The Hindu Business Line : Taking stock after the correction

In the sweeping correction that has caused global stock markets to tumble like nine-pins, the BSE Sensex has shed 9-10 per cent off its peak value. Stocks in sectors such as telecom, steel and construction have plummeted 15-30 per cent the past month. With the recent reversals linked mainly to external factors such as US growth worries and political uncertainties, can investors view this as a buying opportunity? Where do stock market valuations stand now?

An analysis of trends across sectors and stocks during the corrective phase provides some answers. Yes, market valuations are today factoring in more realistic earnings expectations, compared to a month ago. But not every stock or sector that has witnessed a sharp reversal presents a buying opportunity. Given the several new challenges that have cropped up for India Inc in recent months, only select stocks and sectors may participate in any recovery, which may be protracted.

Closer to long-term averages

Though indices such as the Sensex and the Nifty have retreated only 9-10 per cent from their peak value on July 24, the decline has made a significant difference to the price-earnings multiple (PE multiple) at which the Indian market trades. The PE multiple for the CNX Nifty has, for instance, declined from 22 times to about 18.9 times last year’s earnings.

Though this may not seem like a material decline, it really is significant because the market PE has now edged closer to the 10-year average of about 18 times, from being well above it. When viewed on a forward basis, indices such as the Sensex and the Nifty are trading at about 14-15 times their earnings for the next fiscal (FY09). This prices in earnings growth of about 15 per cent a year, which has been comfortably exceeded over the past four years.

The index PE multiple does mask a significant polarisation between sectors and stocks. A third of the stocks in the CNX-500 basket continue to remain in the expensive zone, at multiples of over 20 times. But nearly two-thirds of the stocks in the CNX-500 basket now trade at valuations of less than 20 times their last year’s earnings, down from 55 per cent a month ago. One-fourth of the stocks are at a PE multiple of less than 10 times.

However, lower PE multiples do not necessarily signal attractive “buys” across stocks and sectors.

For one, with recent global events shrinking the surplus liquidity chasing different assets, investors may now be willing to pay less for risky assets such as stocks. This may mean that lower PEs are here to stay, even if earnings growth continues to be healthy.

Second, in sectors such as technology or real estate, a lower PE multiple appears to capture new risks to corporate earnings from factors such as appreciating rupee, an uncertain demand environment and a cool-off in asset prices.

Mid-caps vs Large-caps

A key feature of the recent correction is that mid-cap stocks haven’t gone into a free fall, as they were wont to do during corrective phases in 2006. Between July 24 and August 23, the 9.4 per cent decline in the CNX Nifty has been almost matched by the 9.8 per cent fall in the broader CNX-500 index.

Since mid-cap stocks had not actively participated in the preceding rally, their valuations are even more attractive today than they were a month ago. The PE multiple for the CNX Midcap index, for instance, now hovers at about 16 times trailing earnings, against 18.8 times a month ago.

Does this indicate that investors should forage for buying opportunities among mid-cap stocks rather than large-caps? At this juncture, maybe not. For one, though mid-cap stocks have not tumbled too sharply till date, they still could, i f the correction extends into a prolonged volatile phase. The recent correction has been led by large-cap stocks only because they usually present the most convenient profit-booking opportunities for institutional investors.

Second, an uninterrupted flow of liquidity into markets is a pre-requisite for mid-cap stocks to deliver returns. But the picture on liquidity is not yet clear, FII trends being negative in recent weeks. Third, with PE multiples correcting across the board, even institutional investors may look to cherry-pick from blue-chips, before they forage less known companies.

Investors who have the risk appetite to add mid-cap stocks to their portfolio can wait and do so in phases, as there may be a sufficient window available to accumulate such stocks.

It may be better for retail investors, especially those who are relatively risk-averse, to first identify buying opportunities from among the large-cap and emerging large cap stocks (those with a market cap of Rs.10,000 crore plus). For inv estors who own a portfolio of stocks, this may be a good time to switch from any low quality mid-cap exposures to stocks of frontline companies.
stock-specific trends

A breakdown of the recent correction into stocks and sectors reveals the following patterns:

Sectors with global exposure bear the brunt: Recent global events such as the fall in commodity prices, the turbulence in financial services and cooling property prices in the US appear to have triggered a “de-rating” of va luations in domestic realty, banking, technology and commodities stocks.

Commodities — particularly sugar and steel, PSU banks and software stocks have registered the sharpest falls during the correction. Large real-estate companies have witnessed big stock price declines on property bubble worries, while construction companies have also underperformed on worries about higher interest rates leading to a funds crunch.

High institutional ownership: Trends within sectors show stocks with higher levels of institutional ownership have been more vulnerable to profit-taking. A higher institutional shareholding probably explains why large private sector an d PSU banks have been worse hit than smaller private sector banks during the decline.

In the pharma sector, stocks of fancied Indian bulk drug makers such as Divi’s Labs have declined much more than similar sized peers. In software, stocks with high FII holdings such as Satyam and Hexaware have shed more value than smaller-sized IT companies.

Higher PE, sharper decline: Stocks/sectors with high valuation multiples have seen sharper declines than more moderately priced ones. Media and telecom stocks have suffered some of the sharpest reversals despite the fact that the outlo ok for these sectors is not materially affected either by recent global events or risks such as rising interest rates.

The explanation for this can probably be found in the high PE multiples that these stocks enjoyed (40-50 times for media and 35-40 times for telecom stocks) prior to the fall. The trend of investors taking profits based on relative valuations is also evident within sectors.

A more expensive Reliance Communications has corrected more sharply than Bharti Airtel, while Indiabulls Financial services has fallen more than Geojit Securities. However, sectors with reasonably good earnings visibility such as engineering have not fallen prey to this trend, despite high valuation multiples.

Greater aversion to risk appears to be making investors more wary of paying a high price for future earnings, especially where the earnings stream is not easily predictable.
Where to invest

What do the above trends signify for the sector and stock choices made by retail investors?

Sector choices: Despite the decline in PE multiples, investors may be better off with relatively low weights to technology, commodity and realty stocks in their portfolio at this juncture.

Except for select IT companies that do not have a big exposure to financial services, a good number of IT companies may be vulnerable to a churn in the financial services space, as well as any US related slowdown.

As their fortunes are closely linked to global liquidity flows as well as hedge fund activity, commodity stocks may experience high volatility in the near term. Realty stocks have witnessed a sharp shrinkage in PE in recent weeks.

However, the sector faces several risks in the form of a possible cooling of property prices, restraints on financing options for projects (due to liquidity as well as ECB worries) and higher interest costs, which may impact earnings.

Sticking to one or two of the largest players in this space may be the best course of action. On the other hand, investors can scout for buying opportunities in sectors such as banks, capital goods, infrastructure, telecom and consumer goods in the present environment. Phased exposures and moderate return expectations are however, recommended. For investors with a three-year horizon, some ideas are given below.

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Taking stock after the correction