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.
To put things in perspective, the latest market rally, particularly in the broader markets, was driven initially by a combination of macro improvements and undervaluation. But now most of the macro improvement seems to be tiring. In fact, it is very much possible that during 2HFY24 we may actually see some of the macros like growth, twin deficit, consumption and investment growth, gradually deteriorating.
On a micro level, the earnings upgrade cycle might peak with 2QFY24 results; and we may actually see some downgrades occurring due to poor rains (poor rural demand); further clouding of global demand outlook; margin compression for banks; and the rise in raw material prices (chemicals and metals); etc.
The current valuations are close to the long-term averages and leave little margin for error whatsoever.
As a broader benchmark, under the current interest rate and inflation expectation scenario, a conservative investor like me would be comfortable with a PER between 15-25 for non-cyclical businesses. For cyclical commodity businesses, the comfort would end in an 8-10 band.
I am usually not comfortable valuing asset-heavy businesses with relatively longer and unpredictable revenue cycles on price to book (P/B) or replacement cost basis; because it goes against the principle of going concern. If at all these businesses might be valued at Net Realizable Value (NRV) for limited purposes of judging solvency conditions.
Evaluating financial stocks purely on the basis of net book value is also mostly not a good idea. It is also important to consider the profitability and reliability of the book for corroborative evidence.
These days any query on a corporate database would throw a long (ominously long) list of stocks trading at EV/EBIDTA ratio of over 20. (EV = Market capitalization plus Net Debt; and EBIDTA is earnings before interest, depreciation and tax). It is even scarier to read research reports early in the morning which find stocks with EV/EBIDTA ratio of 20+ as attractively valued.
In case you find this blabbering of mine too academic, I agree. Whenever I suffer from indecisiveness or I am confounded, I go back to textbooks in search of a solution.
In my view currently, the following three are the primary drivers of equity prices in India:
(a) Hope of material improvement in corporate earnings. The rise in public expenditure (both revenue and capital) and hope of revival in rural consumption is fueling the earnings upgrade. Though not completely baseless, in my view, hopes of 18%+ earnings CAGR in FY24-25 may not materialize. The prices may therefore have crossed over the line of reasonableness; though still not entered in the territory of bubbles.
(b) Incessant flow of domestic funds. Still low equity exposure of domestic investors, even after a significant rise in the past three years, is motivating many investors and traders.
On valuation, there is another rather strange argument being relied upon heavily.
Many analysts and fund managers have argued that the current PE ratio of Nifty is much below the peaks seen in previous bull markets, and therefore, the market is nowhere close to a bubble territory. This could be a valid argument on aggregate levels and thus relevant to the investors investing solely in Nifty ETF or Index funds.
Investors who are investing mostly in broader markets need to assess the valuation of their respective portfolios. Anecdotally, I find that the individual portfolios are presently highly skewed toward the very richly (or crazily) valued stocks. These investors may need to restructure or re-balance their portfolios rather urgently.
Remember, the average life expectancy in India is close to 70yrs. This definitely does not mean that people below 60yrs of age need not take care of their health as they are not likely to die anytime soon!
