You've Heard of Mr Market from Graham. Now Meet Mr PE... - The 5 Minute WrapUp by Equitymaster
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You've Heard of Mr Market from Graham. Now Meet Mr PE...

Oct 15, 2016
In this issue:
» The two sides of India's aviation boom
» A roundup of the global markets
» ...and more!

00:00 Chart of the day

Rahul Shah, Co-Head of Research

Price to earnings (PE) ratios tell you how cheap or expensive a stock is. At least that's what they're supposed to do.

What are these PE ratios telling us today?

The large-cap index, the BSE Sensex, stands at a PE of 20.8x. Midcaps, apparently, have taken things further. The BSE Mid-Cap Index is currently at 31x.

And then you have the feisty small caps in a league of their own... The BSE Small-Cap Index's PE stands today at a princely...hold your breath...90x!

What does this mean? Does this mean that large caps are the cheapest of the lot these days? And that small caps are trading so darn expensive that they are to be avoided like the plague?

Many investors take the PE ratio seriously...a little too seriously perhaps. But let me tell you a little secret: Mr PE doesn't always do his job well. Every now and then, he messes up. Now don't get me wrong; it helps a great deal to work with him. But trust him blindly, and you're setting yourself up for trouble.

So for example, using PE ratios alone, you may be inclined to come to the above conclusions about the valuations of small caps, large caps, etc. But PE ratios would be doing you a great disservice here. For in the case of the mid-cap index, and even more so for the small caps, PE ratios are pretty much useless these days. They do not really convey anything of importance.

Why?

Have a look at this chart:

Smaller Companies' Profitability Goes for a Toss


Here's what's happening: With the onset of the slowdown over the last few years, the earnings of many companies have taken a beating. And consequently, return on equity, one of the important measures of the profitability of companies, has headed lower. Now, while large-cap companies' earnings seem to be relatively less affected, their mid-sized brethren have taken a much worse beating.

And small caps? Well, earnings seem to have literally gone out the window. To the extent that the small-cap index's aggregate earnings dipped into the negative in FY15.

Now the problem with our dear friend Mr PE is that he's highly sensitive to dips in earnings. And as the earnings of a company fall lower, even if the stock price remains the same, the PE ratio starts to spike up very sharply. You see, the PE ratio takes only one single fundamental factor into its consideration: the company's earnings in a given year. That's it. Nothing more.

So when a company sees a rough patch, and if its earnings during that period dip low enough, its PE ratio goes berserk. And the thing about the business world is that rough patches are just as much a part of the game as boom times. That's just the nature of the beast.

But sadly, these nuances are lost on the mechanical PE ratio. It can't adjust for these fluctuations. Just like a magnetic compass stops working properly in areas near the earth's magnetic poles, so does the PE ratio as an indicator of value during times when a company's earnings play truant.

So it's important to understand when the PE ratio is useful and when it is not. In situations where it is not, you would do well to take into account other fundamentals to value the business- assets, cash flows, and normalised earnings, etc.

By the way, when the stock markets witnessed a major correction earlier this year, we were among the first to talk about the possibility of a trend revival in corporate profitability...which in turn could drive the BSE Sensex to 40,000 in the coming two to three years.

If you missed our special report - Sensex 40,000: 4 Stocks to Profit from the Coming Stock Market Wave - it is still available for download now.

02:45

Has India's aviation sector taken off? After years of stagnation, there are hopeful signs. As per an article in Livemint, India is a growth leader among seven major markets that account for 82% of revenue passenger kilometres (RPK). RPK is the cumulative distance flown by all passengers in a given period.

There is no doubt that Indians are flying more than ever. Rising discretionary incomes are the main reason. The poor state of the Indian railways is also a cause. The growth has come about due to the addition of new routes by airlines. A couple of days ago, we heard that Indigo was starting several new flights and increasing frequencies in existing routes to cater to increasing demand.

This is indeed good news for the sector as well as the economy. But is it good news for investors? Unfortunately, the aviation sector is notorious for destroying investor wealth. It is extremely difficult for an airline to make money sustainably. But that does not mean investors can't make money in this sector. A good example is our March 2014 Hidden Treasure recommendation. The company is an indirect play on the aviation sector. We closed the position recently with gains of 104% in just two and a half years! You can gain access to Hidden Treasure here.

03:50

The performance of global markets this week was a mixed bag. In China, September producer prices unexpectedly rose for the first time in nearly five years and consumer inflation beat expectations, easing some concerns about the health of the world's second-biggest economy. Earlier on Thursday, worries about China's growth slowdown and weak global demand rattled investors after the country released weaker-than-forecast September trade data. Exports from China tumbled nearly 10% year-on-year, and imports dipped 1.9% from the previous year. September's export drop marked the sixth consecutive monthly decline and the biggest drop since February.

The release of the trade data knocked down global stocks and commodity prices as it revived concerns about the tepid global economy at a time when the Federal Reserve appears ready to raise US interest rates again. The data also increased downward pressure on the yuan, which is hovering near a six-year low against the dollar. The Shanghai Composite Index gained 2% for the week gone by.

European stocks ended the week in positive territory. Equities slid midweek following data that showed an unexpected decline in Chinese exports that created worries about another slowdown in global growth prospects. However, stocks bounced back at the end of the week on positive inflation data coming out of China. Stock markets in Germany and France were marginally up by 0.9% and 0.5% for the week gone by.

In the US, the DJI index was down by 0.6% as earnings season began with mixed results and a decrease in Chinese exports reignited concerns about slowing global growth. Economic data released during the week showed continued strength in the job market and a rebound in retail sales.

Back home, the BSE-Sensex ended the week on a dull note and was down by 1.4%. Sentiments dampened mainly in reaction to the latest US Fed meeting minutes, suggesting a rate hike in December and further worsened with a decline in Asian counterparts, after China reported noticeable contraction in export figures. Industrial output remained negative for the second month in a row, contracting by 0.7% in August due to a slump in manufacturing, mining, and capital goods segments. Meanwhile, India's retail inflation eased sharply to 4.31% in September, the slowest in more than a year, from 5.05% from August, mainly because of a sharp fall in food prices.

Performance During the Week Ended 14th October, 2016

04:56Investment mantra of the day

"Successful Investing takes time, discipline and patience. No matter how great the talent or effort, some things just take time: You can't produce a baby in one month by getting nine women pregnant." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst).

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2 Responses to "You've Heard of Mr Market from Graham. Now Meet Mr PE..."

KD

Oct 15, 2016

Most of the small cap stock are barely break-even or position loss. Just leave your AC office and talk to the people in market. You will hear things like, "I have never seen this kind of slowdown in last 40 years". Yes, the profit of these companies are increasing because their asset value is increasing because of investment in stocks, real estate and other financial instruments.

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KD

Oct 15, 2016

I think P/CF and EVA are better indicators.

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