With valuations of high-quality stocks hitting unreasonable levels, finding value in the market has become quite challenging
16-Oct-2015 •Dhirendra Kumar
I'm writing this after the US Fed announced that it would hold onto ultra-low interest rates, as it has since the 2008 financial crisis. The rates will remain in the range of 0 to 0.25 per cent. In other words, the Fed's easy money regime that the world has lived with will continue for the time being.
It's interesting to note the global equity market's reaction to this announcement. One generally expects lower rates to encourage equities and vice versa, but in the days since the announcement the US markets have fallen sharply. The reason is said to be the comments made by Fed chief, Janet Yellen, about economic weakness in emerging markets. But here, in this emerging market where we live, equity markets were decidedly cheery in their mood.
The reason is clear. In the short term, the easy-money regime makes Indian traders think that more money must be on its way, and will no doubt push up stock prices. However, this will further worsen the basic problem in Indian stock markets, which is the toxic combination of three factors. These are: one, the weak financial condition of many businesses that splurged with debt in the years preceding the crisis; two, the paucity of quality business that can be invested in; and three, the tremendous fund flow in the recent months that has resulted in the easy money boosting up the stock valuations of these quality businesses.
As a result, many thoughtful investors and investment managers have concluded with deep regret that there are two kinds of stocks in the market today - those that are bad investments because the underlying business is shaky and those that are bad investments because the stocks are overpriced. This dilemma of overpriced quality remains even after the sharp fall in the markets in recent weeks.
The events of 2008 and their aftermath have made investors extremely unwary of poor-quality businesses. In the years since, the debt-heavy, earnings-impaired or otherwise compromised businesses have seen a near total exit of discretionary investors. At the same time, the increasing inflow of investments into equity has meant relatively higher flows into the set of stocks identified as high quality. With real, on the ground turnaround still being weak, the result is a large set of stocks which have valuations that are several times higher than what is justifiable. Unless these companies can register several years of huge growth in profits, their prices are not justifiable. Most of these are very good businesses but at valuations that even great businesses would struggle to justify.
This has complicated implications - for investors as well as investment managers. If an investor wants to have any kind of focus on buying stocks at good value then they may have nothing much to do in today's stock markets. One way or another, a lot must happen before equity markets become an inviting, or even an easy, place to invest in. The continuation of easy money regime by the Fed is hardly a problem-solver for India. Instead, the problem-solver can only be years of sustained growth, accompanied by a sustained policy environment that creates an atmosphere conducive to growth. The last 15 months have shown what a morass of hostility faces any efforts at reforms in India. Yet, among emerging markets, India is best placed in terms of the preconditions for growth as well the political will to back up growth.
For equity investors like us, the problem is one of finding value. Not rock-bottom value - the days of finding that are gone for the time being - but at least relative, reasonable value.