Tuesday, July 7, 2009

How to identify Bubble?

What are the main characteristics of a bubble? How can an investor identify early and take advantage or avoid getting punished? Let me give you some examples which can be used to give a fair idea of a bubble in terms of P/E ratio.

All the gurus agree that 21,000 Sensex in January 2008 was nothing but a bubble. What did the valuation look like at that time? The five companies in the Sensex that led this bull market were trading at following valuations:

CompanyP/E of TTM EPSP/E of 10 year average EPS
Larsen & Toubro56135
ICICI Bank3580

Companies were trading at 70-140 times ten year average EPS. When the markets corrected many good companies without any debt on their balance sheet giving good dividend in BSE500 were available at TTM P/E of 3-5 with a P/E of 10 year average EPS of less than 5. The examples were Patni and Maharashtra Seamless. Even Bharat Electronics and BEML were available at P/E of 10 of average EPS of 10 years.

The fact shows that investors were paying too much for the near term growth in profits and were not taking into the account the impact of business cycles. The period between 1999-2003 was such that corporates were earning less than their potential but between 2006-2007, most of the companies were earning above their potential.

Can I locate similar trends in some sectors today? Have a look at the following table to compare valuations of some companies:

CompanyP/E of TTM EPSP/E of 10 year average EPS
GVK Power35150
India Infoline1876
Jain Irrigation3389
JP Associates5584
KSK Energy50287
Mundra Port & SEZ50225
Nagarjuna Fertilizer75135

Many of the stocks seem to be related to Ports, Airports, Metals, Education and Power. Some overvaluation in FMCG has also started to appear. Manish Chokhani says that there might be companies in power sector that grows from small caps to be a part of Sensex one day replacing NTPC similar to what happened in Telecom. But isn't that hope priced in at this point of time?

The overvaluation of stocks can continue for a long period of time since the liquidity chasing the equities is in huge amount. Investors should stay cautious.
Bookmark and Share

No comments:

Related Posts with Thumbnails