Do market valuations signal a buy?

With the roller-coaster ride in the stock market showing little signs of abating, many investors are left wondering ‘what next, where next?'. The strong recovery on the bourses last calendar from the lows of March 2009 has been followed by much volatility over the past 10 months.

Vacillating between sharp declines and spirited pullback attempts, the bellwether indices are down almost 20 per cent from their highs of November 2010. To blame has been a cocktail of factors, including high inflation and escalating cost pressures, rising interest rates, lacklustre results by India Inc., and global economic jitters.

The decline on the bourses has, however, prompted many money-mavens to think aloud that, given the attractive valuations and the long-term ‘India growth story', now may be a good time to go shopping for stocks. On the other hand, there are also the nay-sayers, who say there may be more bad news in the offing.

For the moment though, the optimists seem to be in a majority. We checked, based on some widely used valuation metrics, whether this optimism is justified. Our findings suggest that while the indices are not trading too cheap, there seems to be room for ‘cautious optimism'. Here's why.

Reasonable PE

The latest market fall has been largely size- and sector-agnostic, and has resulted in most indices trading at earnings multiples lower than their long-term averages. Data from the NSE show that the Nifty (comprising the 50 largest companies by market cap) is trading at a price-to-earning ratio (based on trailing 12-month earnings) of around 18.3 times.

This is down sharply from levels of around 26 times in late 2010, and a tad lower than the Nifty's long-term average of around 18.4 times. The PE of the not-so-big companies, represented by the CNX Midcap index has also fallen from around 23 times last November to 15 times.

Though not highly compelling, the current PE levels seem reasonably attractive for investors with a long-term perspective. A few reasons underpin this position. One, a large portion of the recent market fall has been precipitated not by systemic or sector shocks (as in the crashes of 2000-01 and 2008-09) but are because of cyclical macro-economic factors, which should turn in the foreseeable future — at least, in the Indian context.

Inflation, the main bugbear, though still above comfort levels, is expected to moderate this fiscal, given the thrust of the government and the RBI in tackling the issue. This may ease the pressure on Corporate India, which saw earnings grow at an insipid pace (around 4 per cent in the June quarter), following rising input cost pressures. Fears of continued slow growth in the denominator ‘E' (earnings) seem to have resulted in the numerator ‘P' (price) taking a sharper than warranted knock. A return to reasonably healthy earnings growth, not an unlikely or very distant possibility, should see the tide turn.

To be sure, there could be spoilers, especially in the global context, in the coming quarters too and a decline in prices from current levels cannot be ruled out. Investors could, therefore, consider buying fundamentally good stocks available cheap.

No mid-cap party

Next, the gradient of the current earnings multiples across market capitalisations suggests that much of the froth has been removed. During manic bull runs such as those seen in 2000, the earnings multiple of mid-sized and small companies tends to exceed those of the big boys, before the edifice comes crashing down. For instance, in 2000, the CNX-500 traded at 37 times earnings at its peak, compared with 28 times of the Nifty. And the higher they go, the harder they fall. Post the crash, at its trough in 2001, the Nifty PE fell to 12.3 times, while the CNX-500 fell to 11.6. Frothy market conditions, where mid-caps traded at a premium to the large-caps, were not witnessed in the recent market peaks of 2010. Even now, the Nifty (PE of 18.3 times) trades higher than the CNX-500 (17 times), indicating that valuations are in sane territory, in tune with risk-reward profiles. This suggests that, besides the large-caps, good buying opportunities may also be present in the mid-caps.

Low price-to-book

Finally, the price-to-book ratio for the CNX-500, which was at 6.3 times in 2008, had moderated at the peak of the 2010 bull-run to 3.6 times. This was despite the index levels in 2010 coming close to the heady heights seen in early 2008. This suggests a higher capacity build by India. Inc in recent years, which should help drive earnings growth in the future. Also, at present, the price-to-book for the CNX-500 stands at a reasonable 2.6 times, indicating room for price appreciation.

market-cap to GDP ratio

Another factor lending support to our ‘cautious optimism' is reasonable levels of market-cap to-GDP ratio. The recent fall in market capitalisation, combined with relatively strong GDP growth, has resulted in the BSE market cap-to-nominal GDP (trailing four quarters) ratio reaching comfortable levels of around 80 per cent currently.

This valuation metric peaked at around 173 per cent in late 2007, crashed to 52 per cent in March 2009 and recovered to a high of 115 per cent in November 2010. A ratio of around 70-80 per cent is generally considered a good buying level by many, including value investing guru Warren Buffett, though many sceptics question the usefulness of the valuation parameter itself.

That the current 80 per cent is despite the listing of several companies including behemoth Coal India in 2010 provides comfort on existing valuation levels.

Earnings yield

Although the market seems poised at reasonable levels currently, how do earnings yields (profits delivered on each rupee invested) on equities compare against returns on risk-free debt options available to the investor?

Earnings yield (the reciprocal of the PE ratio) for the Nifty currently stands at around 5.5 per cent, compared with the 8.3 per cent yield available on the 10-year government bond. Prima facie , this means that an investor may get more bang for the buck investing in debt than in equity.

However, it needs to be noted that for most of the last decade, the earnings yield on the Nifty has been lower than the 10-year government bond; yet returns on equity have been better than that on debt. So what seems to matter more is the extent of the gap between earnings yield on equity and the yield on debt.

The higher the gap, the greater the chances of the equity market being over-valued. Generally, a gap of more than 4 per cent (as seen in late 2007 and early 2008) has meant danger signals for the equity market. In early 2000, the gap was as high as 7.5 per cent. Currently, the difference stands at a reasonable 2.8 per cent.

Opportunities across sectors

Unlike the previous bull runs, which were largely sector-specific (tech boom in 2000, and realty and infra boom in 2007-08), the rising tide in 2010 lifted most boats.

Consequently, the recent market fall has been felt across sectors.

That buying opportunities may exist across the market is reflected in many sector indices currently sporting lower-than-average earnings multiples.

This includes IT, auto, consumption, infrastructure, metals, realty and PSU banks.

That said, given that some sectors such as metals and realty are increasingly coming under corporate governance and regulatory clouds, it is imperative for investors to analyse individual sector and company fundamentals before deciding to buy.

Low valuations should not be a substitute for solid fundamentals.

Also, investors should exercise discretion and not give in to flavour-of-the-season sector euphoria.

Irrational run-ups are invariably followed by staggering busts, from which recovery is either not feasible or is quite long-drawn.

For instance, during the hey-days of the dot-com boom in 2000, the PE ratio of the CNX IT Index touched (believe it or faint) 420 times, only to crash to lows of around 17 times in 2001. It currently trades at around 18.5 times.

Likewise, the earnings multiple of the CNX Realty Index, which touched a high of 135 times in 2007, fell to as low as around 4 times in 2008 and 2009. It currently trades at around 14 times.

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