A Tale of Two Valuations

For Indian markets it is best of times and worst of times in terms of valuations. A portion of stocks in market have earnings multiples which are in stratosphere. A large number of companies having these valuations in my opinion have only moderate growth prospects. That would mean that investors could face disappointment in future. At the same time the profit levels of the economy are probably at their cyclical low. As profits revert to their mean and perhaps exceed it investors would see very decent returns from stocks of companies which are moderately priced and going to benefit from margin reversal. Here we examine both classes of stocks

First we have a look at segments where valuations are expensive. BSE Small Cap and NSE Small Cap 50 have a PE ratio of 75 and 50 respectively. BSE Small Cap has a total of 761 shares, so that is a large sample size. Clearly a large number of these stocks are overpriced. Even if we assume that many of these companies are wonderful companies, their high share prices mean that they have to deliver high growth rates for a long time. Some might deliver many will disappoint. Even companies delivering high growth rates may not see share prices move much higher because that is something already incorporated into their share prices. Mid cap companies also have a relatively high valuations. BSE Mid Cap is around 34 times trailing earnings. Those valuations are not alarming but surely are cause of concern.

Another group which is highly priced is the large FMCG sector. The growth potential for most of these companies do not justify a valuation of close 50 times their earnings, given there is at least some saturation in their markets.

Profit Margin to GDP India (In %)

FY 02 : 2.2

FY 03: 3

FY 04: 4.7

FY 05: 5.4

FY 06: 6.2

FY 07: 7.3

FY 08: 7.8

FY 09: 5.5

FY 10: 6.5

FY 11: 6.2

FY 12: 4.8

FY 13: 4.6

FY 14: 4.3

FY 15: 4

FY 16: 3.8 (Estimate)

Now we look at the other side of the coin. There are a number of arguments which make valuation of some segments of the market compelling. The profits to GDP ratio has been falling for last five years. Profits are now at 3.8% of the GDP. So for an economy of size of approximately Rs 135,000 lakh crores the profits were only Rs 4,200 lakh crores in 2015–16. With economy picking up and interest rates coming down the profits should return to its mean of 5.5 % per cent in next 5 years. By that time in current prices size of GDP would be Rs 250,000 lakh crores. That would mean that profits could rise to 13,000 lakh crores. There is a possibility of higher profit margin if interest rates remain low. Also typically profit margins do exceed their mean. In any case a three times increase of profits can easily take index up by 2.5 times correcting for current over valuation. The growth would be in all probability fuelled by investment and sustained by low interest rates. That would help grow companies engaged in manufacturing of capital goods. It would also have a positive effect on consumer discretionary companies. Efficient companies in all sectors should also benefit disproportionately. Investing in such companies which are moderately priced would yield good returns. Some of these companies are in BSE Small Cap index , because they are moderately priced and have a decent growth potential.

One sector to look out for is private bank and NBFC segment especially those companies who can keep their bad assets to a minimum. There is a transition happening where banking is shifting from public sector bank to private sector banks. The companies which are moderately priced in these segments can provide outsized returns.