Is market valuation of any relevance?

High weight of low P/E stocks in index pulls down valuation, says report

It is interesting to note that while the popular stock market indices such as the S&P BSE Sensex and Nifty 50 are just a shade lower than their all-time highs, valuations are still not seen as expensive, even as corporate earnings have been muted for three years in a row.

This is where a Kotak Institutional Equities report led by Sanjeev Prasad throws light on some insightful facts, and more important, could be a warning signal for investors.

“The valuations of the Indian market look reasonable on a top-down basis but the valuations of individual stocks are super-expensive or fairly valued in most cases. The high weightage of low P/E PSU banks, commodity stocks and utilities in the broader market indices pulls down the overall valuations,” the analysts note.

It may be tempting to derive solace from top-down (broader indices) market valuations, but it would be more rewarding to disregard indices and focus on bottom-up (stock specific) challenges, the analysts highlight.

A look at the sectoral break-up shows just four sectors are trading below the Nifty-50 valuation of 16.7x, based on 12-month rolling forward earnings estimates. These include technology, utilities, energy and metals. The remaining nine sectors are trading at a huge premium to the Nifty-50, given their price-to-earnings (P/E) valuation ranging 18-43x (see chart).

The contribution of banking, energy, metals and technology to the combined profit of Nifty-50 companies is pegged at 68 per cent for FY17, and excluding technology, the other three are expected to drive a large share of incremental earnings in FY16-19. All of them are trading below Nifty-50 valuation levels, except banking, which is a tad higher than the broader index.

The analysts also say the constant changes to the composition of the index in the past few years may preclude meaningful historical comparisons and compel investors to look at bottom-up valuations. “For example, the recent inclusion of IHFL (India Infoline Housing) and IOCL (Indian Oil) in the Nifty-50 Index has optically reduced the valuation of the market,” they add.

 

The higher weight of low P/E stocks or sectors also tends to hide the more expensive stocks that the market sees as growth companies. In some cases, the market is also willing to pay a high price for companies with sub-par business models.

But, there is a big message for investors. “It seems to us that the market has largely accepted the high valuations of ‘growth’ stocks as ‘normal’ valuations without questioning the sustainability of factors that have supported the re-rating of valuation multiples (low global bond yields) and expansion in profit margins (sharp fall in commodity prices),” the analysts say. The underlying fundamentals, however, are changing with global bond yields looking up and commodity prices also rebounding from their lows. The dollar has also been strengthening and with US Fed rate hikes, it could rise further and hurt foreign flows into equities.

Some other analysts also cite the increasing headwinds for Indian markets. With a sub-par monsoon predicted this year and some disruption expected at the time of goods and services tax (GST) implementation, there is risk to growth rates (demand). If these turn out to be true, it could lead to de-rating of stocks.

What’s more, Kotak’s analysts also point to the potential risk in the mid-cap space. “We find valuations of several mid-cap stocks in our coverage universe very high. In fact, it would not be wrong to say that some are in the ‘bubble’ phase with the market extrapolating strong growth and high returns in perpetuity,” they say.