Sensex: Where to from here? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster
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Sensex: Where to from here? 

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In this issue:
» Roubini: Risks of emerging markets back in spotlight.
» Is China's GDP target too high?
» Bill Gates leads the list of world's richest, again.
» Should one stay away from high valued stocks?
» and more...


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00:00
 
The general elections are arguably the most important political event in any country. And with the same a few months away in India, it would definitely have its implications in terms of influencing stock price movement in the short term. As and when more news and developments take place, the volatility is bound to increase. Especially, considering that a good portion of the investors have placed long term bets on India from a perspective of their preferred political party coming into power.

While the outcome of the elections may see some major market swings, over the long term, it would be the earnings and valuations that would drive the movement in stocks.

Let's take the example of the benchmark index - the BSE-Sensex - for instance. At yesterday's closing price, the index was trading at a P/E ratio of 17.25 times its trailing twelve month earnings. Dividing the Sensex value by the same, we get the earnings per share (EPS) value about Rs 1,230.

Now, if one compares these data points over the longer term period, it does give an interesting picture.

Let's take the earnings growth rates first. Over a 10-year period, the earnings of the bluest of blue chips in India grew at a compounded pace of about 15% YoY. But when seen from a relatively shorter term period, the scenario is a bit different. Over a five, three and one year period, growth rates have deteriorated gradually. The five-year compounded annual growth rate (CAGR) in EPS stood at about 11.6%, while the same for the three-year period stood at 10.2%. However, in the last year i.e. on a YoY basis, the growth stood at 10.7%, which is slightly higher than the growth seen in the three year period.

Now, let us look at valuations. The average P/E over a 10-year period stood at 18.7 (it would be the same if we remove the extreme 10% outliers as well). Over the past five, three and one-year periods, the average valuations stood at 18.9 times, 17.78, times and 17.3 times respectively; indicating that the valuations have been coming down. Now, with the earnings growth rates slowing down, markets have pulled down valuations a bit we reckon.

But what is the way ahead from here?

We would like to clarify that we are not trying to predict the market levels, but are trying to gauge the market drivers going forward.

We believe that since the markets are trading at a discount to its long term valuations, given the relatively slower growth in recent earnings, a certain discount is being priced, thereby making the current valuations fair (discount of about 8%). This makes the growth rate in earnings the key driver of the value of the benchmark index.

We thought it would be a good idea to draw out various scenarios as to show how various earning growth rates and sentiments could drive the Sensex.

Click here to see bigger table
Click here to see bigger table

As the above table would indicate, at current valuations, the movement in the index would largely be driven by earnings growth levels. And what would drive the latter? Well, it would be a mix of factors, not limited to the consumption and investment patterns of the country.

But, it would not be wrong in saying that even at 8% growth rates, the index looks unlikely to fall below 20k even if one considers lower than historical average multiples. In other words such a scenario would only be possible when earnings growth rates deteriorate to closer to 8% mark - which seems unlikely given the long term trend - and also when valuations move closer to the 15 times mark - thereby making stocks cheaper as compared to the long term average, and therefore attractive.

Do you believe the earnings growth rate will drive the movement in Sensex over the medium to long term? Share your views in the in the Equitymaster Club. Or post your comments below.

01:35  Chart of the day
 
The Forbes rich list is here. And Bill Gates has topped the world's richest list on the Forbes magazine annual billionaire once again. Gates remains at the pinnacle after snatching the title from the Mexican telecom mogul Carlos Slim Helu, who ranked number one for four years. His rank has slipped to second position. Notably Gates' fortune has swollen by US$ 9 bn to US$ 76 bn in a span of just one year. Interestingly he has held the top position for 15 of the past 20 years.

World's richest individuals

And topping the India rich list - and 40th on an overall basis - is Reliance Industries Chairman Mukesh Ambani, with a net worth of US$ 18.6 bn. However, it must be noted that in 2008, his rank in the overall list stood at a high rank of 5. Back then, this net worth stood at a staggering figure of US$ 43 bn; with currently having fallen by over 57%. Bagging spot two as part of India's rich list is Arcelor's Chairman Lakshmi Mittal with a net worth of US$ 16.7 bn (overall rank 52). Notably, the billionaire list includes 56 India-based billionaires, which is definitely a feather in the cap of Indians.

02:15
 
Recent events in Ukraine have once again turned the world's attention towards emerging market economies. There is no doubt that they have strong growth potential. But investors also have to bear the additional risk of political stability as well as policy credibility. This has been argued by none other than Dr Doom, Nouriel Roubini. He has opined that in the aftermath of the financial crisis, emerging markets were hot favourites on account of their high growth. And therefore the risks associated with them were all but forgotten. However, recent events in many emerging economies have brought those risks back in the spotlight. Roubini is of the view that the unrest in these economies is mainly a result of growing disparity in both income as well as wealth. And to some extent it is a good thing as per him as the discontent could pave the way for better governance and growth-oriented policies. Come to think of it, this is exactly what seems to be happening in India currently. The present Government has proved totally incapable of controlling the inflation. And this has resulted in most of the gains from economic growth going into the hands of a select few. And although there isn't any major unrest as of now, a big change in the way the country is governed is certainly top on the wish list of most people in India.

02:55
 
China has targeted 7.5% GDP growth in 2014, unchanged from last year, as the government looks to steer the economy onto a more sustainable and balanced path. China has signaled its commitment to overhauling an unsustainable economy and has declared war on pollution. However, the high growth target has both good and bad news. The good news is that Chinese GDP will keep humming along. They have also decided to tackle the overcapacity problem. Targets for cutting capacity will be brought forward a year ahead of schedule. This includes shutting 50,000 small coal-fired industrial furnaces and cutting steel and cement capacity. The bad news is that by setting such a target for GDP, they're not leaving themselves any room to reform the economy. China announced a string of reforms during in November and December last year. Markets will be watching for more details on reforms surrounding local government debt, state-owned enterprises and environmental reforms.

03:40
 
Global asset prices have been rising in recent times led by the loose monetary policies of central bankers in the developed world. And Pimco's Bill Gross is of the view that if these expansionary policies can stimulate growth then risk assets could outperform cash this year. But that could be a problem. The Fed for instance has kept interest rates close to zero ever since the 2008 financial crisis. And this has not really fuelled any sort of meaningful recovery in the US. Poor job growth, unemployment and sluggish economic growth continue to haunt the economy. Same is the case in many of the European countries as well. Bill Gross has also gone on to state that risk assets such as stocks and high yield bonds are not necessarily mispriced despite the Fed's loose monetary policies. But we are not so sure. Excess liquidity has driven up asset prices including stocks even when the fundamentals remain weak. This only highlights how Fed policies have distorted pricing in the market. In fact, to prove that the Fed and other central banks' policies are stimulating growth will turn out to be quite an uphill task, we believe.

04:15
 
Valuations play an important role in investments. After identifying an investment, the decision to buy or not depends upon its valuations. Companies with higher valuation multiples are often circumspect. However, an article in Economic Times subtly highlights how a set of expensive companies (4-5 of them) have outperformed Sensex over the last one year. These companies had trailing P/Es in excess of 100x! Such high multiple, at first instance, does not justify their outperformance over broader benchmark. Yet they have comfortably beaten the Sensex. One the other hand, few companies that were trading in single digits have underperformed Sensex. This seems contradictory to any valuation theory.

This instance brings forward an interesting conclusion for investors. Valuations are a reflection of future growth expectations. Hence, rather than making the purchase decision blindly on current multiples investors should find the reason why the stock is trading at such a multiple. For instance, a company could trade at significantly higher multiple than the market because it may be a monopoly or it may have a strong moat. This may justify higher valuations. On the other hand, a company with lower multiples might well turn out to be a value trap. There may be a reason why it is trading cheap and such a situation may well continue for next few years. All in all, we believe that valuations are subjective in nature. One should not look at them in isolation. In fact, they should be seen in conjunction with business model of the company. Analyzing that correlation and deciding what is high and what is low shall reduce the margin of error when taking a call on valuations.

04:50
 
In the meanwhile, Indian stock markets pared their losses and were trading firm. At the time of writing, the benchmark BSE Sensex was up by 69 points (+0.3%). Capital goods and banking stocks were the biggest gainers. Most of the Asian stock markets were trading higher led by Japan and Indonesia. Majority of the European markets opened on a negative note.

04:55  Today's investing mantra
"Think about what the asset will produce. Look at the asset, not the beta. I don't really care about volatility. Stock price is not that important to me, it just gives you the opportunity to buy at a great price."- Warren Buffet
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1 Responses to "Sensex: Where to from here?"

Dr Rajeev Kapur

Mar 6, 2014

Happy to note that you have accepted the view that is contrary to the popular perception of valuation theory. ET article reference / link is not given but it only confirms what many investors already know. A low P/E ratio is most often a value trap. While markets behave irrationally at times in the long term it values all stocks correctly. The projections for sensex values are interesting but have not factored in the election results. Sensex could drop to 14000 if an oddball like Mulayam Singh, Mamta or Jayalalitha becomes the PM in the most unlikely event of the century. I hope the voters do not make this mistake.

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