Rich valuations can trip investors; look for stock-specific opportunities

With the Sensex trading at a trailing price-to-earnings (P/E) ratio of 29 currently, market participants have begun to worry about rich valuations. Experts have warned that the headline index has crossed the P/E of 26 only thrice—in April 2000, December 2007 and March 2019. The market had crashed each time on the earlier two occasions. Fears are being expressed that it may do so again.

Valuations are rich in large-cap space: The Nifty is trading at a trailing P/E of 29.33, around two standard deviations above its 10-year mean. On a one-year forward basis, it is trading at over 19 times FY20 estimated earnings. “Passive inflows from foreign institutional investors (FIIs) into frontline stocks have pushed Nifty valuations to high levels,” says S. Krishna Kumar, chief investment officer (CIO)-equity, Sundaram Mutual.

While the index has stayed at high levels, earnings have failed to revive. “Market participants have been expecting a recovery in earnings for several quarters, but this has not materialised,” says Ankur Maheshwari, chief executive officer, Equirus Wealth Management.  

The index has factored in every possible piece of good news. Unfavourable election results or any other negative news could cause the market to correct.

May 2019 is not December 2007: Some experts, however, say that just because the Sensex trailing P/E is in a similarly elevated zone, it does not imply that the market will crash again. They point to several differences between now and December 2007. “The price-to-book-value ratio, another measure of valuation is not as high,” says Jatin Khemani, founder and CEO, Stalwart Advisors, a Sebi-registered independent equity research firm. It stood at 6.39 in December 2007 but is only at 3.76 currently. Then, the Nifty had been rallying at a three-year compounded annual growth rate (CAGR) of 43.4 per cent. This figure is a more sedate 14.4 per cent currently. Earnings growth of the Nifty had been at 21.3 per cent CAGR over the past three years in December 2007, whereas currently it is in the low single digit. If earnings recover, the P/E level would appear more sedate. Foreign portfolio inflows had been heavy over the past 12 months in December 2007 but have been more subdued in the recent past. Market conditions being less overheated currently, a crash may not be imminent.  

Opportunities in individual stocks: Notwithstanding the Nifty’s high valuation, stock-specific opportunities still exist within the large-cap space. “Private banks, cement, power, industrial, infra and construction look interesting from a valuation perspective and in the light of the growth opportunities they present,” says Krishna Kumar. Adds Gaurav Dua, senior vice president and head-capital market strategy, Sharekhan by BNP Paribas: “There is value in private banks that lend to corporates. Easing of asset quality issues will result in marked improvement in their profits, and they could get re-rated.” He also sees value in some stocks in the speciality chemicals space.

Venture beyond the Nifty: Some experts are of the view that individual investors should not get overly concerned about high Nifty valuations. “The fund manager of a large-cap fund is bound by his mandate to invest in the top 100 stocks. There are no such limitations on individual investors. His ability to venture farther afield gives him an edge over institutional investors,” says Khemani. He adds that beyond the top 100, investors are likely to find many stocks that offer attractive growth prospects, low leverage, and comfortable valuations. Unlike the Nifty 50, many of whose constituents are large conglomerates that are hard to analyse, the investor will find simple, focused and more easily understandable businesses in that space. Valuations have turned more attractive post the 2018 correction. “Stocks can be found in the ­­­­hotels, quick service restaurants, textile, retail and branded apparels segments at reasonable valuations,” says Krishna Kumar.

Try balanced advantage funds: Avoid bulk investments currently. “Use SIPs and STPs until election-related uncertainties gets resolved,” says Maheshwari. He suggests adding to positions in the mid- and small-cap space, and allocating to consumer funds. These low-beta funds can also provide protection during a correction.  

Investors may also opt for balanced advantage funds. “In such a fund, as equity valuation goes up, equity exposure is reduced and debt exposure is increased, and vice versa. Even if the equity market turns volatile, the impact on investments will be reduced due to the cushioning effect provided by debt,” says S. Naren, ED and CIO, ICICI Prudential AMC. Aditya Birla SL Balanced Advantage (five-star), Franklin India Dynamic PE Ratio Fund of Funds (four-star) ICICI Pru Balanced Advantage (four-star) offer highly rated funds within Sebi’s balanced advantage/dynamic asset allocation category (ratings are from Value Research).      

RankMF, an arm of Samco Securities, has recently launched an algo-based rating of funds. “Our algo evaluates the constituents of the portfolio on fundamental parameters. it uses technical parameters to judge if the current portfolio valuation provides a margin of safety,” says Omkeshwar Singh, head of mutual funds, RankMF. Currently, owing to lack of valuation comfort, only 10 equity funds out of 845 enjoy a five-star rating. Investors and their advisors may evaluate such new rating approaches to see if they can help them avoid valuation risk.