Some Thoughts on Market Valuations…

The Sensex closed at 19,594 yesterday which is still around 7.5% away from its all time high of 21,200+ in Jan’08. This raises a question about the valuation of the markets. We are almost within kissing distance of the all time highs and there is a need to evaluate the market conditions.

The current rally which began way back in March’09 as a bounce from highly over sold territory has seen the Sensex rise almost 140%. A large part of the rise from 8000 to 16000 was almost vertical and took place in just 3 months (Mar’09-Jun’09). Time and again the markets have refused to correct and several investors have missed the rally completely. September is traditionally supposed to be a “down” month but here we are making new highs every week. So let us retrospect and see how the world has changed and what could be the possible road ahead.

The world has changed a lot from Jan’08 till date. Baer Sterns, Lehman Brothers, Merrill Lynch no longer exist. GM has filed for bankruptcy while AIG, Citibank and several other behemoths are propped up on Government support.  Governments around the world undertook several stimulus packages to boost growth and stem the collapse in trade and private consumption.

Crude oil is still 50% away from its peak of $ 147. Gold has moved up from $840/ounce to $ 1280/ounce outperforming most other asset classes. Dubai, Greece, Portugal, Spain, Ireland have all given the markets a scare with the possibility of debt default. All these countries have unsustainable levels of Debt/GDP and their bonds are continuously being downgraded. Their fiscal deficits show no signs of shrinking and going ahead the markets may get spooked if one of them default.

In the developed world, US (93% Debt/GDP), UK (78% Debt/GDP) and Japan (227% Debt/GDP) continue to pile up debt. Given the huge Debt pile up across the globe (chart below) it is difficult to imagine that we would be getting back to the 4% Global GDP growth any time soon. However Indian equities don’t seem to care for any of these danger signs and continue to march ahead.

Since I am not an expert on Global Macro-Economics this article will now focus on market valuations. For those who are technically competent (in Economics) and would like to read about the scary details of Government Finances please visit this excellent site by John Mauldin. The ones who are not very competent can visit a much simpler series of article here (By Vivek Kaul of DNA, he puts the same concepts in much simpler words). The articles in both places are equally scary so be warned.

Coming back to market valuations where do we stand? Let us look at some possible alternatives.

1. Sensex P/E – The Sensex P/E stands at a rich 23.4 times as of date. This means we are around 44% higher than the long term average P/E of 16 times (data from brokerage reports). This P/E is a composite P/E of the 30 underlying companies. So it means that some of the companies would be trading at over 23 times while some will be trading below 23 times. The distribution of P/E is given below.

Here we can see that 20 out of 30 stocks are below the Sensex P/E while 10 have P/E ratios higher than the average. L&T  and Jindal Steel & Power are the most richly valued companies with P/E’s of over 40.

The P/E ratio is an indication of the expected growth rate of EPS. In my last article I have written about the lack of growth in Sensex EPS over the last two years. Looking at the historical EPS data it looks highly improbable that we can have a consistent 23% earnings growth going ahead.So based on P/E alone, the markets don’t leave much scope on the upside.

But if markets were still to go up then how high can they possibly go? Let us look at the historical peak P/E values during the last few Bull Runs.

During the Harshad Mehta led Bull Run in 1992, the market traded at an astronomical P/E of 56 times (which means we could potentially double from here on!!!). During the Dot-Com bubble we were at a less astronomical 33 times and during the Great American Subprime Bubble we were at a much conservative 27 times multiple. So given historical Bull Run P/E multiples, the markets could still go up. All that is needed is irrational exuberance of investors and ample liquidity.

As many experts have pointed out, a lot of funds and retail investors have missed the rally in Indian equities. MF assets have been shrinking over the last year. Pension money (Indian) is yet to come into the markets. FII inflows have been very good this year ($ 10 Bn plus). Interest rates are still very low across the globe. India is probably the only convincing balanced growth story. If the growth in the developed world continues to flag or worse we have a double dip in US and EU, a lot of funds would look to increase exposure to emerging markets and India would definitely get greater exposure. If everyone were to rush in, there is every chance we may head much higher.

2. P/BV and Div Yield – The P/BV stands at 3.7 times while the Div. Yield stands at a measly 1.07. These ratios indicate that the markets are highly over valued. But since we are looking at composite values for 30 companies there are some things to watch out for.

The P/BV is high for companies with very few tangible assets (Software, Telecom) while low for companies with large hard assets (Cement, Metals). Given that we are predominantly a service economy we should be able to have a higher P/BV than say a country like China or Russia which have large number of Manufacturing or Metals & Mining related companies as part of their stock index. I shall need to dig deeper on the P/BV data on individual companies to come up with any logical conclusion but anything over 3-4 times P/BV can be termed expensive.

In terms of Div. Yield we have to look at 2 aspects. Firstly in a fast growing economy, companies will want to retain earnings (i.e. pay less Dividend) as they need to fund capital expansion (As per the Pecking Order Theory of Finance, internal accruals/retained earnings from PAT remains the cheapest source of funds).Indian companies have also been acquiring companies globally since 2005. So several companies may want to retain funds for pursuing possible acquisitions.

My theory holds up pretty well given the fact that Bharti Airtel gave its first dividend last year as it believed prior to that it was better off ploughing profits back into their business. Similarly Infosys maintains Cash balances of almost $ 3Bn+  as it may want to acquire companies in the West. If companies retain or reinvest profits, Dividend payouts are bound to remain low and thereby keeping Div. Yield low.

Secondly, Indian companies are not the best when it comes to sharing wealth. If an American company skips or reduces dividends, it is taken very seriously. Investors over there would demand an explanation for such an action. But in India, most investors are invested for capital appreciation. Div. Yield rarely matters to aggressive investors who dream of making multibagger returns.

So based on P/BV and Div. Yields we seem to be in over valued territory but unlike the P/E ratio, dissecting these ratios is very difficult and hence making predictions based on them is inconclusive.

3. M-Cap/GDP ratio – I have written a detailed article on this ratio here. The current M-Cap for all BSE companies stands at $ 1.53 Tr while the Indian GDP stands at $ 1.23 Tr. Thus, the M-Cap/GDP ratio stands at 124% putting us in “Significantly Overvalued” territory.

4. Technical Analysis – For the readers who are unfamiliar with technical analysis, there is no need to worry. I shall try to look at current market valuations without use of too much technical jargon. I have focussed on a simple method based on the 200 Day Moving Average (200 DMA) to gauge the probability of a market correction. Markets are supposed to “Revert to Mean” meaning that stock markets cannot move vertically either upwards or downwards and excesses will get eventually get normalized. In simple terms we are playing with the law of averages.

Consider the chart below at the time of significant corrections since 2003. The whole idea of using the 200 DMA here is that it is considered as a long term support. Time and again during the last Bull Run, the Sensex has bounced off the 200 DMA proving its significance as a long term support. We have a few such instances shown below in “Red” where the market moved significantly ahead of the 200 DMA and an instance in “Green” where the market was much below the 200 DMA.

The data for the periods when the market was over-bought and then under went a correction is as below. I have approximated the values to the nearest hundred for ease. I have considered the lowest value within first 3 months of an intermediate peak to calculate the extent of the correction (as the period 2004-2008) was a constant uptrend.

The results here are interesting. In May’04, the market was a good 48% higher than its 200 DMA. It soon went a 32% correction when the NDA lost the elections in 2004. This was the day when the market hit the 10% lower circuit and later the 15% lower circuit.

Later on in May’06, the market was around 36% higher than the 200 DMA and soon experienced a correction of 30%. After that there were 2 minor corrections of around 10% each during Feb and July’07 when the market was above the 200DMA by around 15-20%.

Then during Jan’08, the market experienced a sharp 30% correction (which marked the beginning of the down-trend) and the difference between the market and the 200DMA was around 30%.

All in all data seems to suggest that the 3 major corrections (when the fall was around 30%) have all coincided with the market running ahead of its 200 DMA by at least 30%.  So, anytime the market moves ahead of its 200DMA by 30%, history suggests that it may be a good idea to look at booking partial profits.

Note:- It is necessary to understand the underlying dynamics of the 200DMA to make meaningful inferences. For example, when the market moved up sharply from 8000 to 16000 last year, the difference between the market value and the 200 DMA was massive. But the rally was V-Shaped and hence the difference was bound to be significant.

Once a significant gap is built up 2 things can happen. Either the market can correct and this reduces the gap between the market and the 200DMA. Or, the markets could move sideways (in a trading zone) and the 200 DMA can play catchup (like 2nd half of last year).

The chart below shows a snapshot of what happened last year. In June’09, the market was at 15600 while the 200DMA was a 11085 creating a massive gap of around 40%.

Ideally, the market should have corrected however the markets remained range bound and the 200 DMA played catch-up and once again the up-trend of higher tops and higher bottoms is in place.

Now, where do we stand on basis of this theory? The market is currently just 12% away from the 200 DMA indicating that it could still move up before undergoing a significant correction.

Conclusion:- I have looked at several parameters, some conventional and others not so conventional to look at market valuations. The markets appear expensive on several counts like P/E, P/BV or M-Cap/GDP. But history shows that markets can defy logic and move even higher. As the saying goes “Markets can stay irrational longer than you can stay solvent”.

I remember 2008 and the IPO market was crazy. The Reliance Power IPO was oversubscribed by 72 times attracting bids worth $ 186 Bn (almost 1/6th of the M-Cap of the whole of BSE at that point). Future Capital Holdings was oversubscribed by over 133 times!!! These 2 issues alone managed to get bids worth almost $200 Bn. The mood was super bullish and sectors like Power, Infra, Capital Goods and Real Estate were literally on fire. There was a deal making frenzy and we had a PE deal in India almost every day. It was a mood as if nothing could go wrong.

Today, there is still a lot of skepticism about the current market rally. Some IPO’s have struggled and retail investor participation has remained poor. The market volumes are also lower than that in 2008. This skepticism is in fact a very good thing as the crazy exuberance of 2008 is missing. This leaves room for some more upside.

I believe we could still see another 10-15% upside before we finally pause for breath. Slowly brokerages are suggesting that this rally may take us to the highs of Jan’08. This is a bad sign as the extrapolation game has just begun. No one would have thought in Sep’08 that the market would be back to their highs so soon. It appears as if something is wrong given that the Macro-Economic situation has changed dramatically.

But as they say Mr. Market is always right. It doesn’t care for economics. It doesn’t care what I think. The only factor that matters is global liquidity and investor risk appetite. Global liquidity should remain abundant as no debt ridden government wants to increase rates and hurt the fragile recovery. The RBI has taken baby steps in terms of rate hikes in spite of the fact that consumer inflation in India is in double digits.

Now what could be the key risks to the uptrend? Anything from terrorism to interest rate hikes to a slowdown in China or a default scare in Europe or elsewhere could spook the markets. A slowdown in China would definitely hurt commodities and earnings. Apart from that there is a huge pipeline of IPO’s waiting in the wings. A flurry of IPO’s could soak up the excess liquidity. If RBI decided to tackle inflation head on expect a 2-3% rise in Home and Auto loans and these sectors could be badly hit. No one knows how the markets may pan out.

But one thing is certain. And that is markets will remain exciting. Maybe they should have a tag line “Mr. Market – Expected the Unexpected”

The mystery of Sensex EPS growth

Just last week I had pointed about the stock weightage issues with the Sensex over here. This week Deepak Shenoy (who has a wonderful blog at http://www.capitalmind.in) has discussed the fact that the Financial Services & Oil & Gas sectors have 20% weightage each for the Nifty. I had calculated the sectoral weightages for the Sensex but turns out the equation holds true for the Nifty as well. This creates a bias as the index value computation becomes heavily correlated with the performance of these 2 sectors. Also, these weightages do not necessarily imply the contribution of the sector to the underlying economy (It is largely believed that the Nifty or Sensex values are indicators of the underlying economy).

Apart from the similarity on sectoral weightages, he has written about the lack of growth in the EPS of the Nifty. I was planning to explore the same for the Sensex but with a different angle. So here goes.

Equitymaster has the following data on Sensex EPS from 1998 till 2010.

The Sensex EPS has grown from Rs. 163 in 1998 to Rs. 838 in 2010. This means the CAGR of earnings has been a decent 14.62%. The chart of EPS growth y-o-y is given below.

On basis of the given data we can make a couple of simple observations. The EPS CAGR of 14.62% is very much in line with the usual expected returns from equities. Over the long term most financial planners will project equity returns in the range of 12-14%. Data over the last 13 years does seem to be in line with these claims.

What is striking however is the fact that even though the Indian economy has grown every single year since 1998 (average GDP growth has been around 6.5+%), we have still had years when EPS growth has been either negative or in low single digits (1999, 2009 & 2010). What bothers me is that whenever I go through any research reports by prominent brokerages or I-Banks, they tend to assume earnings CAGR of 20-25%. It is common to find research reports projecting FY10 Sensex EPS at 1000+. Today we stand at Rs. 840 odd on the EPS front which is a good 16% below most estimates.

Also most brokerages use a common logic for projecting EPS.

First assume GDP growth at 8-9% (real growth). Based on historical WPI averages, project the WPI inflation in the range of 6-7%. Hence, Nominal GDP growth should be 15-16%.

Since the Sensex or Nifty companies are the usually the largest companies in their respective sectors, it is assumed that their topline growth will be in line with growth in Nominal GDP (i.e. 15-16%). Also, it is assumed that since these companies are the blue-chips of India they can improve operational efficiency each year and hence the profits will grow at a pace higher than the topline growth (1.2-1.3x multiplier). Thus we get a projected EPS growth outlook of 19-20%.

But practically this does not happen and may not happen in the future. The large part of EPS growth has happened between 2002-2008 (EPS CAGR @ 24%) when the economy was booming in sync with a global boom.So GDP growth does not necessarily translate into constant EPS growth every year. There has to be a better explanation for this lumpiness in earnings growth. The answer lies in 2 basic concepts of Corporate Finance – Operating Leverage and Financial Leverage).

Indian GDP growth was slow in 2000-2003. Capacity utilization for many companies was low (Autos, Metals, Cap goods etc). Once the GDP started accelerating and capacity utilization went up, the concept of Operating leverage kicked in (basically Fixed costs of running a business get distributed over a larger volume increasing Profits much faster than Sales). This coupled with rising commodity prices (which helped Hindalco, SAIL, Tata Steel, ONGC, RIL etc) led to an acceleration in profits unlike any other time in history.

In terms of Manufacturing, companies like Maruti, M&M, Tata Motors, BHEL, ACC, Ultratech etc benefited from greater capacity utilization while the same period saw the comeback of the IT biggies (Infosys, TCS and Wipro) and the emergence of Telecom (Airtel). The cement & steel sector gained from a boom in housing and infrastructure.

Now, let me focus on the role of Financial Leverage in EPS growth. As a company takes debt, its RoE improves. Most DCF models, make use of terminal growth rate “g” which is “Retention Ratio * RoE”. Mint has a chart of the RoE from 2003 onwards.

Using the DuPont Identity, RoE = NPM * Asset Turnover Ratio * Financial Leverage.  As the capacity utilization expanded, the NPM increased and the Asset Turnover Ratio also increased. The chart below clearly shows that RoE for the Nifty shot up from 16% to 28% in 3 years. This in turn allows the market to trade at a higher P/E multiples as a higher RoE gives a higher DCF based value.

Thus, the period of 2002-2008 was truly golden in terms of earnings as both Operating Leverage and Financial Leverage kicked in causing earnings to accelerate.

It was in 2007-08, that a lot of companies started doing acquisitions and also undertook a fresh round of capex to increase capacities. Cement,Steel and Auto companies are in an overdrive to increase capacities across the board. Acquisitions like Novelis (by Hindalco), Corus (by Tata Steel) & JLR (by Tata Motors) have added debt onto the balance sheets of companies. This coupled with Capex expansion, will cause the double impact of rising depreciation (from Capex) and higher interest cost (from Debt) which could keep earnings growth subdued.

Similarly, commodity prices are much softer today than in 2008 (Crude oil is still 50% below its peak of $ 147). Cement prices are expected to remain soft given the huge capacity addition taking place. So going ahead it may be a while before we can see 20-25% profit growth for all the companies.

One more aspect needs to be considered while looking at Sensex or Nifty earnings. Given that the Index comprises of 30-50 stocks, there is a natural EPS cancellation that occurs. Variables like interest rates, forex rates and commodity prices affect some companies positively and others negatively. A rise in commodity prices will be good for Cement & Metal companies but will hurt the earnings of Auto, Infrastructure and Construction companies. Similarly a rupee appreciation against the $ will hurt IT companies but will benefit companies importing Iron Ore, Coal or Crude. Hardening of Interest rates will help the earnings of Banks but hurt the Real Estate, Auto companies  & others in general. Thus, there is no single sweet spot where all companies can earn optimum profits and the Index EPS is maximized.

Conclusion:- The idea here is to give a probable explanation for the lumpiness in earnings growth irrespective of GDP growth. Also above data suggests that it may be a bad idea to extrapolate earnings in a linear fashion on the basis of historical performance.

India Inc. will take a while to digest all the acquisitions, debt funding and fresh capacity addition and once that is done we may again see an acceleration in earnings. The last couple of years have seen almost flat EPS growth (2008-2010 EPS CAGR @ 0.8%). If we continue to grow at 8.5%, and given that earnings have been flat for almost 2 years now, expect the next round of EPS acceleration to begin in year or two.