Market Valuations – November 2018

Market Valuations

Over the last few weeks, the Nifty index has seen a decent double digit percentage correction. The midcap and smallcap index are performing even worse. The buzz on the street is that the market valuations are at a healthy zone and it is a good time to start picking stocks. The current valuations of the Nifty 50 index are given below.

Market Valuations

The mean PE of the Nifty is ~ 19 and the index is now trading above it’s +1 Standard Deviation. The PE Ratio was at 28.55 in late August 2018. When the PE Ratio is high, the prospective returns are low even over a multi-year period. Sticking to quality stocks at low to fair valuations and a healthy percentage of cash in the portfolio can help navigate inflated valuation periods in the market.

PE Ratio Chart

The current valuations of ~ 25x PE is still not cheap especially when the earnings growth is just 8% p.a. The market is bullish and stock prices rally as PE multiple expands. However, the returns earned over 12-18 months can vanish overnight as investors have seen multiple times in 2018.

The Return on Equity is a dismal 13.17% particularly due to lower margins. For ROE to improve, earnings will have to grow. Earnings growth will come with revenue growth and expansion of profit margins.

Historical ROE Chart

There are signs of recovery in revenue growth based on Q2FY19 numbers and also the RBI data on Capacity Utilization. An increase in the CU is a strong indication of demand picking up. The order book growth of large infrastructure and heavy industry companies also points towards a healthy growth in revenues and earnings over the next few quarters. Even if revenues grow by 10%, the margins will have to expand for earnings growth to be > 15%.

RBI Data on CU

 

Outlook

We believe that the Nifty index will return a CAGR of 8% to 10% over the next 5 years. A good portfolio of equities will still able to deliver returns of 20% p.a. and higher over the same period. Our portfolio for new investors is still cash heavy with nearly 60% of the funds deployed in cash (Check out our Live Portfolio). Most of the mid and small caps still trade at premium valuations to what they ideally should be commanding. For example, many auto ancillary companies with low pricing power still trade above 20x PE.

While the market valuations cool off in a rising interest rate environment, we continue to add good quality stocks at fair valuations to our portfolio.

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