The Nifty index is at 11,600. We are at all time highs but most of the investors are seeing their portfolio down from highs due to a considerable erosion in the mid & small cap segments. It is safe to say that we are now in that phase of a bull market when most stocks have stopped performing and a few names are pulling the index up. We see a correction in individual stocks as a healthy event which restores some sanity in the valuations.
Nifty 50 – the largecap index still trades at expensive valuations [PE of 28+] with earnings growth at just 4%. Earnings growth is at a bottom and there are signs of margins expanding for companies across sectors. A big reason for the seemingly low earnings growth is the write-off’s in banking companies for the NPA’s. Once the NPA issue is sorted we will see a sharp rise in earnings which can cool down the PE ratio.
In the past, the markets never traded at these PE ratios for long and the market sentiment was of Euphoria. There is no euphoria of the ’99 dot-com and ’07 bull markets. In our past posts we have highlighted how previous market tops were a phase of peak growth in earnings, expansion of margins and maximum capacity utilization. The earnings growth is low, utilization is subdued and we have not peaked out on various data points. However, earnings will eventually have to catch up. While we do not foresee a “crash”, we do see a time-wise correction coming in. A period of low returns and consolidation while the earnings catchup. Are earnings catching up?
The earnings growth is still at a dismal 4% and the primary reason for this slowdown is the big write-off’s in the income statement of the banking companies. Few triggers to monitor for earnings growth are:
i) Positive earnings from banks
ii) Increase in demand and a stable inflation
iii) Higher credit growth
We see the recovery in Capacity Utilization continue over the next few quarters. CU has reached a multi-quarter high (The highest since Q415-16) and we expect it to cross 78% eventually. As CU rises, we will see a rise in capital expenditure too as companies push for expansion in capacity. Private investment has been low over the last 4 years which reflects in the low credit growth that has plagued the banking system.
Credit growth has returned to multi-year highs too, in-line with increasing capacity utilization. These factors indicate a revival in spending by the private sector. We see both economic growth and inflation picking up.
Price to book ratio
The price to book ratio of the Nifty 50 index is still cheap. The PB ratio, unlike the PE ratio, is nowhere close to it’s previous highs and infact it has remained stable for the last few years as shown in the chart below
The PB ratio is still low because of a depressed Return on Equity. The ROE of the Nifty 50 index is 13.3% which is just above the average cost of equity (around 12% in India). We expect the ROE to inch back to ~ 17% eventually.
Now, the book value of the Nifty index is 3072.27 and for an ROE of 17%, the EPS has to move up to 522 from the current 409. This is in-line with the market’s expectation of the EPS growing by 20% to 25% over the next few quarters.
One has to keep in mind that the PE ratio reported by the NSE is based on standalone earnings and investors should always look at the consolidated data for a holistic view. However, we can use standalone data as a fair indication of valuations and earnings growth trend.
It is tough to predict the direction of the market especially in the year of elections. The market wants a stable Government at the centre and would hoping for the BJP with 230+ seats OR the Congress with 200+ seats.
In the current environment, it is easy to make mistakes and these mistakes can be very expensive. We are primarily looking for companies with strong financials, fewer red flags and visible earnings growth outlook. Also, we want to buy such companies at cheap to fair valuations.
Kajaria Ceramics, Symphony, etc are examples of “high quality” companies which were trading at expensive valuations and then they eventually corrected by more than 40% in less than a year!
We would rather be in cash till we don’t get the companies that we are looking for at the price which we are willing to pay. Liquid funds and short term debt funds yield ~ 7% p.a. and this seems higher than the prospective returns from most individual stocks.
How many stocks do we own in our portfolio: Live Portfolio
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