If you are an investor who likes to play it safe, chances are you didn’t make big stock market purchases in December 2011. When the Sensex languished at 15,000-16,000, there was little reason to be optimistic about either the Indian economy or corporate profits.

The story changed, however, after foreign institutional investors (FIIs) decided to make a comeback. A 30 per cent rally in stock prices since then has taken the Sensex back to 20,000 levels. So should you buy stocks at all at these levels? And if so, what should you buy?

The answer to the first question is yes. You get stocks at reasonable prices only when the outlook for India Inc isn’t completely rosy. And when assessing whether you can put fresh money into stocks, valuations matter much more than absolute index levels.

Therefore, what matters now is not that the Sensex is at 20,000, but that it trades at PE multiple that is much lower than the previous market high. The Sensex’ price-earnings multiple at 18 times (trailing earnings), is moderate. Experience from the past three bull markets suggests that a PE of 24-25 times usually represents danger zone.

But do note that today’s PEs are not at rock-bottom levels (10-11 times) either. So it is best not to go overboard and make large lumpsum investments in equities in your keenness to catch up with the bulls. Instead, phase out your purchases.

Having said this, if you are planning to add to your equity portfolio today, there are three themes you should go for.

Blue-chips rather than small-caps

It is small-cap stocks (market cap of less than Rs 2,500 crore) that have led the charge in this bull market, stealing the limelight from better known companies. With stock price gains in small-caps driven more by hope than by hard numbers, their PE multiples have bloated.

When this rally started, the PE multiple of the CNX Small-cap index was 12, a discount to the Nifty’s 16.5. Today, the CNX Small-cap’s multiple is at over 30; the Nifty’s is at a more modest 19. Whenever the valuation for less known stocks has overtaken the bellwether in the past, it has meant trouble for the markets.

Therefore, this appears to be a good time to take profits, if you have any, in small-cap stocks and move into the blue-chips. Recent earnings surprises from Infosys, HCL Technologies and Reliance buttress the case for blue-chips too.

Value rather than growth

One strange aspect of this market rally is that investors who bought stocks based on conventional wisdom have lost out to those willing to throw caution to the winds

Investing in high-dividend-yield stocks or stocks trading below book value, has not been a winning strategy this past year. This is why ‘value’ funds have been relegated to the middle or the bottom of the mutual fund performance charts.

But after this breathless rise, stocks across the board are no longer cheap. In fancied sectors such as FMCGs and pharma, investors are likely to get more demanding about profit growth to match those fancy multiples.

Given that the economy is still mired in a slowdown, high profit growth may not be easy to come by. Therefore, owning stocks that are at a discount to market seems to be the safe strategy. That means going back to the time-tested ‘value’ strategy of buying stocks that offer high dividend yield, or those that trade below book value.

Where opportunities lie

So, going by the above tenets, where should you look for opportunities today?

Obviously, in sectors and stocks where valuation multiples have stayed put or have actually fallen, as stock prices rose. A comparison of the PE multiples of the CNX 500 stocks in November 2010 and now, suggests three areas where investors should look for ‘value’ buys.

Public sector banks, automobiles and frontline software companies, where valuations have declined sharply between 2010 and now.

Select stocks from infrastructure and capital goods, reliant on segments such as housing and roads, rather than on the capex cycle.

If you can handle higher risk, large commodity players in segments such as base metals, steel and so on. Commodity stocks have been completely ignored in this rally because of the uncertain outlook for global industry and by extension, industrial raw materials. But the demand outlook is getting better with the Chinese economy beginning to surprise on growth and the US housing markets perking up. That makes for a good opportunity to selectively buy stocks of quality commodity companies that are today trading far below the value of their assets.

But if you don’t have the time or the resources to select stocks on your own, go for equity funds that play on the above themes.

Aarati.k@thehindu.co.in

(This article was published on January 19, 2013)
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