Markets Are at All Time High PEs and Still Not Falling. Why?

Jan 19, 2021

Rahul Shah, Editor, Profit Hunter

Corporate earnings of the biggest companies in India have grown at a CAGR of roughly 15% per annum over the last few decades.

Have these earnings come out of thin air? Of course not. It has come from making investments in plant and equipment and working capital.

Assuming India Inc has earned a fixed return on capital over the years, it may have had to grow its capital base by 15% every year in order to bring about the 15% growth in earnings.

So if a company has a capital base or Rs 100, it will be fair to assume it has earned Rs 18-20 on it historically (the top 30-50 companies).

Out of these earnings, roughly 20% has been paid out as dividends. The rest has been reinvested back in the business to expand the capital base from Rs 100 to Rs 115 or so.

This new capital base again earns 18%-20%, part of which is paid out as dividends and a big chunk reinvested back in the business.

It's this reinvestment of capital that has allowed India Inc to grow its earnings by around 15% per annum on a consistent basis.

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Now, the question is how much would you be willing to pay for an asset class of this kind?

Historically, the Indian investor has been willing to pay average earnings multiple of around 20x to park their hard earned savings into equities.

They believe if they pay this multiple, they will earn their 15% per annum over the next few years and sell to another investor at or around the same 20x should they need to cash out.

These days though this Indian investor seems far too optimistic.

They're willing to pay close to 35x earnings to invest in India's top companies. This high level of multiple is justified only if earnings are likely to grow at significantly higher than 15% growth rate over the foreseeable future.

Do we have an economic system capable of doing that? Can earnings grow at significantly higher than 15% over the long term?

Perhaps it can for a few years to make up for the lower than 15% growth in the recent past.

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However, to assume that corporate earnings can grow at a much higher rate than 15% on a permanent basis, may be too bold an assumption. The evidence of such a thing happening is simply non-existent.

Thus, the markets may get a reality check over the next few quarters once the earnings growth shows no signs of justifying the high PE ratio.

And when this happens, we may either see a big crash or a range bound market for a few years.

Does this mean that we should sell all our stock holdings and get into the safety of cash?

Certainly not.

What I've just outlined is improbable but certainly not impossible. It's quite possible the markets keep going higher and don't crash until they reach a price to earnings multiple of 50x.

Or they may continue to stay at these levels for a few years. Therefore, completely sitting out of this rally may really hurt an investor's long-term returns.

The simple way out of this dilemma is to stay at least 25% invested in stocks at all times.

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At the other end, staying at least 25% in cash at all times also makes sense. This is because we can never know when a big crash may be just around the corner.

The remaining 50% can be either fully invested in stocks or bonds or half each in either of the asset classes.

Back in March 2020, when the markets crashed, it was a good time to put the entire 50% into stocks and the take the stock allocation to as high as 75%.

Now, as the markets trade at all time high PE multiples, it is a good idea to be as much as 75% in cash or perhaps 50%.

I love the simplicity of this approach and how it enables us to do the right thing from a long term perspective.

You can get into stocks after they have fallen. Then book profits and take some money off the table after they have gone up.

The biggest advantage of this approach is the freedom it gives from making any stock market prediction and from worrying about all time high PEs.

Good Investing,

Rahul Shah
Rahul Shah
Editor, Profit Hunter
Equitymaster Agora Research Private Limited (Research Analyst)

PS: Join Richa Agarwal, our smallcap stocks guru, at the Smallcap Revival Summit on 28 January to find out the 3 best smallcaps in the market. Register for this free summit here.

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