If you invest in stocks enamoured by their earnings generation capacity and have the financial strength to hold through market cycles, you will certainly earn returns.

Suresh Krishnamurthy

ON Monday, August 8, stock market operators received a vote of confidence from the Finance Minister, Mr P. Chidambaram, who rejected assertions that a bubble is building up in the markets. He called our markets one of the best regulated. In the same breath, he added that there is scope for improvement.

The last statement would have left you wondering how much improvement is needed to make the markets a safer place for investors. Many would categorically assert that the stock market is a den of operators. Notwithstanding such extreme positions, it would be appropriate for retail investors to exercise caution as valuation levels are now factoring in sustained growth over the next few years.

There is still a reason for long-term money seeking returns of 10-12 per cent over the next three to five years to flow into the market. In contrast, there may be unsettling times ahead as short-term money seeks returns of 20 per cent plus in the next 12 months.

On bubbles: In an article on bubbles, Bloomberg columnist Chet Currier said that the best test of whether a bubble is building up is to find out one's own motivation for buying a stock. If you are buying a stock because of a hot tip from a broker, then you are not safe from the bursting of a bubble.

Another issue is that the stock market is, in reality, a market of markets. The trades for each single stock constitute a market. There could be a bubble in some of the markets (read stocks), while the price formation in several of the other markets may be primarily determined by the capacity of the companies to generate earnings. It is in this backdrop that there are a few causes for concern.

For instance, the spectacular spurt in stock prices and trading volumes in stocks that are part of groups in BSE such as T, B2, S and Z needs to be considered carefully.

The valuation of select mid-cap and small-cap stocks also may need to be closely observed. Stocks such as Max India, Shyam Telecom, Financial Technologies, Petronet LNG, Reliance Capital and Aurobindo Pharma are trading at PE multiples that are wildly optimistic. There may be bubbles building in such stocks.

Caution advised: More than the Finance Minister, investors would be better served if they paid heed to the observations of the SEBI Chairman, Mr M. Damodaran. In an interview to a television channel, he said that if you take informed investment decisions, there are reasonable returns to be made. He also said that nobody ever gives you a guarantee that everything is one hundred per cent right in the market.

The key term here is informed investment decisions. If you invest in stocks enamoured by their earnings generation capacity and have the financial strength to hold through market cycles, you will certainly earn returns. Then, you may also not have to worry about the threat posed by motivated operators.

Having said this, there are indications that from a portfolio perspective, investors may have less reason to worry about a precipitous fall in stock prices. Even though valuations are definitely high there appears to be no cause for alarm. The valuations may still not be totally out of tune with growth prospects.

For instance, the market-cap weighted price-to-earnings multiple of large-cap stocks is 19. The market-cap weighted PE of mid-cap stocks is 21. The PE for stocks owned by public shareholders is 22.3. And the PE for stocks owned by FIIs is 22.4. While the numbers are certainly on the high side, they may be supported by expected earnings growth.

If earnings growth does disappoint, then, in many stocks the downside may be limited to 10-20 per cent over the next 12 months.

Over a longer term of five years, stock prices would have recovered from any such downturns to deliver returns that will beat inflation and debt markets comfortably.

(This article was published in the Business Line print edition dated August 14, 2005)
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