Vijay Kumar Gaba

 I indicated yesterday that I see markets fast moving to a point where it becomes worrisome. The argument for fresh buying or taking a leveraged position is vitiating every day. The sentiments of Greed (making some quick money) and Fear (of missing out on a rally) are already beginning to dominate the conventional wisdom, in my view.

My discussions with a variety of market participants in the past couple of weeks indicate that we are at a stage in the market cycle when the investors and analysts begin to change their valuation arguments. Extrapolation of one-quarter performance to the next ten years, “story” pages of corporate presentations, political visions of growth, etc. begin to dominate the assumptions in the valuation matrices. Three to five years of forward earnings are being considered for arriving at twelve-month price targets.

My experience of the past three and half decades suggests that this kind of deviation always leads to mispricing of stocks and eventual sharp corrections.

It is important to remember that the return on the investment in publicly traded equities is a function of three factors: (a) earnings growth; (b) changes in price earnings (PE) ratio and (c) dividend.

The earnings growth is a function of multiple factors, e.g., (a) capacity (production capability); (b) demand environment (market leadership); (c) competitive landscape (pricing power, cost advantage); (d) innovation and technology advantage; (e) resource availability (raw material, labor, capital, managerial bandwidth, etc.), etc.

Price-earnings ratio (PER)

The price-earnings ratio (PER), one of the most popular equity valuation criteria, is the ratio between the earnings of a company and its market value. It broadly signifies that at the current rate of earnings how many years it will take for the company to add the value that an investor is paying today. Principally, an acceptable PER for a company's stock is defined by (a) the return on equity or capital employed (RoE or RoCE) a company is able to generate on a sustainable basis and (b) the growth rate of earnings that could be achieved on a sustainable basis. A company that could generate higher RoE/RoCE consistently and is likely to grow faster, is usually assigned a higher PER as compared to the ones that generate lower RoE/RoCE or have low or highly cyclical earnings growth.

Re-Rating

A rise in PER, if not commensurate with the rise in earnings profile needs deeper scrutiny. Sometimes the rise in PER occurs due to correction in anomalies (undervaluation) of the past. This is a welcome move. Sometimes, PER changes (re-rates) due to relative forces, e.g., a rise of PER in comparable foreign markets or a change in the return profile of alternative assets like bonds, gold, real estate, etc. This is usually unsustainable and therefore a short-term phenomenon. Many times, demand-supply mismatch in publicly traded equities also drives the re-rating of PER (excess liquidity chasing few stocks and vice versa). This is again usually a short-term phenomenon.

Dividend

A sustainable rise in dividend yield could be a sign of improvement in (i) profitability; (ii) stronger financial position (B/S improvement by deleveraging); and/or (iii) stronger cash flows. In some cases, however, it could reflect stagnation in growth. Investors need to assess the reasons behind higher dividend yield before getting lured by it. A higher dividend for lack of growth/reinvestment opportunities would often lead to the de-rating of PER, thus reducing overall return for investors.

 In the first two months of FY24, Indian markets have done well. The market breadth has been strong and; volatility very low. The latest market rally could be described in at least three different ways, viz,

1.    The benchmark Nifty50 has gained ~6.5% from the end of FY23; and the broader market indices like Nifty Midcap100 (~12%) and Nifty Smallcap 100 (~13%) have done significantly well during this period, indicating much improved sentiments. This view would imply that presently the sentiment of greed is dominating the sentiment of fear.

2.    At the current level, Nifty50, Nifty Midcap100 are close to their all time high levels recorded in the 4Q2021 and again in 4Q2022. Whereas Nifty Smallcap100 is still about 20% lower from it’s all time high level seen in early 2022. So effectively the markets have been oscillating in a wider range after the sharp rally post March 2020 Covid panic lows. This view would imply that since the market is now close to the upper bound of its trading range, traders would be looking to pare their long positions; especially because most of the good news (rate and inflation peaking; earnings upgrades; financial stability; etc.) is already well known & exploited; while the fragility in global economy and markets has increased and hence the present risk-reward ratio for traders may be adverse.

3.    From a historical relative valuation perspective – Nifty is currently trading at ~3% premium to its 10yr average one year forward PE ratio. The same premium for Nifty Midcap100 is 14%; while Nifty Smallcap100 is trading at ~2% discount to its 10yr average one year forward PE ratio. The discount of smallcap PE ratio to Nifty PE ratio is presently close to 22%, larger than the 10yr average of 16.5%. The sharp outperformance of smallcap may be a consequence of value hunting rather than greed; and the traders may soon return to Nifty as the valuation gap is filled.

Whatever view one takes, in my opinion, it would make sense to take some money off the table, especially from broader markets and high beta.

While discussing the present state of affairs in the markets, especially the valuations, two statistical parameters are used most often – (1) The price to earnings (PE) ratio of the benchmark (e.g., Nifty50) and (2) the market capitalization to GDP ratio (popularly known as Warren Buffet indicator).

Both these indicators may soon lose their relevance, particularly in the context of Indian markets.

In next couple of years a large number of new economy stocks may get listed. Many of the new economy stocks that listed earlier may get included in the benchmark indices. Obviously, the old economy stocks, especially PSU and cyclical commodity stocks will pave the way for these new economy stocks. The point here is that the new economy stocks are valued at multiple of revenue not profits.

For example, it is expected that in the next Nifty reshuffle Avenue Supermart (198x PE) or Info Edge (500x PE) may replace Indian Oil Corporation (5x PE). This will obviously inflate the composite valuation of Nifty in PE ratio terms. At some point in time Reliance Retail (100x PE), Reliance JIO (150x PE), Zomato (200x PE), PayTM (150x PE) Indiamart Intermesh (80x PE) etc shall find place in the benchmark index at the expense of Coal India (7x PE), BPCL (8x PE), NTPC (7x PE), Power Grid (9x PE). Assessment of market valuation through Nifty PE ratio would become totally meaningless at that point in time.

The Warren Buffet indicator has already become less relevant in the case of Indian markets, in my view. This indicator completely ignores the rise in private equity investments. In Indian context for example, the equity investment in self owned enterprise and home equity has risen sharply in past one decade, as compared to the decade prior to that. Besides, the size of unlisted private businesses has increased significantly. Factor in the estimated market value of Amazon India, Vodafone India, PayTM, FlipKart, Honda India, Hyundai India, LG India, Samsung India, Apple India, etc. and you will find this ratio running much higher than what the present statistic might suggest.

So the present argument that Indian market is “expensive but nowhere closer to bubble territory” based on historical PE ratio trends, may become totally redundant. The market participants might have to evolve new parameters for valuing the market that would be appropriate in the evolving scenario.

Till then, Nifty50 is trading above 1SD 12 month forward PE and GDP to market cap has crossed the threshold of 100%.