Is it time for you to play safe? - Views on News from Equitymaster

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Is it time for you to play safe?

Feb 11, 2010

The BSE-Sensex is usually taken as a benchmark index for any comparison, be it returns or valuations. These comparisons can be made to a performance of a particular stock over a time frame as also for comparing valuations. In this article, we have compared the P/E ratios of three key indices as against that of the BSE Sensex. These three indices are the BSE-100 Index, BSE-Midcap Index and BSE-Smallcap Index. It must be noted that data before 2008 was not available. What we have done is that we have compared the price to earnings ratio (P/E) ratios garnered by the particular index by the P/E of the BSE-Sensex. For example, on 10th February 2010 i.e. yesterday, the BSE-Sensex was valued at 19.7 times, while the BSE-100 Index was trading at a valuation of about 20.4 times. Therefore, the ratio is 1.04 times (20.4/19.7).

This calculation is effectively done to try and find out the difference between the valuations that the BSE-Sensex commands in comparison to that of the other indices. In other words, one can know how a particular index is valued as compared to the benchmark index, the BSE-Sensex.

Let us begin with the BSE 100 Index. As obvious as it may be, there will not be much discrepancy between the valuations that the BSE-100 and the BSE-Sensex command. This is on the back of the companies forming part of the latter having significant weightage in the BSE-100 Index. The average difference ratio (between the respective indices' P/Es) has been 1.05 times over the past two years.

Data Source: CMIE Prowess

Moving on to the next index, the BSE-Midcap Index, we can see from the above chart that the difference between the valuations of the two indices i.e., the BSE-Midcap and BSE-Sensex has been quite volatile. Back in January 2008, when the markets touched their all time high, the valuations of all the indices had gone for a toss. At that time (1st January 2008), the valuation of the BSE-Midcap Index was marginally lower than that of the BSE-Sensex. The ratio back then was 0.99 times. This means that the BSE-Midcap Index was valued at similar levels to that of the BSE-Sensex. However, the period post then i.e., since the markets began their downturn, midcap stocks and their valuations dropped majorly.

The markets began their upward journey post March last year. Valuations also followed suit. At current levels, they seem to have reached a similar level to what was seen about two years back, when the difference between the valuations the BSE-Sensex and the BSE-Midcap Index was marginal. The average ratio over the past two years stands at 0.8 times.

The situation of smallcaps has been quite similar as well. On observing chart above, one can notice that the valuation of the BSE-Smallcap index has never come close to that of the BSE-Sensex. However, what is of concern is that at present, the difference between the BSE-Smallcap and the BSE-Sensex's valuation is much thinner. Even thinner than what was seen back in the heydays of early 2008. The average ratio of this period has been 0.64 times. Currently, this ratio stands at 0.81 times.

Conclusion

Considering that the BSE-smallcap and BSE-Midcap indices have moved up significantly from their lows, and that their valuations have followed suit, it is time for investors to be cautious. It is recommended that investors take a bottom-up approach in their stock picking methods and should take into one key factor - valuations - under consideration.

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5 Responses to "Is it time for you to play safe?"

Mandar Vaze

Feb 23, 2010

Good article. Equitymaster should include more of these nature. For example similar comparision between large vs midcap indexes in US / European markets, other BRIC nations etc. Keep up the good work.

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ramaraom3

Feb 21, 2010

this is a real effort on the part of equitymaster to be really useful to the investor. what a contrast from moneycontrol advisers! perhaps the equitymaster should commence commenting on the members` portfolios

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Ramana Kumar

Feb 19, 2010

Good article, it highlights the differences between mainline indices and small & midcaps. Midcaps and Smallcaps only start to move after the largecaps have moved up. However, in terms of risk, the 'expertspeak' seems to be that stock picking in Small and Mid caps is the way to make money in 2010. So gains from broad markets- whichever index u study- will be limited.

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Girish

Feb 16, 2010

Can you do same analysis for last 10 years or even 20 years? That will be better analysis to take note of this flash point. While it does sounds like the danger is lurking, but if you know how many times crashes or recessions have ocurred from such flash points then one can decide how much risk one should take. This will be true value addition from Equitymaster to retail investors.

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samir roy

Feb 13, 2010

market view

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Equitymaster requests your view! Post a comment on "Is it time for you to play safe?". Click here!

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