The markets made an all-time high in April 2019. The markets are consolidating close to these highs. The General Election of 2019 is going on and as we write this newsletter, most of the constituencies have already voted. By the time we write to you the next month’s newsletter, the election results would have been out. While the Bharatiya Janata Party is most likely to be the single largest party, the markets will be having a keen eye on the number of seats the BJP wins on its own. Anything above 220 will keep the sentiment positive on Dalal Street. However, if the single largest party fails to win 200+ seats, then the markets could react adversely. In 2009, the markets were locked in upper circuit after the Congress won 200+ seats on its own and the UPA retained power with an even more powerful majority.
Talking about the elections might be fancy, but the real issue is the missing earnings growth. The Q4FY19 earnings have been disappointing. The Nifty’s EPS has shrunk to ~ 400 per share and the PE Ratio is at a bubble territory of ~29+. These valuations are not sustainable, and we need to be very selective of the stocks that we buy now.
HIGH PE Ratios – The new normal?
In the late 90s, the dot-com boom created bubble valuations, in 2007 the economy grew at such fast pace and the markets rose up to bubble valuations. People justified those valuations citing some or the other factor behind a sustainable long-term growth in earnings. However, the valuations cooled off as the markets crashed. This time, the investor community is citing the low interest rates that are keeping the valuation levels elevated. Interest rates globally are near zero and this has created immense liquidity, a lot of which has flowed into emerging markets. Rs 67,122.07 Crores has been pumped into the Indian equity markets in 2019 by the FIIs. In 2018, FIIs had withdrawn Rs 53,020.87 Crores.
Analysts are expecting the Nifty EPS to increase by nearly 60% in FY20 because of positive earnings from banks. The NPA crisis has eroded the profitability of banks and this depressed earnings. If indeed the Nifty EPS grew by 60%, the PE ratio would cool down to ~ 20. Such expectations of a bump in earnings growth have been there for the last 3 years, but in vain.
Low interest rates mean low returns from safe assets like Government bonds, term deposits, etc. When the returns from risk free assets go down, the expected returns from equities also go down.
|10%||18%||When the risk-free return is 10%, I expect atleast 18% from equities|
|6%||12%||The risk-free return is down to 6%, I am happy with 12% from equities|
When an investor expects 18% returns from equities, he will want to pay lower valuations (Maybe a PE of 15). But if his expected returns from equities go down to 12%, then he will be ready to pay higher valuations (Maybe a PE of 22-25). This is a very generalized example. The financial theory behind this is an entire subject.
What makes up the returns?
In the above scenario, the earnings have grown by 100% while the share price has grown by 266%. This is because of the expansion in valuation multiple that the investors were paying for the shares.
In the above scenario, the earnings have grown by 50% but the price has risen by only 35%. This is because of the contraction in the PE multiple that investors were paying. In the dull market phase of 2011-2013, many good companies were available for a PE ratio of < 10. Today, very few good companies are available for a PE ratio of < 25. If we pay such valuations today and the earnings do not grow over the next 3-5 years, then the valuations will cool off and we wouldn’t be able to make such returns.
We are not saying that one should only buy stocks that are trading at cheap PE rations. Infact that is one way to load up cheap quality companies. We should pay high valuations only when we are sure that the earnings growth will continue long enough. Now, in the stock markets the ‘sure’ term doesn’t exist. So, our research is focused on determining the longevity of earnings growth, high ROCE, etc.
Very few companies can sustain such valuations for a long period of time. Most companies see sharp cool down in valuations eventually and leave behind a lot of retail investors stuck at higher prices. When the valuations are elevated, we prefer to maintain a decent cash allocation in the portfolio.
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