Don't let valuations spook you
12th September, 2016
The Hindu BusinessLine
Investors can continue investing regularly, with a moderate return expectation, writes Mahesh Patil, Co-Chief Investment Officer, Birla Sun Life Asset Management Company
The most important question keeping the market fraternity preoccupied is: Is the Indian market overvalued? Let us try to answer this.
The Indian markets, from a historical perspective, are trading above long-term average levels. If you consider the PER (Price to Earnings Ratio), a similar level was seen in December 2007 and September 2009. However, there are marked differences between these periods - 2007, 2009 and 2016.
Firstly, the constituents of the index (let's take the case of the widely tracked Nifty Index) have undergone a change. From the dominence of cyclical sectors like Energy, Metals and Engineering in 2007, the index is now dominated by secular growth sectors like FMCG, Pharma, NBFCs, Private Sector Banks and Autos. These sectors carry different profitability profiles and hence command premium valuations. This is getting reflected in the valuation of the Index as well.
Secondly, at the end of 2007, the markets had seen a multi-year super-normal earnings growth and gave higher multiples in terms of valuation. The markets started correcting in January 2008 to adjust for the higher valuations but it coincided with the global financial crisis which, in turn, resulted in a deep correction. In 2009, the markets moved ahead of earnings growth from all-time low levels.
As the earnings caught up, the markets became reasonably priced, which also resulted in the index clocking double-digit returns by September 2010. Only in late 2010 did the markets sense the slowdown in the economy which later reflected in the lower earnings growth. September 2016 is different. Today, the index P/E looks high on subdued earnings, which have been flat for the past two years. The current index level is what it was more than 18 months ago. There is a high probability that earnings would rebound in this fiscal itself (estimate of 14 per cent growth in FY17) and the momentum of the same could see much higher uptick in FY18 (estimate of 16 per cent growth). When this is factored in, the large-cap Nifty index would be lesser than median valuations historically.
Thirdly, the risk free rate (RFR) used in valuation models was at its peak in 2007 and masking it were the assumptions in top-line growth of companies. The scenario is different now. We are in an accommodative stance of the central bank and the RFR considered in valuation models is still high. There is scope for RFR further coming down. When this is factored in, the fair value of the markets would increase.
Finally, if you consider the metric of market cap/GDP (popularised by Warren Buffett as the single best measure), it was 1.3x in 2007 and is at 0.77x currently.
Upbeat emerging markets
Looking at the global peers, the observation is that any country that has growth visibility is trading at a premium to the rest of the markets. In this basket are India, Indonesia, Mexico and the Philippines.
Some might argue that liquidity is taking the markets higher, the reality is different. The net FPI flow into India was $3.2 billion in 2015 and $5.9 billion in 2016 YTD - much lower than the five-year average of S17 billion. There is no sense of an upbeat bull market sentiment among market participants like in 2007 but there is a sense of cautiousness.
The companies that are not delivering in their numbers are punished while those that are exceeding expectations are being rewarded - a natural practice of the markets historically. So, the excessive cautiousness about the elevated market valuations is highly unwarranted.
Will there be a correction? Those who have been tracking markets for a while or have read about its history would concur that corrections in markets are par for the course. It is healthy also because of the reality check it provides and weaker hands are kept under check. Will markets have a deep correction as in 2007? The answer is No! Can we see a correction? The answer is Yes! It is difficult to fathom what will spook the markets.
A big event like Brexit and the depreciation of the Chinese yuan over the past few weeks (more than the quantum in August '15) had no impact on the markets. The most talked about rate hike from the Fed is round the corner, which is already priced in by the markets. With the readjustments done in EM currencies and growth coming back into EM economies, it is hard to fathom that a Fed rate hike would create an impact seen during "Taper Tantrum" in May '13.
The advice to investors is to keep investing into markets regularly with a moderate return expectation (as the return in alternate asset classes has come down). It is pertinent to choose your risk curve and participate in it through various categories of funds - large-cap, multi-cap and mid-cap funds. Remember, as Peter Lynch says, "Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves."