Decoding Nifty Valuations

We have been writing about Nifty valuations for quite sometime now and have maintained a neutral to mildly bearish stance for quite sometime. Our portfolio was tied up in debt funds to the extent of 68% and we did make 13% to 15% returns on GILT securities last year thanks to the interest rate cut cycle and demonetization drive. This level of return will not be seen again for a very long time. So our portfolio has to move to equities or else be stuck in cash and hardly 1% above inflation. But is there any room left in equities for double digit returns?

To answer this, we look at the Nifty 50. This is an indicator for the overall market and is not theme or sector specific. Where does Nifty's valuation stand today?

P/E Ratio: 23.1

The above chart gives a graphical representation of the PE ratio. Just looking at it you will realise that we are at the upper range of the historical PE zone and that it is a pretty expensive zone for equities. 

So do we crash now?

This is anybody's guess! In the past the PE ratio has gone to levels of 26-28 before correcting. Some stats on the PE ratio now:

Nifty's mean PE is 18.86. Mean is just an average and seen alone, averages are of no use. Now Nifty will always be moving up and down in cycles and at times creates some excesses. How much can Nifty deviate from it's mean? The standard deviation shows us this ratio. The upper band of Nifty's standard deviation is 22.31 and historically (since 1-Jan-1999), Nifty has traded above the +1 SD band 25% of the days. The main area of it's movement is between the -1SD and the +1SD where it has spent 63% of its trading days.

So what does all this mumbo jumbo tell us?

That we are at an expensive level of valuation and that PE levels will correct sooner or later. But that does not mean that markets have to CRASH. It can be time wise correction (flat market for 2 years) or a price correction of say 10% to 15%, now that isn't exactly a crash. A crash is  >40% fall in the index as per us.

For the PE to correct, either the index falls to the earnings catch up. This brings us to the topic of earnings.

Earnings growth stagnated since 2015 and slipped into negative territory by the end of 2015. That means, the EPS (Earnings per share) of all Nifty companies was falling on a Y-o-Y basis. But now, the earnings growth rate has bottomed out. We are going to see earnings growth rate head higher and the EPS to increase going forward. 

The above chart graphically represents the EPS growth rate and the yellow highlighted area shows that we are now coming back into the +ve growth trajectory.

How much will earnings grow?

India's real GDP growth is at 7% p.a. and the nominal GDP growth rate (which takes into account inflation) is at around 11.5% to 12% p.a. If the economy is growing at 12% p.a. then the earnings of corporate houses that form a part of the Nifty index should grow at that rate too! But then there is room for a higher growth rate.

When earnings grow, the market capitalization of the companies goes up due to different reasons. The market cap-to-GDP ratio is a ratio used by many top investors across the globe. Now this ratio is not free from flaws. One flaw being that the market capitalization of all listed companies can go up when new companies get listed and India's IPO market was lying dull till the end of 2015. But all metrics of valuation have their own flaws and that is what makes investing an art rather than just statistics.

India's market cap-to-GDP is around 75% and the developed markets usually have this ratio at around 140% to 150%. There are times when this ratio goes above 100% in India too! Assuming that this ratio can go towards 100% in 5 to 7 years time, then if GDP is growing at 11.5-12%, we can expect earnings to grow faster than that, maybe say 14 to15% p.a. over the next 5-7 years.

How much are investors paying now?

Lets say investors are assigning a 2 year forward P/E of 18.5 to Nifty, then at current levels of close to 9,000 they are expecting an earnings growth of 12% p.a. which is inline with the GDP growth. But this is talking only for Nifty. The midcap and smallcap space is at extremely high valuation levels and this comes with hardly any growth in earnings. Large caps are undervalued and no retail investor is looking towards them. Momentum is in the small and midcap space as new inflows into mutual fund schemes that invest in this space is going up day by day.

So how to invest in this market?

It is a company specific approach that we need to take. Look at individual companies that are doing well in terms of growth and margins and at the same time are trading at decent valuations. These are the stocks that will give you 15% to 18% CAGR over the next 5 years. If the market does correct 10% or 15% from these levels, you'll see these stocks fall too! But the earnings and growth won't fall and thus you'll have a chance to invest more.

This is truly a traders market. Buy and hold for a day, a month or a year. You are trading and putting your money on momentum. Investing is when you are ready to hold on for 4-5 years patiently.

Are you a long term investor? If yes, you should read more about our investment advisory services. We help investors build a long term portfolio and take informed financial decisions.
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