Exercise caution as valuations peak

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By Nimesh Shah
Managing Director & CEO
May 22, 2017
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Current equity market valuations can soon get realigned to historical valuations, as and when earnings growth materializes


Indian equity markets are trading around their lifetime highs, propelled by strong liquidity flows. However, this jubilation has led to some frenzied buying in select stocks. We would advise exercising caution now than be sorry later.


Warren Buffett, one of the world's richest men and legendary investor says: "Be fearful when others are greedy and greedy when others are fearful."


Equity prices are soaring to all-time highs, driven by strong flows and we have experienced that flow-based markets often become volatile in the short term.


Valuation appears expensive


The trailing price-to-earnings (PE) multiple for S&P BSE 500 Index is currently at 26 and more than a quarter of stocks are trading at over 40-times trailing 12-months earnings—the highest ever.


To get a perspective, in December 2007, the median PE for the S&P BSE 500 was 21, and 24% of the stocks were trading at a PE of over 40.


However, we are strongly convinced that current equity market valuations can soon get realigned to historical valuations, as and when earnings growth materializes.


We expect strong earnings growth going forward. However, when stocks are trading at a PE of 40-60, the growth in the immediate years is not that important, what matters is whether the company can sustain high earnings growth for an extended period.


Earnings lag expectations


The earnings growth expectations have not been in-line over the past three years due to a host of factors, including a slowdown in discretionary consumption and lack of credit off-take following stringent asset quality review by banks.


However, there's optimism that it may rebound strongly going forward, due to positive macroeconomic factors and a steady recovery in the economy. Many large companies have spare capacities which are yet to be utilised.


This can enhance tremendous operating leverage in the economy, without incurring much capital expenditure in the immediate term. The single digit Returns on Equity (RoE) are at their lowest in decades and can only rise from the current levels. Reforms like the Good and Service Tax may result in positive gains going forward.


Realign your portfolio


As equity prices are hitting all-time highs, investors often tend to become greedy. But it is time to rebalance portfolios. During this interesting and dynamic environment, products such as dynamic asset allocation/ balanced funds need attention and consideration, to help investors navigate through a volatile terrain.


Dynamic asset allocation funds provide exposure to both debt and equity. These funds are very dynamically managed: The exposure to either of the asset class is based on its relative attractiveness at any given time.


The markets have mostly factored in this year's earnings growth, so from a short-term perspective, market valuations may appear expensive. However, for long-term investors, these are times to remain invested, as Indian economic growth soars to robust 7%-plus, making it the fastest growing emerging market globally. A wide political mandate has given scope for bold economic reforms, setting the stage right for good times in Indian equity.


This article was first published in Morningstar on May 22, 2017

 

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