The Hindu Business Line : The search for the 17-PE stocks

STOCK market indices have doubled from their lows of May 2004 and the price-to-earnings (PE) multiple of many of these indices, as indicated by stock exchanges, is puzzlingly still only about 17.

Many fund managers advocate caution but they reason the market is not necessarily over-valued since the PE is only 17.

But where are those stocks with a PE of 17 or lower? A PE of 17 is more of a myth.

A substantial segment of the stock market universe, going by market capitalisation, is trading at significantly higher valuations.

In particular, larger stocks are trading at relatively rich valuations.

Misleading stories: In recent days, one of the oft-heard formulations about the stock market goes like this: The Indian stock market is now trading at PE of 17.

With earnings growing at about 15 per cent, the forward PE is less than 15. Ergo, the market is attractively valued.

Look closer, however, and you will be hard-pressed to find stocks that you like trading at such attractive valuations. Half the stocks with a market capitalisation of over Rs 500 crore are trading at a PE of 22 or more. Half the stocks with a market cap in excess of Rs 1,000 crore are trading at a PE of 24 or more.

Stocks of companies that you would think make for less risky investment options, are already trading at rich valuations.

No particular number can capture for you the valuation of the stock market.

Trying to find a PE for the market is also an exercise in futility. It is in no way going to make the job of stock-picking easy.

Many, however, still feel comfortable using a particular number to capture the stock market's valuation levels.

Seventeen is, however, not that number. It is not representative of the valuation levels in the market.

Smaller segment: The aggregate market capitalisation of about 3,100 stocks works out to about Rs 22 lakh crore now.

Of this, nearly 850 stocks of loss-making companies account for almost Rs 60,000 crore.

There are another 1,286 stocks trading at a PE of less than 17. These account for a market capitalisation of Rs 8,16,000 crore.

That suggests that only about one-third of the stocks (by market capitalisation) is trading at a PE of less than 17. Nearly 900 of the 1,286 stocks have a market capitalisation of less than Rs 100 crore. That is not a segment most retail investors would want to identify with.

What about the potential for diversification? If you are hunting for stocks exclusively within this segment, there appears to be considerably low potential for diversification.

Four broad industry classifications — oil and gas, banks and finance, power and metals — accounted for 99.7 per cent of the market capitalisation of stocks with a PE of less than 17.

It would be difficult to outperform benchmark indices with such a less-diversified portfolio of stocks. Tata Equity P/E fund, which invests in stocks with a PE less than that of Sensex, has underperformed the Sensex in the past 12 months.

If you want to outperform, you would be forced to adopt a risky strategy of investing in a smaller set of such low PE stocks.

If you were to create a meaningfully diversified portfolio, then it would, in all likelihood, include a number of high-PE stocks. That is inevitable.

Overvalued? To move from here and state that Indian stocks are overvalued would, however, also be inappropriate. There has been substantial improvement in the productivity of India Inc over the past three years. In addition, the economy has been growing at a robust rate.

Investors who have loads of money at their disposal believe that the growth story would continue and that the improvement in productivity is here to stay.

From a retail investor's perspective, they should put their money into companies that can, in their view, stay efficient.

Most of these stocks are trading at PEs of between 20 and 30.

They can also invest in stocks that they consider under-valued and trading at low PEs. Most of all, they would also need to have the patience to hold for a longer term of three years or more.

With this kind of a strategy they stand a bright chance of beating returns from the debt market despite the stock market remaining stiffly priced now.

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