The Hindu Business Line : Time to forage among under-performers

As the large-cap stocks, and more expensive ones, have largely driven this rally, this is the right time to diversify into mid-caps and look for stocks that offer better value for money.

Aarati Krishnan

A veritable deluge of funds in the Indian stock market over the past year has catapulted the BSE Sensex from 10000 to 20000 points. The investors’ voracious appetite for the biggies of India Inc has also sharply expanded valuation levels for these blue-chips. The PE multiple for the Sensex basket, a moderate 18 times trailing earnings in June 2006, now hovers at a demanding 26 times.

But chances are that the returns from your portfolio of stocks haven’t matched the spectacular appreciation in the Sensex. This is because seven out of every ten listed stocks failed to keep pace with the index in its breathless climb from 10k to 20k.

However, this may actually be good news for you, as an investor! It throws up opportunities for you to book profit on some of the out-performers and switch to stocks that have remained on the sidelines of the rally.

It also presents an opportunity to de-risk your portfolio by switching from stocks with a high asking price to those that offer greater “value for money” at this juncture.

Business Line analysed stock price returns from Sensex levels of 10,000 to 20,000 for over 900 NSE-listed stocks, to gain insights on what has driven stock price performance and how the tide could turn now. Only stocks with meaningful financials have been considered for the analysis.

Returns on broader indices such as the BSE-500 have matched the Sensex, in its rally from June 2006 lows. This may give the impression that the rally cut a wide swathe across stocks and sectors. But the fact is that a good number of stocks have failed to participate in the bull party.

Many miss the bus

In fact, seven out of every ten stocks listed on the NSE (636 out of 900) fell short of Sensex returns between June 19, 2006 and end-October. More importantly, five out of ten (484 in number), did not manage even half the index return of 50 per cent.

While the Sensex may have doubled in value over this period, median return on NSE-listed stocks was at a mere 42.5 per cent. This may be the number that is most relevant to investors, as it gives you the average, excluding extremes in the return spectrum!

With half the listed stocks lagging far behind the index, there remain quite a few buying opportunities for an investor willing to forage the list of under-performers. Investors wary of high valuations should consider replacing stocks in their portfolio, instead of taking their money entirely off the table.

How your portfolio fared in the Sensex move from 10k to 20k depended largely on the profile of stocks you packed it with. If you held only large-cap stocks (those with a market capitalisation of Rs 10,000 crore or more), your portfolio may have surprised you with a whopping 248 per cent return between last June and now.

But if you displayed a penchant for small and mid-cap stocks (less than Rs 2,500 crore market-cap), the returns would have straggled way behind the index, at 59 per cent for the same period.

The list of large-cap stocks also featured far more market-beaters than the mid- or small-cap spaces. These results are not evident from a comparison of the BSE Midcap or Small-cap indices with the Sensex because of the fairly sharp divergence in returns within each of these segments.

What explains this huge gap in investor preferences between large-cap and mid/small-cap stocks over this period? Well, the answer could be that stock returns over this period have been driven mainly by fund flows from FIIs, with a swelling variety and number of such investors.

New foreign investors entering Indian markets for the first time may automatically gravitate towards the well-known names of India Inc, as these companies have the advantages of scale, good management and low execution risks, relative to their smaller peers. Institutions such as hedge funds or offshore funds seeking a country exposure would also tend to be partial to index and large-cap stocks, given that they offer good liquidity, and the ability to transact large volumes with low impact costs.

Time to turn to mid-caps?

Recognising that the rally from 10k-20k has been focused mainly on large-cap stocks, what should investors do at this juncture?

Those who have invested mainly in index/large-caps, should look to book some profits on these stocks and peg up allocations to mid-caps or to emerging large-caps, represented by the basket of Junior Nifty stocks.

We say this for two reasons. One, frontline stocks are now trading at stiffer valuations than before, having seen a sharp expansion in their PE multiples over the past year. This makes them more vulnerable to any earnings disappointment or adverse news flow at this juncture. Second, softening interest rates in the US, the prospect of a slowdown there and tempered concerns about a global liquidity crunch, suggest that liquidity flows into islands of growth, such as India, may continue.

Mid-cap and small cap stocks would be key beneficiaries of sustained liquidity flows, as investors exhaust large cap options and search deeper in the Indian markets for investment opportunities. Mid- and small-cap stocks also trade at a significant discount to large-caps and thus factor in more modest growth expectations.

Another key trend in this bull phase that has lessons for investors is the relationship between stock valuations and their returns.

Surprisingly, the lesson is that buying into stocks with a low absolute PE (what is termed “value investing”) has simply not worked. Sample these numbers.

High PE, high returns!

While stocks with a PE multiple of over 30 times in June 2006(trailing earnings) have averaged a whopping 167 per cent return over the past year and a half, stocks with a PE of less than 10 then have scrounged up less than half this return, at 75 per cent. And this is not simply because of a few stand-out performers in the high PE bracket. The list of expensive stocks also featured far more market-beaters in their ranks, than the “value” stocks (See Table).

One reason why “growth” stocks so clearly stole a march over “value” stocks in this rally, is that the Indian market is sought after by investors anxious to ride the growth momentum in its economy. Institutions have automatically flocked to the stocks and sector themes that most visibly represent the “growth story” and these were invariably the ones with a high PE.

However, this is not to say that investors have taken no note of valuations while indulging in a buying frenzy during this rally.

Some of the stocks trading at moderate valuations have witnessed a sharp re-rating, but subject to two factors. One, stocks in the large-cap basket that were trading at a relatively low PE have witnessed a sharp expansion in multiples and have been out-performers. Power stocks such as NTPC and Reliance Energy, which were trading at a valuation discount to the Sensex basket, have risen two- and three-fold in value respectively over this period. Reliance Industries and ONGC, hovering at mid-teen PEs in June have been marked up. The PEs of Tata Steel and SAIL have expanded from single to double digits over this period, helped by a favourable turn in the steel cycle.

However, such re-rating has been confined only to sectors that have been already fancied in the markets and enjoy significant visibility on growth.

While investors have been quite willing to mark up the valuations for a Jaiprakash Associates, an Indo Tech Transformers or a Tata Power that have linkages to the infrastructure or power sectors, they have ignored pharma, textile or automobile stocks, languishing at a low PE.

These remain quite plentiful even at today’s prices. As “growth” and “value” themes tend to outperform each other in cycles, one may be tempted at this juncture to make a large-scale switch into low-PE stocks.

However, given that investors with an appetite for “growth” are clearly driving India’s stock market rally, it may be more prudent to take the middle road. A mix of high as well as low PE stocks in the portfolio may be required for it to match market performance going forward.

Overall, the fact that the rally has been focussed in large cap stocks with a growth bias, suggests that buying opportunities for investors at this juncture may emerge mainly from mid/small cap stocks that trade at moderate PE levels.

However, the experience so far suggests that it may be best to buy into low PE stocks only on the evidence of strong earnings growth that is ignored by the market or signs of an incipient turnaround in the sector.

We present a portfolio of value stocks for investors. This portfolio has stocks from diverse sectors trading at PEs of 15 or below, which have a good record of profit growth and a high return on net worth. (See Table).

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