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Cash in while they crash down

Jun 11, 2004

Markets have corrected almost 15% since the start of calendar year 2004 and this has led many experts to conclude that the valuations have again started looking attractive and this is an opportune time to cash in on the growth opportunity by investing in a long-term portfolio. In this article, we have made an attempt to find out the degree of co-relation betweeBSE-Sensex P/E and the rate of returns over different time horizons starting calendar year 1999. Let us see if history has sided with the market experts and if yes, then to what extent. The table below illustrates a simple relation between the Sensex P/E and the returns that an investor has got over three different time horizons viz. one year, three years and five years if he had invested on a particular date. The date of investment is uniform all across i.e. last day of the year. For e.g. for the year 1999, the Sensex P/E that has been considered is the P/E at the time of market closing on December 31, 1998. The returns are on a compounded basis for a three-year and a five-year time horizon.

P/E and return matrix...
As on... P/E ratio* 1 Year 3 Years 5 Years
Dec-98 12.1 63.9% 2.2% 13.8%
Dec-99 20.9 -20.7% -12.3% -0.2%
Dec-00 20.8 -17.9% 13.7% -
Dec-01 15.6 3.5% 14.9% -
Dec-02 12.0 72.9% - -
Dec-03 17.3 -15.3% - -
Today's P/E 13.1 - - -
(*year-end P/Es)

As indicated in the table above, an investor who had invested on the 31st of December in 1998, at a Sensex P/E of 12x would have made a CAGR return of nearly 14% if he had held the investment for a period of five years. The returns would have been lower at just over 2% if he had held it for three years and the maximum for a holding period of one year. As is clear from the chart, chances of an investor getting superior returns increases manifold when the market is trading at a low P/E as compared to the period where the P/E is at the higher end of the spectrum. Investors who would have invested just at the start of the year 1999 or exactly four years later would have gone laughing all the way to their banks.

In stark contrast are the ones who burnt their fingers and suffered negative returns by investing at a time when the indices had already run up quite a bit and valuations i.e. P/E had started looking stretched. This was true for investors who had entered at the height of the dotcom bubble and the ones who entered at the start of the current year, when the markets had already touched dizzying heights and had just started looking overvalued.

As evident from the afore mentioned incidences, markets have seldom spared those investors who have ignored fundamentals and bought into stocks on the basis of speculation or succumbing to herd mentality. After all, as we have time and again mentioned that there is a price that every business commands and no matter how strong the fundamentals are and how good the management is, its better to steer clear from such stocks when valuations start looking stretched.

The question that would be uppermost in everyone's mind now would be: Do the markets look attractive at current juncture and are the fundamentals strong enough to enable one to earn good returns over a long-term period? We believe that the correction that has happened in the market at the time of 'Black Monday' and thereafter has rendered it attractive from a long-term perspective. The Sensex P/E currently stands at 13x on a trailing twelve months basis, which when compared to the table above would fall at the lower end of the P/E spectrum and thus result in a high probability of earning strong positive returns in the near future. Our optimism also arises from the fact that while the correction in recent times has mainly happened over fears about continuation of reforms, we believe that the current government is no stranger to reforms and hence barring a couple of exceptions, the fundamentals have largely remained intact. This is likely to ensure that India Inc grows at the same pace as before or even better and in the process renders investing in equity an attractive proposition at the current market levels.

While investments with one year horizon have given good returns during favorable periods, they have also been the ones who have been worst affected during periods of weak market performance. Therefore it is always better to have a longer-term horizon in mind. While they may give lesser returns than the former ones, the probability of negative returns also decreases considerably. Hence, once again the key words are fundamentals and long-term.


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