While some valuations may look cheap now, it is important that you do not go the whole hog and invest aggressively.
Experienced investors, successful or otherwise, develop their own methods. Individuals have different goals, different risk-taking appetite and seek returns in different timeframes. Some have a perspective of six months; others of several years.
Most investors back growth, some are value-investors and some look for growth at affordable prices. Obviously, returns depend on, among other things, the quality of information, the quality of judgment and the luck factor.
The returns may be higher for those who are out of step with consensus. The biggest returns come when somebody buys during a bear market when stocks are cheap and sells during a bull market when stocks are expensive. This is the precise opposite of normal investor behaviour.
One famous example of a massive contrarian play was that made by John Templeton in mid-1939. On the eve of World War II, Templeton bought every profit-making business that was trading below $1 on a NYSE afflicted with pessimism. He had to wait six years. But he eventually made over 400 per cent profit.
At first glance however, a contrarian style may be a recipe for underperformance, if not outright disaster. If you buy too early into a bear market, you spend months or years sitting on losses. If you sell early into a bull market, you make less in the way of profits.
Being contrarian is therefore, a high-risk strategy. Ideally, a contrarian must sense when a trend is close to exhaustion. This in itself scares a lot of investors away from trying to be contrarian because it appears similar to "timing the market".
However, the best investors (growth or value) tend to be natural contrarians and natural market-timers as well. This is because they look for bargains and bargains tend to pop up late in bear markets. A Warren Buffett for example, doesn't try to time markets. But he buys only when he thinks businesses are cheap. As a result, he has displayed an uncanny knack for making investments close to rock-bottom prices.
While Buffett ignores market sentiment, others look at statistics that try to directly measure sentiment. Typically, bear market bottoms are characterised by exceedingly low volumes accompanying low prices. They are also characterised by doom and gloom pronouncements from various experts across the economic space. Everybody is pessimistic at a bear market bottom and that means most of the selling is over. Conversely everybody is gung-ho at the top of a bull market but precisely because of that, most of the buying is over.
A conscious contrarian may try to combine the value-criteria and sentiment indicators to get additional margins of safety. That way, he knows that he is buying cheap and also that he's buying close to bear-market trend exhaustion.
This approach seems to have worked historically.
Right now, the Indian market meets some of the criteria that contrarians seek. There is doom and gloom galore. Volumes have dried up to a considerable extent. Most investors are pessimistic. So the sentiment signals certainly seem attractive for contrarians.
But the valuations are still well outside the zone of comfort. The Nifty is at a 2007-08 PE of 18+, the Price-Book Value ratio is about 3.8 and the dividend yield is around 1.3 per cent. Historically, bear market bottoms come at PEs below 12, dividend yields of over 2 per cent and PBV ratios of below 2.5.
Whatever valuation metrics you apply, those numbers are too high. Consensus earnings estimates are about 15 per cent which implies that the Nifty is trading at 2008-09 PE of about 16. That means the PEG ratio is above 1 and that's a sign of over-valuation. A comparison of earnings yields to GoI security and T-Bill yields (above 9 per cent) also suggests that the PE is much too high for a bear-market bottom.
In order that the current prices translate into attractive valuations, either a longer timeframe is required, or there must be further falls in price. This means India is not yet near the point of bear market trend exhaustion. So it isn't yet time to go out and invest heavily using a shotgun Templeton approach.
If you buy now, buy selectively and remain prepared to average down with a 2009-10 perspective.
