By almost all traditional measures, current market valuations are punchy. Nifty50 is trading at 22x, a 37 percent premium to its 10-year average. NSE500 price-to-book is at a 33 percent premium as compared to the same time two years ago. Stock-level valuations are even more intimidating with more than thirty companies (in NSE500) trading well above 50x on their estimated FY23 earnings. Whilst everything seems expensive, valuation debates are notoriously hard to argue.
Value is a matter of perception without the benefit of hindsight. “Unrelenting increase in stock level valuations is likely to continue”, “financial market history teaches us this is a dangerous sign ergo stick to cash”, “as long as you stick to quality names over a long enough time horizon, valuations shouldn’t matter” – amongst many other arguments. This can be confusing, especially since most of these arguments have large swathes of truth in them and are backed with data. How does one navigate this?
Are markets really expensive?
Multiples cannot be looked at in isolation. Price has to be looked against the value one derives from it. In a company’s case, an investor purchases growth and return on equity (RoE) and pays what they believe will allow them higher growth than most other asset classes (cost of equity). If market perceives that a company will be able to grow long term at 8 percent, investors can generate better returns by correctly understanding if it can deliver more.
However, recent increases in valuation are less a function of higher growth rates or RoE but rather a falling interest rate cycle. In August 2021, NSE500 price to book value was 3.6x far ahead of the 2.7x in August 2019. But, an investor buying in 2021 is paying for 11 percent long term growth versus the same 11 percent in August 2019. It is only cost of equity (we take that as 10-year Government bond yield plus 5 percent) that has reduced causing the multiple to increase while keeping the ROE expectations consistent.
Therefore, it would be wrong to believe that the markets today are more expensive than pre-Covid at a company level by just looking at the optical P/E multiples.
Many will argue that changing constituents of the index may cause a skew in numbers. 100 largest companies listed for the last 10 years are put through this exercise. End result: Implied growth today is around 10 percent versus arund 11 percent, two years ago. Valuations are lower! However, the growth that investors are paying for is significantly higher than the around 7 percent in August 2011. So clearly, while the markets are more expensive than in the past, they aren’t more from pre-Covid levels.
Although, markets aren’t as expensive as they look but the risks have increased. Investors may be good at identifying companies that have a strong outlook on growth and RoE but that alone isn’t going to ensure best returns. For one, in disruptive times, getting a clean grip on potential growth rates and RoE is hard. Moreover, as interest rates (cost of equity) increase, eventual returns may be much lower than expected as multiples go down. While this was true in the past 10 years too, it played a much lesser role.
What can an equity investor do?
There are three things that could help gear your equity investments in such times (a) spread your risk by following an SIP based routine and; (b) be mature enough to accept lower returns and may be even some underperformance in the near term to earn a margin of safety and most importantly (c) don’t be tempted by silly things.
Try to pick companies based on current reality rather than labels of “high quality” or “strong narrative” at any multiple. Such narratives need to be backed with solid numbers – prefer companies that are showing sales growth now and are more palatable on valuations on reported earnings rather than future potential.
We typically hunt for “catalysts” such as promoters investing in their own shares, mergers and acquisitions and private equity buying stakes as good starting points to identify future outperformers. Pertinently, we believe that making fewer mistakes is highly rewarding to one’s portfolio even if it means missing out on a few strong outperformers. As the great Morgan Housel has said “Good investing is not necessarily about making good decisions. It’s about consistently not screwing up.”
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