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Stockmarkets: Investing on 'margin'!

Sep 13, 2005

As the Indian stock markets continue their move uphill will much vigour and gust that would even embarrass Roger Federer (the US Open champion), the fact that investors need to extend their investment horizon beyond 2-3 years to garner adequate return has come to the fore. While this does not mean that investors need to benchmark any index for making their investment decision, it is always important to look at the mood of the broader market along with researching a stock before committing money.At the current levels, the NSE-Nifty is trading at a P/E of 15.3 times trailing 12-month earnings. This has led to views abound that these are pretty comfortable levels and that Indian markets are not overvalued in any sense of the word. While we do believe that the Indian growth story is here to stay and that investors in the same will reap decent rewards, the fact that fresh investment at the current levels need to be undertaken with utmost care and caution, needs to be understood.

We have conducted a small exercise with respect to the Nifty P/E and have arrived at the conclusion why the investment horizon needs to be long. We have used Benjamin Graham's 'margin of safety' principle to arrive at this judgement.

'Margin of Safety,' is among the concepts that are at the core of stock market investing. For stocks, the margin of safety lies in an expected 'earning power' considerably above the interest rates on debt instruments. Simply calculated, earning power is equal to the reciprocal of P/E ratio, i.e., E/P. For example, a stock with a P/E ratio of 15 has an earning power of 1/15, or around 6.7%. In common parlance, this is often known as the 'earnings yield.' This acts as a protection to investors in the form of a buffer (extra gain over interest rate on a benchmark debt instrument) that they want for the risk they are ready to take by investing in stocks.

Here is a table depicting the margin of safety for investors in the broader Nifty. In the table, 'current' indicates the Nifty P/E of today and the next two rows indicate what the P/E might be 1 and 2 years hence respectively. For arriving at the P/E for the next 1 and 2 years, we have discounted the current P/E by the expected average earning growth of Nifty stocks, i.e., 15% per annum. We then derive the 'earning power' (as explained above) by calculating the reciprocal of the Nifty P/E for each period. And finally, considering the risk free rate of 7% (the current yield on a 10-year G-Sec paper), we arrive at the margin of safety.

What's the margin of safety?
When? (A). Nifty
PE
(B). Earnings
yield (1/PE)
(C). Risk-free
rate (10-year G-Sec)
(D). Margin of
Safety (B-C)
Current 15.3 6.5%7.0%-0.5%
Current+1 year 13.3 7.5%7.0%0.5%
Current+2 years 11.6 8.6%7.0%1.6%

The table indicates that as you hold your investment (Nifty, in this case) for a longer duration, your margin of safety will increase. However, readers need to consider that this table is made on the basis of two key assumptions:

  1. Earnings of Nifty stocks will grow at a rate of 15% per annum (If earnings grow faster/slower than what is assumed and other things remain constant, margin of safety will be higher/lower than what is indicated in the table).

  2. 10-year G-Sec interest rate will be 7% in all the three periods (If this rate were to rise/fall while other things remain constant, margin of safety will decrease/increase).

Investors can use this principle of margin of safety for the stocks that they intend to buy of for those that they already hold and want to check if it is the time to sell. However, other parameters like earning growth potential, management vision and overall growth of the industry also need consideration before making investment decision, the key is to understand the investment properly before committing money.


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