The rising tide

Markets are booming but high valuations can be a spoilsport

A rising tide is lifting all boats in the markets. The Nifty and the Sensex have hit record levels and the primary market is buzzing. In calendar 2021, 58 companies have already filed draft red herring prospectus (DRHPs), which exceeds the combined tally of initial public offers (IPOs) in calendar 2019 and 2020. The number of IPOs can easily exceed 100 in 2021 if this trend lasts. Supportive valuations across sectors have led to a wide variety of businesses targeting IPOs. Moreover, many IPOs have listed at a premium and, thus, have earned a quick buck for the allottees. The outstanding DRHPs include businesses as diverse as FMCG, insurance, chemicals, power and wealth management firms. In addition, the easing of the listing norms by the regulator has made it possible for loss-making start-ups to seek listings. Zomato started the gold rush in the start-up space and, following its success, unicorns like One97 (Paytm), PB Fintech (Paisa Bazaar), and FSN E-commerce (Nykaa) are all looking to go public.

The market rally has been driven by several factors. One is a rise in global activity, which has meant big bull markets for industrial metals, and fuels. Another is the accommodative stance of every large central bank, including the Reserve Bank of India. There’s cheap money easily available, with policy rates held low, despite an inflation spike. Paradoxically, there’s also more money available because the Indian economy is operating below capacity— businesses have limited working capital needs and less desire for capital expenditure. The returns from alternative avenues such as debt are low, or negative in real terms. All these factors have together fuelled interest in risky assets. The Nifty is trading at a valuation of 26.5x price-to-earnings (PE) for the previous four quarters. The optimists believe that this is equivalent to a forward 2021-22 PE of about 21-22x, given the base effect of a poor 2020-21 and the high growth in profits over the past three quarters. The Nifty midcaps are trading at a trailing PE of 31x and the smallcaps at 29x and similar jumps in earnings are expected.
 

The benchmark indices for every market segment are close to their respective record highs and each has returned a minimum of 16 per cent in calendar 2021, with the midcaps and smallcaps outperforming larger stocks. There was a divergence in performance in the recent past as the BSE tightened price bands for small caps and less liquid stocks. In the last six sessions, the Nifty Midcap index has corrected by 5.4 per cent from a record high and the Nifty Smallcap index by 9 per cent. However, clarifications by the BSE may assuage investors’ doubts on this account, and also the stocks that are affected represent a small proportion of total market capitalisation.

It is rational for businesses to raise cash during this frothy phase. It is even rational for investors to take risks for higher returns. But high valuations for good businesses often go hand-in-hand with high valuations for those who really don’t deserve takers. Investors and traders would do well to curb their over-enthusiasm, and recall the old saying: “Only when the tide goes out, do you discover who’s been swimming naked”.  A reversal in sentiment could lead to an equally deep bear market.