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This Proven Formula Is Predicting Big Returns for Stocks

Oct 20, 2016

In this issue:
» Global investors sitting on large cash holdings
» Government looking at high impact farm sector reforms
» ...and more!
00:00
Rahul Shah, Co-Head of Research

Investing legend John Bogle believes Indian stocks can return more than 20% per annum over the next five years...22.7% per annum to be precise. This is huge, nearly 50% higher than the indices' long-term average.

Now, Mr Bogle didn't actually come to this conclusion. It was his formula. And the formula is pretty simple. It is this:

10-year annualised stock market returns = Dividend yield + Earnings growth +/- Change in PE ratio

Mr Bogle was looking for a broad prediction about market returns because even index investing is fraught with risks if the valuations aren't right. If a lot of the future growth is already priced into the stocks, then below average or even negative long-term returns are more likely.

In such a scenario, it would be better to invest in a fixed interest instrument than the benchmark index. So it makes sense to use the formula every now and then to check the return-generating potential of the broader markets.

Now, Mr Bogle has proof of the effectiveness of this formula. He's analysed stock market returns for every decade since 1900. And over a 10-year period, the formula has been a good approximation of what the stocks eventually delivered barring a huge deviation from the PE norm.

Let's try and use this formula for the Indian markets to predict the returns over the next five years. Since the formula works more effectively on a 10-year horizon, let's go back five years so that the total period considered becomes 10 years.

Over the last five years, the index has returned around 11% CAGR. That's good but not great. However, if you dig deeper, you'll find that earnings growth has only been 8% CAGR while the remaining 3% has come from PE expansion.

We don't expect PEs to expand at the same pace. Even if they does, we can't rely on it to drive the stock prices higher; that would be speculation. Even dividend yields aren't going to budge much from the current levels - at least, they haven't historically.

So it's all about earnings growth. And we believe earnings can grow more than 20% over the medium-to-long term thanks to a reversion to the mean.

You see, net profit margins of Indian corporates were at a ten-year low in the previous fiscal. And profit margins are believed to be the most mean-reverting figures in finance. If they go too high, competition comes in and drives them lower. And if they go too low, companies go out of business and margins start to climb back to their long-term averages.

So, what will happen if profit margins revert to their mean over the next two to three years? We have done the calculations, and we believe that the Sensex's 15% average annual earnings growth may go a bit higher - to 20%.

So Bogle's formula simply reinforces our view that Sensex could go to 40,000 in three to four years. Full details in our special report.

But these predictions aren't what we'd call outlandish. We only expect market multiples and earnings growth to behave in a manner consistent to their past. We see no reason they should deviate from the trend.

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02:35 Chart of the day

Have you wondered why, despite all the big economic uncertainties across the globe, stock markets in many parts of the world continue to remain at lofty levels? Today's chart of the day may throw some light on a part of the answer.

A report in the Mint citing research from BlackRock points out that investors across the world are holding a humongous US$ 50 trillion of cash these days. To put this in perspective, this dwarfs the size of some of the biggest economies in the world.

It's almost three times the size of the US economy. And twice the balance sheets of all the world's largest central banks put together. On the negative side, it shows that investors are still too pessimistic to deploy this cash in productive assets. But it may also be acting as anchor for expensive markets. This is because even if investors decide to put a small part of this in financial assets, it could have a huge bearing on asset prices even if irrationally so. Thus acting as a considerable deterrent to all the bears out there.

Investors Sitting on Huge Cash Piles


03:40

Amongst all the buzz about manufacturing in India, agriculture remains a dull and neglected area of the economy. But that may soon change. Reports suggest that the government is very busy these days preparing a whole banquet of detailed reforms for the farm sector. Further, and more importantly, it is also looking at immediate implementation of these reforms. All with the ambitious goal of doubling farm incomes in the next five years.

The reforms include actions like liberalising contract farming, allowing direct purchase by private players from farmers, permitting farmers to sell to consumers directly, single trader licences, single point levy of taxes and freeing agri-produce form mandi laws.

Since agriculture is a state subject, getting its agenda through state level governments will be a key obstacle for the central government in the coming days. Niti Aayog members will now have to get busy meeting principal secretaries of all states and get them on board.

If the reforms see the light of day on the ground level, they can mean elimination of middle men and big gains for farms. In turn, this can mean a boost to the Indian economy. We'll be keeping a keen watch on how developments pan out here over the next year or so.

04:48

The Indian stock markets were trading strong today on the back of sustained buying activity across most index heavyweights. At the time of writing, the BSE-Sensex was trading up by around 135 points. Gains were largely seen in banking and auto stocks.

04:56 Investment mantra of the day

"Cash combined with courage in a time of crisis is priceless." - Warren Buffett

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

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