The Hindu Business Line : Cues from the market decline

Investors who joined the stock market party after August last are probably struggling to find a silver lining in the present downturn. The market correction has been unrelenting and across-the-board, with few stocks managing to withstand the selling pressure.

Almost all the wealth created in the steep ascent between October and December has been wiped out. But what has declined the most and are valuations more reasonable now? Do these trends have any cues for investors? Business Line analysed trends from the market meltdown between January 8, 2008 (the day of the highest closing for the Sensex) and now to find answers.

Battering of stocks

The Sensex has declined about 25 per cent from its January 8 peak. But portfolios of most investors are likely to have witnessed far steeper erosion. Eight out of ten stocks traded on the NSE have declined more than 25 per cent. About 15 per cent of this universe has shed more than 50 per cent.

Few stocks were spared from this bruising decline. Barely 15 of the 1,190 actively traded stocks on the National Stock Exchange recorded positive returns during this period.

Stocks belonging to defensive sectors such as pharmaceuticals and FMCG managed to contain their declines better. Sun Pharma, Ranbaxy, Gujarat NRE Coke and Hero Honda Motors were some of the prominent stocks that managed to stay afloat.

Universal de-rating

The market tumble has seen PE multiples (valuations) collapse across stocks, sectors and market capitalisation ranges. A combination of higher aversion to risk and some earnings disappointments has led to a significant de-rating of Indian stocks. As is to be expected, stocks with high valuations bore the brunt of the sell-off. Stocks that were trading at 50 times their trailing earnings and above and those that did not have any fundamentals to speak of took a hard knock, dropping anywhere between 20 per cent and 50 per cent. But this aside the correction has been largely valuation blind.

Meaning, stocks were de-rated irrespective of the valuation they enjoyed at the peak. If you thought holding stocks with a low price-earnings (PE) multiple would have protected you from downside, think again. Stocks that traded at a PE multiple of less than 10 (based on trailing earnings) as on January 8, declined on an average by 35 per cent since.

Cheap stocks, therefore, only turned cheaper. For new investors, this de-rating does, however, present more attractive investment opportunities. There are a good many stocks now available at valuation multiples of less than 20. Close to 50 per cent of the actively traded stocks are available at an earnings multiple of less than 15.

Brutal sell off in small-caps

Small-cap stocks, which were hyperactive in the October-January period, have felt the most pain, with the BSE SmallCap Index shedding over 40 per cent from the peak. But this does not even compare to the massive meltdown in small-caps outside this index.

Stocks with a market capitalisation of less than Rs 2,000 crore have, on an average, shed 40 per cent; some stocks have crashed 60-70 per cent from their January 8 levels. Small-cap stocks, by their very nature, tend to be more vulnerable to market meltdowns than their larger peers, as they are relatively illiquid. They were all the more susceptible this time, as investors sought to book profits in small-cap stocks that saw an unprecedented rally in the last months of 2007.

Between October and December 2007, the BSE SmallCap Index gained 47 per cent, outperforming the BSE Midcap and Sensex. But much of the action was actually witnessed in stocks outside the indices. Several stocks with poor fundamentals also moved up. The market meltdown has, however, wiped out almost all the gains of the preceding rally.

In contrast to small-cap stocks, mid-caps (stocks with a market capitalisation of between Rs 2,000 crore and Rs 10,000 crore) have fared relatively better. In fact, while the BSE Mid-cap Index shows a steeper decline of about 33 per cent, the average decline of stocks in the mid-cap universe is about 29 per cent.

This means that if you had held some of the larger mid-cap stocks, you might not have been much worse off than if you held large-caps. Or, viewed differently, these stocks protected downside much better than small-cap stocks.

Valuation gaps widen

The de-rating has also widened the valuation gaps between large-cap, mid-cap and small-cap stocks. At peak levels, the price-earnings multiples of stocks across market capitalisation range were at 28-29 times. The Sensex now trades at a price-earnings multiple of 19.5 as against 28.5 two months ago.

The BSE Midcap now trades at a multiple of 16 and the BSE Small Cap at a valuation of 12.7. Large-caps now enjoy a premium of 20 per cent over mid-caps and over 50 per cent over small-caps. This offers some room for valuation upside in mid-cap and small-cap stocks, provided liquidity and market interest in these stocks improve.

However, with increasing volatility and concerns of a slowdown in earnings, it is difficult to say for certain whether these valuations really signal the bottom.

Sector trends

There weren’t any significant sector trends in this across-the-board market correction. But export-sensitive (US-dependent) sectors have expectedly taken a beating. Frontline IT stocks have not been hit too badly, but this could be because they underperformed in 2007.

Huge outflows from the Indian markets have also ensured a relatively stable rupee in recent months, a positive for IT stocks. On the other hand, smaller companies in the textiles and gems and jewellery sectors were among the worst affected.

Sectors that ride mainly on domestic themes, however, were not altogether safe. Real-estate stocks have crumbled on fears of cooling property prices. Stocks of brokerages have nose-dived 50-60 per cent, as fears about margin funding and falling volumes were seen to weigh on near-term earnings. Stocks that were previously being valued for their subsidiaries — the very popular concept of value unlocking — have also gone up in smoke.

Key takeaways

It has been a gloomy couple of months for investors, especially the recent entrants. For those who have seen their capital eroded by 30-40 per cent, you must be wondering if it is better to throw in the towel and cut losses. However, But wait, take some time to re-evaluate your portfolio and double-check on the fundamentals. Retain stocks in which you have high conviction.

While valuations have corrected considerably, the de-rating is backed by genuine concerns about earnings in some sectors. You can consider switching your investments from problem sectors to stocks with better prospects and try and recoup lost value.

It is difficult to call the bottom and this may well be a good time for new investors to begin buying quality stocks in small lots. At the same time, given the concerns on the global front, the market may not rebound anytime soon. This is a market for more long-term investors with a two-three year perspective and return expectations in the medium term will have to be modest.

While selecting stocks, focus on those with higher certainty of strong earnings growth rather than those that are available cheap. A strategy of picking stocks merely on the basis of low valuations does not seem to have worked so far.

Given the tough market conditions, equity mutual funds with a strong track record remain the best route for investments, especially for novice investors. Systematic investment plans may be a good way to smoothen the impact of volatility on your portfolio.

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