Has the Sensex really run ahead of fundamentals? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Has the Sensex really run ahead of fundamentals? 

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In this issue:
» Yellen: Interest rates to remain low for an extended period of time
» Marc Faber on his fondness for gold
» HDFC Chairman, Deepak Parekh on maintaining RBI's independence and more
» Alibaba, another big ticket IPO hits the US shores
» and more....

00:00  Chart of the day
There's been quite a lot of material written on how investors should be cautious given the run up in stocks in the recent past; we ourselves have written about the same. A favourable outcome of the ongoing elections has been the key reason for the market run up in the past few months. With such expectations, investors - both foreign and local - have increased their participation in the Indian equity markets in hopes of not missing out on any market rally.

With this background in mind, we thought it would be a good idea to do some basic level digging and check whether the same holds true; i.e. gauge the impact of the run up in stocks as opposed to the change in fundamentals.

In today's 5-Minute Wrap up, we have taken a slightly different approach from our usual format as we have included a few charts as we thought they would help readers better understand what we are trying to convey.

The following is the first chart we made.

Sensex Marches on Despite Earnings Growth Slowing Down
Data Source: ACE Equity

A quick glance at this chart indicates that the Sensex has run up in recent times, despite the earnings growth rate slowing down.

But then, you would think, does this comparison make sense without looking at valuations?

This led us to generate the following chart:

But... when it comes to valuations, things do not seem all that bad

The slowdown in the earnings growth seems to have been reflected in the lower valuations as well. At least in the past few years; since 3QFY11, if one goes purely by the chart. The current valuations of the index are also lower than what they have been in the decade gone by.

However, having seen this, you would probably make the case for the Sensex usually reflecting future earnings. Which is why gauging the one year forward P/E Ratio would make sense!

Okay sure...

The following chart depicts the same...

Sensex: 1-Yr Forward P/E Ratio (assuming 10% growth in earnings)
Data Source: ACE Equity

We have generated the above chart by dividing the Sensex value at the end of each quarter by the trailing twelve month EPS of the corresponding quarter one year ahead. At the current juncture, the Sensex is seemingly trading at 16.7 times its estimated one-year forward EPS, which is equal to its long term average. And guess what, this is when considering a modest growth rate of 10% in EPS.

We must confess that before starting this procedure, we thought the results would be quite the opposite, i.e. the market run up in recent periods would have actually seemed euphoric. But that does not seem to be the case, at least going by the data provided above. What the data indicates is that now is as good a time as any to invest in stocks from a long term perspective. An investor can be assured of reasonably good returns.

Nevertheless, given that the Sensex is a collection of many stocks, it goes without saying that taking an individual stock approach to investing would make sense. With a lot of uncertainty over how the economy will shape up a year from now, with the new government about to come in, sticking with companies that that are likely to post good growth figures would be essential. While there may be certain pockets of the market - such as the defensives - that offer such a feature, the key aspect to be remembered here would be not to overpay for such stocks; as the valuations could be driven by sentiments.

Whatever may be the outcome of the elections, the probability that stocks will remain volatile in the short term is quite high. Whichever direction the markets move, do remember that in the long run, the fundamentals tend to determine the movement in stock prices.

Do you believe that there is a certain amount of euphoria surrounding Indian stocks at the moment? Let us know in the Equitymaster Club or share your comments below.

Editors Note: We've roped in wealth coach Mark Ford, the man behind the globally successful Wealth Builders Club, to share his best wealth-building ideas with you in a special Sunday Edition of The 5 Minute WrapUp. Don't miss this once in a lifetime opportunity for anything! Remember, this coming Sunday...

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To a man with a hammer, everything looks like a nail, opined Buffett's famous partner Charlie Munger once. In other words, there's this tendency amongst us humans to try and apply the same solution to all the problems we encounter. And look no further than the US Fed in case you need a real-life example. The US job market has remained far from satisfactory for many years now. But what is the US Fed doing about it? Well, it has tried to apply the same medicine over and over again. The medicine of ultra low interest rates that is. Last heard, the situation is unlikely to change in the future as well. As per reports, the newly anointed Chairperson, Janet Yellen has given out enough feelers about the interest rates remaining low for an extended period of time. However, is this going to work? We don't think so. While low interest rates do bring relief in the short term, it does not correct the underlying structural problems that the US is facing right now. Therefore, no sooner will the rates be raised, the problems are likely to resurface and with even greater intensity. Does this mean a bigger crisis than what we saw in 2008? That's well within the realms of possibility, we reckon.

Big ticket IPOs seem to be making a major comeback to US shores. As if the Facebook IPO was not enough, this time it is China's e-commerce behemoth Alibaba which plans to come out with its IPO in the US. As reported in the Economic Times, the company is expected to raise US$ 15 bn to US$ 20 bn which would make it the biggest IPO since Facebook, which raised US$ 16 bn in May 2012. The IPO is being touted as a chance for investors to tap into China's growth story. Hence, it only makes sense to look a bit into the financials of the company. For starters, Alibaba's nearest peers in the US would be Amazon and eBay. When compared to these two, Alibaba's margin profile is way superior at around 45% compared to much lower 18% for eBay. If one looks at the trend in revenue and profit growth, both have been consistently rising. But the major deterrent and a valid one at that is that Alibaba is governed by Chinese laws and regulations that are difficult to take a call on. More importantly, there is considerable amount of ambiguity with respect to foreign ownership in the company. Thus, it might be that Alibaba garners more funds than Facebook. But whether shareholders will benefit much from this will remain the million dollar question.

Marc Faber's criticism of US Fed's ultra loose monetary policies is nothing new. He has been claiming since long that the unprecedented money printing that the Fed has indulged in has created an imbalance in asset prices. This has resulted in huge wealth inequality. The rich have gotten richer as asset prices have increased with cheap liquidity, while the poor have turned poorer with increase in cost of living and rising unemployment.

Thus, the US Fed, in his view, is an institution of destruction which has laid foundations of a bubble economy. And one day the bubble shall burst leaving investors in disarray. Hence, investors shall do well to have gold in their portfolios but ideally, outside the US. Whether he seriously doubted that the custodian banks in US would confiscate gold or this was just a mere hyperbole is difficult to say. However, what was clear was his fondness of gold and dislike for Fed. In fact, Fed's policies have been subject to criticism all over the world. It is not that the institution lacks competence. Basically it lacks intent. It is more comfortable in delaying the aftermath rather than facing it upfront and allowing the economy to come out of the debt mess. However, the more it will play the delaying game, the greater shall be the repercussions.

In an interview to the Economic Times, HDFC Chairman Deepak Parekh, spoke on a number of issues that caught our attention. There has been speculation that post elections; a BJP led government would change the RBI governor as he has been unwilling to reduce interest rates due to high inflation. According to Mr. Parekh, such a move would bring the government a bad name. Not only that, this would put India at risk of a sovereign rating downgrade. We do agree with his view that there should be no threat to the RBI's independence.

Regarding the serious economic issues facing the country, Mr. Parekh is of the view that the new government should re-state its fiscal deficit numbers. This would bring credibility to the numbers as Rs 1,100 bn of pending subsidies were not accounted for in FY14. He has also suggested bringing in the private sector in a big way into key sectors like energy and coal. The resulting competition would keep end-user prices in check. Apart from this, if the government were to reduce unwanted subsidies and bring down its stake in PSUs, it would give the economy a big confidence boost. These are all very laudable suggestions we believe but it would all depend on the commitment of the next government to push through tough reforms.

India's manufacturing sector has been facing challenges on a lot of fronts, labour issues being one of the key problems. The growing incidences of tussle in the auto sector between the labour and management are warning signals that have been ignored for long. As suggested in an article in Livemint, the prime issue in such cases is archaic labour laws. The same have forced employers to hire more contract workers. So much so that that share of share of temporary workforce in the auto sector has gone up by 30% in the last 10 years. This compares to just an 11% average annual growth in the auto industry over the same period. And the outcome is social insecurity among the workers. The same is getting manifested is in the form of growing labour unrest, strikes etc. And the trend is not just limited to auto sector.

While to some extent, the use of contract labour has spared the employers from tough labour laws in the past, it seems to be backfiring now; as contract workers have started unionizing as they are gaining majority. The practice also adversely impacts employers' investment in human capital and deprives organisations of rich experience of long term employees. Further, it does not guarantee job security for the employees. It's time that the government relaxes labour laws and creates a long term win-win situation for all.

In the meanwhile, after opening the day on a positive note, selling pressure led the Indian stock markets to slip into the negative territory. At the time of writing, the benchmark BSE-Sensex was down by 6 points. Sectoral indices were trading mixed with banking and consumer durables stocks being the biggest gainers, while realty and FMCG stocks were trading weak. Majority of the Asian stock markets were trading positive led by Japan and Korea. The European markets opened the day on a strong note.

04:55  Today's investing mantra
"In the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw there from." - Benjamin Graham
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