, invest in the stock even if the PE may be high (say, above the long-term median Sensex PE).
My own view here is that while there is some merit in this argument, remember that here we are talking of PE levels above 20. Sustaining an earnings growth rate of 20 per cent plus for several years in succession is not an easy task for any corporate. If an investor decides to invest on the basis of the PEG ratio (despite a 20-plus PE), he must make a careful assessment of the company’s prospects and whether it is capable of sustaining a high earnings growth rate. In doing all these assessments, think probabilistically: play a hand only when the odds are tilted in your favour. High market valuations tilt the odds against you and reduce your chances of winning the investment game.
Being of a conservative bent, I would counsel investors to exercise patience when markets turn expensive. Unlike a mutual fund manager who has to match the returns from the Sensex, the category average, and so on, you can afford the luxury of waiting. In today’s expensive market, study stocks and then create a list of favourites. Also assign a valuation at which you would want to invest in the stock. The markets may be expensive today but they will not always remain so. There will come a time when stock valuations will become more reasonable. That’s when you should display courage of conviction and buy the stocks in your list of favourites. When the time arrives, act decisively and be ready to deploy large amounts. That’s the way great investors like Warren Buffet play the markets. Emulate them.