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There is something very strange about this bull market, which has seen the Sensex gain 21 per cent since end-December 2011. Very few investors seem to have made money in it. Therefore, you have the Sensex poised at 19k levels, even as domestic investors are enveloped in deep gloom. The market price-earnings multiple stands at a lofty 17 times, even as profit growth estimates for companies are being cut to single digits.
Valuation gap
Delving into the PE (price earnings) ratios of the listed universe reveals a sharp polarisation in the market. Within the CNX 500, four out of every ten stocks struggle at a PE ratio below 10. But what makes the market PE look good is the fact that a fifth of the stocks, mostly from the pharma and FMCG spaces, enjoy PEs of 30-40 times. A similar divide is reflected in banking too, where the public sector banks languish at less than their book value, while private banks trade at 3-4 times their book.
What we have, therefore, is a bull market in certain defensive sectors and a bear market in most other spaces.
Consumer Vs Industry
The above valuation divide would have one believe that everything is hunky-dory with the Indian consumer and the companies which cater to her. But there are blacker days ahead for companies that make capital goods or build the country’s infrastructure.
But a reality check on corporate performance over the past two quarters suggests that this reading isn’t entirely correct.
Consumer companies, particularly FMCG makers, who did prove resilient to the slowdown for a while, are now having a tough time driving offtake. With sales at a standstill, they are finding profit growth hard to sustain. Pharma stocks too, as the accompanying story reveals, are facing new regulatory risks which could mute their financial performance. And among the beaten down industrial names, there are quite a few who are managing some growth despite the tough times.
Mismatch
If this trend holds, the markets would have to re-adjust to the yawning mismatch between the PE ratios of 30-40 that some FMCG or pharma stocks today enjoy, and the profit growth of 10 per cent or so that they are able to deliver. The opposite holds true for industrial names such as L&T or IRB Infrastructure.
Assuming that stock markets do act rationally over the long term, all this suggests that the equity market could be in for a corrective spell that re-aligns valuations to fundamentals.
For one, the overall market PE will have to correct to more realistic levels (of, say, 12-13 times) for equities to turn an attractive buy for long-term investors. At current levels, there is no case to abandon equities, but there is no compelling reason to add to them either. Two, the over-fancied consumer and pharma stocks will have to decline, so that their prices reflect their long-term fundamentals. As these are the over-owned segments of the market, it is quite likely that if markets do correct, the top performing stocks from these sectors will tumble the most. After all, investors will only take profits where profits are available. Finally, when this correction eventually makes way for the next bull market, hopefully underpinned by a rebound in the economy and corporate profits, leading industrial names, public sector banks, infrastructure companies and capital goods makers will be direct beneficiaries of this. They will need to be re-rated to better valuations than they enjoy today.
Such sector rotation has indeed been witnessed in every market cycle over the last decade. If the 1999 bull market was led by tech and telecom stocks, it was an entirely new set of realty and infrastructure names that drove the 2007 rally. These took a battering in the subsequent correction to be replaced by defensives.
Given this history, it appears quite likely that the next bull market (if one wants to look that far ahead) will be led, not by the front-runners of this rally (namely — all things consumer), but by a completely different set of stocks, possibly with closer linkages to industry or services. So investors who have missed the bus in this bull market, should resist the temptation to jump on to it now.
Others should reduce risks on their portfolio by lightening up on the sectors that have been star performers in this rally (namely defensives) and accumulate (in phases) beaten down industrial companies. But given that India Inc is still in the throes of a severe slowdown, it is best to remain quality-conscious in this stock selection. Large-cap industrial names should score over mid and small-sized companies. And companies with low debt and strong balance sheets should be preferred over highly leveraged ones, no matter how cheap the latter may seem.
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