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Is it too risky to bet on Indian stocks now?

May 04, 2017 13:05 IST

The Nifty Index features 50 of the largest companies in the country and represents close to 50 per cent of total market capitalisation.
It is now trading at valuations that could only be justified if India Inc grows earnings at better than thrice the GDP growth rate.
This is extremely unlikely, feels Devangshu Datta.

The corporate results season has just started and at the time of writing, there are a few clear trends to focus on.

The information technology sector is under pressure, but that's not news. Other sectors have not come through with enough data for definitive trends.

From first principles, investors will need to examine the fourth quarter (Q4) and full-year results, look at growth prospects, valuations and also make a call on future interest rate trends.

India, like every other stock market, has a long record of booms and busts.

Index valuations right now are at around price to earnings (PE) ratio of 23.

History tells us that returns from these levels tend to be negative for three years or longer.

Investors need to be careful and only pick stocks that seem to have extraordinary growth prospects or attractive valuations, if deploying fresh investments at these levels.

Interest rates and projected inflation are crucial in judging what valuations can be sustained.

As of now, interest rates appear stable.

The Reserve Bank of India has held policy rates steady in the past three reviews and has, at the same time, tightened the spread between policy rates.

Assuming the previous rate cuts are fully transmitted by the banking system and non-banking financial companies (NBFCs), commercial rates could come down but not by too much.

Yields on government securities (g-secs) yields are trading in the range of 6.25 per cent or slightly higher.

Most professional forecasters polled by the RBI don't expect yields of g-secs to fall lower than six per cent in the current financial year.

That's another 20 to 30 basis points (bps) and this implies the RBI isn't going to cut or not cut rates by much.

Hence, investors comparing returns across assets will assume the risk-free return is in the range of 6 to 6.5 per cent at minimum and build their expectations on top of that.

If the debt yield is in that range, the earnings yield or the earnings as a percentage of price should be equally high or higher.

Since the earnings yield is an inverse of the PE ratio, that gives a methodical investor a range of 14 to 16 PE, as the upper limit of an investment model driven by earnings yield.

Ideally, therefore, the investor should look for a trailing PE less than 16.

A higher trailing PE can be justified only if the anticipated growth is much higher.

If the investor is using a PE growth model (PE divided by expected growth rate in percentage of earnings per share), it should not exceed one.

Ideally, it should be less than one.

If, for example, the index is trading at a PE of 23, a 'PEG-style investor' buying the index should be hoping for earnings per share (EPS) growth (weighted in free float style like the index) at 23 per cent or higher.

To put this in perspective, gross domestic product (GDP) growth this year (2017-2018) is expected to run at approximately 7 per cent.

The Nifty Index features 50 of the largest companies in the country and represents close to 50 per cent of total market capitalisation.

It is now trading at valuations that could only be justified if India Inc grows earnings at better than thrice the GDP growth rate.

This is extremely unlikely when we are talking about a well-diversified set of large companies that generate a considerable proportion of GDP.

Simple base effects make it very unlikely. Doubters can take a look at historical EPS growth rates across, say, the top 100 companies.

In that set, recording EPS growth of 25 per cent and/or 3x of GDP growth rates is rare.

Smaller companies can, however, attain growth rates in this zone of 3x GDP growth or even higher much more often.

Base effects work in their favour.

The other case where base effects work in favour of high growth is in turnarounds where the earnings base is negative or very low.

This gives investors a broad range of parameters for long-term investment.

Ideally, look for companies trading at PEs of less than 16.

Avoid paying a higher discount unless the growth prospects are truly exceptional in a company. Those are likely to be available only in small companies or in those coming back from a loss.

Buying at higher discounts or without higher growth prospects, or without a strong probability of a sustainable turnaround, would be extremely risky.

Devangshu Datta
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