The Hindu Business Line : Why index levels don’t really matter

Given that the market could head lower in the short term, investors should build a portfolio that has potential to participate in a recovery, while reducing downside risk from short-term market swings. Here’s how.

Aarati Krishnan

The unimaginable has happened, with the BSE Sensex closing last week at a four-digit figure. So where is the next ‘support’ for the index? Will it stop at 9700? Or will it head further southwards to 8800? If you are a long-term investor, the answer is: It doesn’t really matter.

In the short term, with the liquidity picture shrouded in uncertainty, more pain may well be on the cards. But, for long-term investors, valuations are compelling enough to start accumulating blue-chip stocks. In the long run, as long you buy quality stocks, it isn’t going to matter much whether you bought them at a Sensex level of 10000 or 10-15 per cent lower.

Too much energy has already been expended over the past ten months, in second-guessing market direction over the next trading day or week. Whether you were trying to ‘short’ the market at every bounce or buying into it for ‘trading gains’ on falls; it is likely that you lost a packet to the market’s whimsical swings.

With liquidity flows and FII action deciding the market direction; no one, not even market watchers who today claim that they saw it all coming, can accurately predict where the market may go over the short term. Experts couldn’t foresee market plunging all the way from 21000 to 10000 and the same experts can’t tell you when the markets will bounce back from 10000 to 15000!

Better entry point

Having admitted this, all we can say today is that a stock market at Sensex 9700 provides a far better entry point for long-term investors, than the one which saw the Sensex at a dizzy 21000. Yes, FIIs have been in the exit mode from Indian stocks for ten months now.

Indian companies are today grappling with a slowdown and there are worries about whether the global credit crunch will hit their expansion plans. Yet, it is these fundamental risks that are captured in the lower valuations and stock prices of today. If all was well with global liquidity and the Indian economy, you wouldn’t be getting to buy stocks at 2005 prices!

Too much pessimism?

The Sensex is today trading at about 10.3 times its estimated earnings for the current year. Stocks outside the index basket are at bargain-basement prices, valued at 6-8 times earnings. Current price earnings (PE) multiples are at the lower extreme of PEs for Indian stocks over a ten-year period.

To put the valuations in perspective, the S&P 500 index, the bellwether index for the US markets, today trades at 11.5 times its current earnings- a premium to the Sensex valuation! Yet, the US is the epicentre of the recent credit crisis.

Analysts actually expect the US economy to slip into recession and the earnings of its leading companies to shrink over the next few quarters.

In contrast, worries about the Indian economy are largely confined to a slowdown in growth. Not even avowed pessimists expect the low growth in India to last for the next five or ten years. With India’s economy vulnerable to a global slowdown, earnings can dip and PEs contract even further over the next one year.

But not all companies will fall prey to this trend. Even as the recent stock market meltdown has been ruthless in whittling down stock prices; there remain a good number of Indian companies that will deliver a 15-20 per cent earnings growth even over the next couple of years. You may not have a better opportunity to buy these stocks.

What to do

So having accepted the fact that the market could head much lower in the near term, what should be the course of action for investors today? Build a portfolio that has the potential to participate in a recovery, while reducing the downside risk from near term swings in the market. Based on the composition of your portfolio today, here are a few suggestions:

If you are a first time investor in equities, this is a great time to buy quality stocks. But make sure your investments are well diversified over options as well as time. Investors who find stock selection difficult can buy Exchange Traded Funds (ETFs) that track the Nifty (Nifty BeeS) or the Sensex (ICICI Pru Spice), through the exchanges.

Add diversified equity funds that have a bias towards large-cap stocks (DSP Top 100, HDFC Top 200, Sundaram Select Focus). In order to make sure you don’t expose your investment too much to further downside, split the investment into several portions, and systematically buy units at every 300 point dip in the index.

If you already have an equity portfolio built at much higher index levels, don’t liquidate it now in panic. That will ensure that you close out the possibility of recouping some of that money. Instead, consider switching into stocks and investment options that have a greater chance of participating in a market recovery- as and when it happens.

A switch from small and mid-cap stocks into index heavyweights or into the index ETFs mentioned above will help contain losses if the markets fall further, while ensuring participation in any upside.

If you have lost a lot of capital to the market meltdown, don’t average the stocks that you already bought. As the earnings outlook for a good number of companies has deteriorated, some of the stocks that have fallen do deserve to trade at these prices. To contain losses, add bluechip names now and look to liquidate poor quality stocks in a rally (even a bear market is likely to be interrupted by brief rallies).

Finally, avoid leveraged and short term trades. With global volatility at a historic high, and stocks experiencing unprecedented volatility, betting on short-term trends will be a sure-fire way to lose your shirt!