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Our Verdict on Sensex: 70% Value and 30% Froth

Dec 1, 2017

Rahul Shah, Editor, Smart Contrarian

Stock market valuations are like a mug of beer with a little bit of froth at the top.

The beer is the investment component; and froth the speculative component.

Sometimes, the mug is full of beer with no froth. It is all value and no speculation. A fantastic time to buy stocks.

At other times the froth of speculation takes up a significant portion of the overall valuation. Not a good idea to buy beer here. Or you end up with a whole lot of pointless froth, and not enough of the good stuff.

So far so good. But here's where the analogy starts falling apart.

With a beer mug, it's easy to tell where beer ends and froth begins. Anyone could point out the level to which the beer mug is filled. It is so obvious, it's impossible to go wrong.

No such luck with the mug of stock market valuation, though.

Ask two different investors what they think about a stock's valuation, and they are likely to come up with two completely different answers to how much of it is investment and how much is speculation.

This is what makes stock market investing so challenging. And, to me at least, so fascinating.

According to my investing hero Benjamin Graham, the most valuable contribution that research analysts can make to the art of investing is to determine the investment and speculative components in the current market price of any given stock.

In other words, an analyst should figure out where beer ends and froth starts.

Let's try this exercise on the Sensex, as it's easier to separate the beer from the froth for broader markets than for individual stocks.

While the benchmark index has bounced around a lot, it has traded at an average PE ratio of 18x since the turn of this century.

The fair value of Sensex therefore can be reliably assumed to be this earnings multiple: 18x.

With the index perched at a lofty multiple of 25x right now, simple math leads us to the conclusion that at current levels, the index has 70% investment component (ie 70% of 25 equals around 18) and the rest, 30% can be ascribed to speculation.

So, if you are paying Rs 100 for a mug of beer, there's only Rs 70 worth of beer in it and the rest is froth.

As an investor, how should you invest in a market as frothy as this?

An extremely useful rule that we follow in our Microcap Millionaires service is to reduce 10% allocation to stocks with every 10% rise in the speculative component.

The maximum we have in stocks at any given time is 75% at the valuation of 18x or below. But when markets rise and froth builds up, we recommend subscribers to go on reducing their exposure to stocks and increasing exposure to bonds. Right now, the service is 65% bonds and only 35% stocks, a function of the 30% speculative component embedded in the broader markets.

This technique has served us remarkably well.

Changing allocation levels based on an investment-speculation matrix has led us to being predominantly in stocks just when there was hardly any froth, and predominantly in bonds when there was a lot of froth.

It won't be wrong to say that this smart allocation has played a stellar role in Microcap Millionaires earning a strong 180% returns since inception, as against the 65% returns achieved by the Sensex.

So if you're worried that the markets can't work for you when they are frothy - as they are now - don't be. If you just look in the right place - there's always a way.

Good investing,


Rahul Shah (Research Analyst)
Editor, Smart Contrarian

Editor's Note: Speaking of finding a way, most people worry that you need a lot to make a lot in the markets. But there is a way to make a lot from a little - even set yourself up for retirement - just by understanding this one secret.

Brain Food for the Day

What About Reversion to the Mean?

People refuse to believe that there could be a 30% speculative component - especially in the current index level.

They justify the super-high price to earnings (PE) multiple by saying the denominator i.e. the earnings, are not the true earnings.

Earnings are significantly lower than the long-term average, and should it go back up to its true level i.e revert to the mean, a lot of the froth will turn into beer. The speculative component may vanish value will increase.

And this is precisely why we are 35% in stocks in Microcap Millionaires - not totally out of stocks. If these folks are right, and the index does go up further, our 35% exposure will be able to catch some of those gains.

We know we can never be totally right about how much is investment and how much is speculation. So we recommend being at least 25% in either asset class at any given point in time.

Isn't it always better to be approximately right than exactly wrong? You bet it is.

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2 Responses to "Our Verdict on Sensex: 70% Value and 30% Froth"

S K LIMAYE

Dec 2, 2017

Bonds do not give good returns.We can reduce the amount of ' froth ' by being very selective in choosing our stocks.

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Anil Agrawal

Dec 1, 2017

Dear Sir,

Your headlines are excellent. Your return claims are fantastic. IF I know correctly- your associates have a mutual fund also. But returns in those schemes are nowhere comparable to the returns claimed in articles. This leaves me totally confused about your various products.

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