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To outperform, buy cheap!

Dec 20, 2012

A few days ago, fund manager Prashant Jain appeared on a business channel discussing why retail investors - more often than not - lose out while investing in equity markets. His argument was simple. Retail level interest rises only when the markets rise; thereby, leading them to buy into stocks at expensive valuations. According to Mr. Jain, nearly 80 to 85% of the money (of retail investors) invested in mutual funds comes in at Price to Earnings Ratio (PEs) in excess of 17 to 18 times. In fact, retail investors are believed not to really put in money when the markets are lower or trading at lower PEs.

While investing in markets at peak levels (and high valuations) is one thing that investors should avoid, the ultimate aim for any investor is to outperform the benchmark indices by a healthy margin. As such, an underperformance to the benchmark over a long period should not be desired. Over the last two decades, the BSE-Sensex has risen at a compounded rate of 11.2%. Therefore, any returns below this level - on a compounded basis - would be considered as 'underperforming the benchmark index'.

And this was essentially Mr. Jain's argument! For investors to outperform the markets over the long term, it is important for them to invest in times when the markets are cheap. This would eventually lead them to see good returns as opposed to burning their fingers or being disappointed by the returns due to investing at high valuations. In the interview, he termed PE ratios of below 17 to 18 times earnings (long term Sensex averages) to be reasonable levels to enter the markets - albeit keeping a long term picture in mind.

We will try to see the difference between the returns investors could generate at two levels - above and below the long term average PE ratio.

We have excluded the extreme 10% PE levels (or high and low valuations) of the BSE-Sensex over the past two decades. On the balance data, the average Sensex PE came at about 18.7 times over this two decade period.

Data Source: ACE Equity

The chart above displays the Sensex's movement and PEs after excluding the extreme 10% levels as well as the average PE ratio of the index over this period.

We sorted the data as per PE ratio after that. We thus had different dates with data on individual date Sensex closing level and PE. We then calculated the compounded (depending on the date of the PE Ratio) returns from the Sensex closing on each date till the Sensex's closing levels as of 17th December 2012 i.e. last Monday. The data so compiled could be sorted into two broad categories. The 1st was the returns generated when Sensex PE was below the average PE. The average of the compounded returns of this group stood at 15.2%.

On the other hand, the average of the returns when invested at levels above the average PE ratio of 18.7 times stood at a relatively miniscule 7.2%. That is a difference of 8% per annum on a compounded basis. And if one would know about the power of compounding, he would know how much of a difference a small amount like 8% could make on one's portfolio returns.

As you would know, timing the market is a very difficult task and one that cannot be done to perfection. However, one thing that all investors can control is the valuations at which they invest into stocks. Going by the long term data displayed above, buying cheap does provide better returns.

Devanshu Sampat

Devanshu Sampat (Research Analyst) has a degree in commerce and nearly 5 years of experience in equity research. He draws inspiration from successful value investors across the globe and constantly endeavours to refine his own unique stock picking approach. While a firm advocate of the principles of value investing, he believes in adapting a versatile investing strategy in response to varying market conditions. Devanshu contributes to our Megatrend investing service The India Letter.


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