Thursday, June 4, 2009

Are we following the footsteps of the US?

I want to bring to notice the shift in investor methods of valuing a company in Indian stock market lately. It seems that too much emphasis is given today on future growth in profits than the current and past earning power of the company, the method followed by value investors. As shown in my previous post, the earnings can become stagnant even though the economy is growing, as happened between 1996 and 2002. During these times, the valuation of the companies do not depend on their growth but clearly on the current earning power of the company. When the growth will evaporate, the P/E ratios of companies will come down near to inverse of after tax yields on bonds, i.e. earnings yield (inverse of P/E) will match the after tax yields on bonds. The CNX 500 clearly shows the shift of P/Es to higher levels over the last 6 years. If we consider the data between 1 January 1996 to 30 April 2003, which includes the P/E ratios of 2001 tech bubble, 53% of the time CNX 500 P/E was below 14 but if you take data between 1 May 2003 and 2 June 2009, that 53% comes at a P/E of 17.5. CNX 500 remained below P/E of 15 for 65% of the time during 1996-2003 and during 2004-2009, only 20%. The other reason for this shift can be low interest rate too, but keeping interest rate too low for long periods of time can also lead to disasters.

How does this shift in P/Es affect an individual investor? As can be seen in American Market, if it is already known that stocks give good returns over all the asset classes in the long run, they will be quoted higher by bidding up the prices and the outperformance will no longer happen. For Indian equity markets too, I feel that the recent shift in investor enthusiasm will erode the gains in future. Anybody who is investing today will after 10-20-30 years realize that they overpaid for growth. People who bought stocks in 1996-2003 period paid for value and are getting rewards for their conservative investment strategy. Investors buying today with a hope of growth are just diminishing their real investment returns of future. Seth Klarman, a renowned value investors had commented recently that stocks in the US were never allowed to become cheap in the last 20 years (average P/E of 24.9 vs 17.2). What followed is that at the end of this overvaluation, stocks underperformed the bonds as discussed here. A similar fate can be seen in Indian markets 10-20-30 years later when people like me are near their retirement age and will feel the same as Baby Boomers generation is feeling right now in the US, 'helpless'.

The only advice is "be cautious".
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