Timing is key to maximise gains

Data on key indices in India and US suggest returns are higher when investors buy at a P/E of 15 or less

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Timing is more important for long-term investors than generally believed. Long-term series data for US S&P 500 and BSE Sensex suggest when investors buy at a price to earnings (P/E) multiple of 15 or below, the returns in the following 10 years are better. In comparison, 10-year return is in low single digit when investors enter the market at higher P/E valuations of 20 or more.

The S&P 500 currently trades at a P/E of 19 and the Sensex is valued at around 20 times, capping the long-term return for investors who plan to enter the market now.

In the US, there is a 60 per cent negative (minus 0.6 per cent) correlation between the valuation ratio in a particular year and investor return over the next 10 years. In other words, for every one percentage point increase in purchase price (in terms of P/E multiple), the annualised return over the next 10 years is impacted by 60 basis points.

In India, the negative correlation is even higher, at minus 0.8 per cent. American data is, however, statistically more reliable - key valuation ratios of the S&P 500 index are available from 1954, while BSE Sensex data is only available from 1991 on (see chart).

The analysis is based on calendar year and financial year end-index value and its underlying trailing PE for the S&P 500 and BSE Sensex, respectively.

For example, American equity investors who bought the S&P 500 in the late 1970s and 1980s, when the index's trailing PE ranged from eight to15, got annualised return of 10-15 per cent over the next 10 years. The returns for long-term investors began to decline from the late 1980s, as the index progressively became expensive. Those entering the market at the height of the dot.com boom in the late 1990s, when the S&P valuation was high, lost money over the following decade.

S&P valuation peaked in December 1999, at a trailing PE of 29.3, according to data from Bloomberg. Investors buying the index that year earned annualised return of minus 2.7 per cent over the next 10 years.

Indian investors who entered the equity markets in the late 1990s and early 2000s, when the benchmark BSE Sensex was trading at a trailing PE of around 16, have got one of the best returns. For example, investors buying an index-like portfolio in March 2003, when the index was trading at a trailing PE of 13.3, ended with an annualised return of 20 per cent in the following decade. Conversely, investors entering the market in March 1992, when Sensex valuation had peaked at 55 times its underlying trailing earnings, earned a negative 2.1 per cent annualised return over the next 10 years.

The recent decline in long-term equity returns in both the markets has gone hand in hand with the steady rise in equity valuations in the run-up to the 2008 global financial crisis.

Bulls, however, say the correlation might not hold in the future, due to depressed corporate earnings in the recent past. "Valuation peak in the past happened along with an explosion in corporate earnings. Now, the P/E multiple is higher due to a lower denominator," says G Chokkalingam, head of Equinomics Research & Advisory.

According to this view, long-term investors can still make double-digit annualised returns if economic growth and corporate earnings make a strong recovery, as expected this financial year.