Nifty is Approaching 20,000: What Should Investors Do?

There are situations in nature when two plus two equals ten.

A little cool air from the north is no big deal. A little warm breeze from the south is pleasant. But when they mix together, you get a tornado.

Two calm water currents are not a problem. But if opposing currents meet, you get a deadly whirlpool.

Bleach and ammonia are common household products. Mix them together and you get lethal chloramine gas.

If you look at the initial ingredients above from a standalone perspective, then all of them when taken in to isolation are absolutely harmless. However, a combination would lead to destruction.

What if we extrapolate the same to human traits. Investing is a behavioral science to some extent.

The reason why bubbles in any asset class happen is when confidence (good trait), optimism (good trait), positivity (good trait) mix to form greed and complacency (bad traits).

In short, a mixture of harmless things, when combined have the potential to form something extremely destructive in the market.

Charlie Munger once said...

• Failure to handle psychological denial is a common way for people to go broke.
  
  You've made an enormous commitment to something. You've poured effort and money in. And the more you put in, the more that the whole consistency principle makes you think, "Now it has to work. If I put in just a little more, then it'll all work."
  
  People go broke that way, because they can't stop, rethink, and say, "I can afford to write this one off and live to fight again. I don't have to pursue this thing as an obsession in a way that will break me."

Now why am I writing such a negative commentary when the markets are breaching all-time highs every day supported by momentum in the small and midcap space?

Well, there are always two side to every coin.

Risk management, i.e. being cognizant of the risks when all people talk about is everything going right, is the most important trait an investor can have. This is different from timing the market.

There are two things which in my view determine the direction of the markets.

• Earnings
• Valuations

Everything else is purely noise.

It's said that the India story disappoints both the optimists as well as the pessimists.

So here are the positives...

• Strong earnings growth in FY23
• Better than expected monsoons as against an expectation of El Nino
• Decline in raw material costs which is the biggest lever for margin expansion
• China plus 1 in some sectors
• GST collections hitting all time highs every month i.e. strong consumption
• Positive FII Flows over the past 3 months
• Steady rise in SIPs i.e. strong retail participation

However, eternal optimists or perma bulls, more often than not, ignore the negatives. So let me present certain negatives in my view...

• IPOs of unknown companies are getting listed at astronomical valuations
• Valuations for many small and midcaps are discounting the next three years of earnings
• There is a slew of block deals from promoters and financial investors selling their stakes
• WhatsApp groups buzzing with penny stock ‘tips’

Then the most important thing which decides buying or selling for long term investors is valuations.

The FY23 PE ratio of the Nifty is 24 times.

The only comfort here is the expectations of strong earnings growth.

Even if you take a 13% growth of Nifty companies over the next two years, the Nifty PE falls to around 19 times, two years forward. Even this is not cheap by any measure.

And when you look at small and midcap companies, the euphoria is building up. When low quality companies trade at unjustifiable valuations, it's time to be cautious.

The euphoria stage of the market happens when your barber tells you which stock to buy. At least I haven't had any such conversation with my barber. The last time he spoke to me about stocks was in 2021, when the benchmark indices had more than doubled after the 2020 crash.

In my opinion the euphoria and valuations have not reached the bubble stage. The market is expensive but not yet euphoric.

Still, I think the time has come to become cautious in the stock market.

Warm regards,


Aditya Vora
Research Analyst, Hidden Treasure
Equitymaster Agora Research Private Limited (Research Analyst)