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Don't fall for the "long term" argument - think independently
One of the simplest measures for understanding whether Equity markets are overvalued or undervalued is the trailing Sensex or NIFTY PE (Price to Earnings) and/or PB (Price to Book Value). It may not be the most accurate measure as these are trailing PE or PB and not forward looking; nevertheless it still gives a reasonable indication of market valuations. Unfortunately we have never married Fundamentals to Equity investing. At 7,000 NIFTY, we said invest for long term, at 8,000 NIFTY and again at 9,000 NIFTY we repeated the same investment call of investing for long term. Definition of Long Term got stretched (to suit our calls) from 3 years to 5 years to maybe 7-10 years going forward.
However, there may be times when underlying Earnings may be on the lower side (like the current scenario) and hence the overall market valuations look to be expensive. Current NIFTY PE as of February 27'2017 was 23.21 and PB was 3.37. These may seem to be overstretched on PE side butmaybe not so on PB matrix. As all of us are aware, earnings growth over past few years or so are muted and likely to remain so post demonetization impact. As and when the earnings improve the denominator of PE Ratio viz. EPS of the markets will improve; thereby making the overall markets look attractive as PE = Market Price/Earnings Per Share. That is the time when the entire PE band will get rerated and current expensive valuations based on PE/PB matrix will start to look attractive.
Another example of overstretched valuations which may not reflect underlying true picture is the PE of say BSE Small Cap Index which is at 64.38. In this case many of the Small Cap companies may not even have any earnings (E) and hence due to the lower denominator, valuations look extremely overstretched (as there is no E in many cases). Hence, one should take into account these factors before arriving at some kind of consensus on market valuations.
If we divide the markets into three zones (the Signal which was designed by IDFC AMC to make us understand different zones of the markets) viz. Green (Cheap Valuations), Yellow (Reasonable Valuations) & Red (Expensive Valuations) and then analyze how investments made in these three different zones have performed; it will give a fair idea on how markets have delivered excellent results in Green Zone periods, reasonable returns in the Yellow Zone periods and dismal in the Red zone periods.
Also, different Fund Houses use different Matrix for valuing these zones from Most Expensive to Cheap Zones. Even MisterBond has his own Algo which gives a cue on these parameters. Some of the Valuation Indices of ICICI Prudential MF, MotilalOswal MF &MisterBond's own Index shows more or less similar results as follows:
Different Algo numbers as on February 28'2017 and interpretation of the market valuations
Currently, all three Algos are indicating that inspite of this market rally, we are in the Yellow Zone.
Price to Book Value compares the Intrinsic Value of the Company v/s its market Valuations and based on that markets seem to be in Fair Valuation zones. As against that, Price to Earnings compares Company's Market Valuation v/s it's Earnings for the year. This is more volatile and looks at past performance (trailing PE) rather than Forward PE (based on Estimates).
Hence, it would be advisable to look at various available Indices and come to your own conclusion based on other macro factors prevalent in the market. I have analyzed the same using both PE bands as well PB bands and come to some similar conclusions: If the PE and PB bands in terms of Green, Yellow and Red zones are divided as follows (you may wish to tweak with these bands and create your own bands like say Red Zone for PE can start from 21 and above as Red zone, etc.):
Based on the above, if anyone had invested in the Green Zone through PB Matrix in NIFTY from anytime between 1999-2017 and held it for 5 years thereafter; returns were Minimum: 9.58%, Maximum 44.90% and Average of 28.11%.
As you get into the Yellow Zone; Minimum Returns have come down from 9.58% to 2.56%, Maximum Returns have come down from 44.90% to 36.13% and Average Returns from 28.11% to 15.02%.
The most dismal performance as one would expect is in the Red Zone; where dramatically, Minimum Returns over 5 year holding has gone in the negative territory to (1.16%), Maximum Returns have dropped to 23.03% and Average Returns have dropped to 8.95%.
Something similar is being observed when use PE Matrix instead of PB Matrix as shown below.
Unfortunately, statistic shows that 80% of investors invest in the Red Zone and only 1% inflows come in the Green Zone. That is the reason why:
Investment Returns are never Investor Returns Investors rarely have a happy investment experience in Equity as an asset class and Mutual Fund as an investment vehicle Investors never become brand ambassadors of the Mutual Fund Industry
These small measures from our side to guide investors on the right path, invest at right times and disinvest at appropriate times will go a long way in getting Mind Share and Wallet Share of Investors both in Equity as an asset class and make Mutual Fund products the First Recall preferred investment vehicles.
To conclude, I would recommend to look at some of these simple parameters including some of these Valuation Index of different AMCs or Algo of MisterBond to figure out if markets are in Over Bough or Over Sold Zones. Some AMCs depend on pure PB Model (ICICI Prudential), some on only PE (IDFC AMC), some on PE/PB/Dividend Yield (MotilalOswal) & some a combination of PE/PB like Algo of MisterBond. Also as explained above one parameter may give contradictory signal to the other; in such a scenario look at other Macro factors, Sensex 10 Year Rolling Returns & its correlation to current Valuation (will be covered in next article), Market Cap/GDP, Earnings Growth, etc.
Content is prepared by Wealth Forum and should not be construed as an opinion of HDFC Mutual Fund.
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