Stockmarkets: Tone down those expectations.. - Views on News from Equitymaster

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Stockmarkets: Tone down those expectations..

Mar 31, 2005

73%, 13% and -4% These are the returns provided by the BSE-Sensex in the years 2003, 2004 and 2005 (to date) respectively. Thus, contradictory to the bull runs witnessed in 2003 and 2004, the Indian indices have had a rather volatile and weak start to the current calendar year. However, what the bull runs have done is that they have raised the expectations of investors, who are now very much used to (if we may say it) seeing returns in excess of 25%. We know that this is a low return considering the two years prior to 2005, a period wherein even large-cap and index stocks emitted a mid-cap type behaviour, appreciating by the hour (!) Thus, in the backdrop of the recent weakness in the markets, we conducted a poll on our website to gauge what are investors' expectations in terms of returns with respect to their investments in the stock market.

The poll conducted on our website asked our readers, "What is your desired rate of return from equity investments over the next 3 years?" A significant number of people (62%) who took the poll expected returns of over 20% p.a. over the next 3 years, while 34% expected returns between 10% to 20% p.a. However, there were a few (4%) who seemed satisfied with less than 10% p.a. returns. Let us look at each of this in a little detail in the reverse order.

Below 10% p.a.: Well, while we did expect to get some hits on this option, 4% beats our expectations! Investors must note that equities by their very nature are a risky investment option and this is what justifies a higher return on these. If an investor were satisfied with less than 10% p.a. returns, then our sincere advise to him would be that it would be better off to invest in government instruments like NSCs or PPF, the returns on which though somewhat less than 10% p.a., they do provide absolute safety of their invested capital unlike an equity investment, wherein erosion of capital is very much a possibility. It must be noted that this option and these kind of expected returns are suitable for a retired/aged person for whom safety of capital is of critical importance.

Between 10% to 20% p.a.: It must be noted that the Indian stock markets have usually commanded a P/E valuation of 16x to 17x, a fact justified by the CAGR earnings growth of approximately similar levels delivered by India Inc. over the last decade. Thus, going forward, it would not be inappropriate to expect returns in this region but only over the longer-term, as annual returns from equities tend to be volatile and may be negative in some years. Of course, while the story of triple digit returns is over, considering the developments in the form of reforms that have taken place in our economy, equities would continue to deliver decent returns. The only caveat here for an investor is the detection of an investment candidate with good management and business model that would reward the investor.

Above 20% p.a.: We would like to say only one thing to people who expect such kind of returns - tone down your expectations. We believe that such returns are not possible on a sustainable basis over a long period of time, as returns have to move in tandem with the earnings momentum, which are unlikely to register such growth rates due to inherent problems at the macro level like lack of political will, poor infrastructure, slow reforms, etc. Further, considering the fact that competition - both within the domestic market and also from international entrants - has been on the rise, it is likely that margins would trend downwards or at the most stabilise at the current levels, thus capping the growth in profitability.

To conclude, it would be advisable for investors to curtail the high expectations, as there is a greater chance of disappointment. However, considering the various positives working in favour of Indian equities at the current juncture, we do believe that a long-term investment horizon and systematic investment in fundamentally sound companies is a reasonably foolproof method of mitigating risks and creating wealth. We also believe that over the long-term, money flow into equities will rise. One needs to practice patience and give time for investments to grow.

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