The market action for the past two years has been quite narrow. A few highly-valued stocks, many of them trading at price-to-earnings (PE) 65x or higher (trailing PEs), have boosted the market indices. These are all consumer-facing businesses, or “stable” sectors, like FMCG, Pharma, IT, and private banks. The majority of stocks outside these few areas have very low valuations.
Any long-term equity investor should have an answer to an important question: Given a risk-free return of x per cent, how much of a minimum premium over x is desirable for equity investments? Right now, there’s low inflation (about 3-4 per cent) and risk-free returns are ranging between 4 per cent and 7 per cent nominal (bank fixed deposits rates and government treasury yields).
What sort of equity valuations are reasonable? Say, you want an equity premium of 4-5 per cent over risk-free returns. Then you’re looking at a nominal return of, say, 11 per cent in terms of earnings to price. The implied PE would be 9x (Invert Earnings over Price to gauge PE). You should not be prepared to pay over PE 9-10, except for extraordinary growth prospects.
The current crop of market leaders, which are trading at PE 65 or higher, don’t have such extraordinary prospects. This is a safe prediction. These are all big companies, with long track records, and large revenues. The large bases mean we cannot expect huge growth acceleration. At best, these favourites will have stable growth rates ranging at the current levels, or a little higher.
This has multiple implications. In broader terms, since we can’t see extraordinary growth for these leading companies, there is likely to be a drop in valuations for these market leaders at some stage. If other sectors pick up in terms of valuations, fine. Otherwise, the entire market may go bearish.
It may be noted that the large indices (Sensex/ Nifty/ Midcaps 250) have never dropped below an average PE 14 or so, in the 21st century. That was during the 2008 crisis. Another fall to those levels would have catastrophic impacts on portfolios.
For the long-term investor, this narrow pattern indicates an urgent need to diversify outside the universe of safe, high-valuation stocks. These are trading at very high PEs. While these are great companies, they are unlikely to deliver EPS growth that justifies current valuations and that strongly implies some valuation downgrades.
However, where does the investor seek alternatives? One option is beaten-down infrastructure sectors such as cement, steel, construction, and mining. History tells us that these are never high-valuation industries. But they are very low-valuation at the moment. So there is room for higher valuations. There is also room for better earnings growth, as and when the commodity cycles change, and infra spending picks up.
The other option is to start hunting for small businesses that could see much higher growth rates, regardless of the direction of the overall economy. Base effects are favourable with smaller businesses. Singhania has done the investor community a service by pointing out the anomalies in valuations. Now it’s up to the individual to decide: Stick with high-valuation blue-chips, switch to low-valuation big stocks, or switch to small caps?