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Suresh Krishnamurthy

Taking a view on the market based on Sensex levels, or even market cap-weighted valuation multiples, is fraught with risk. It would be better if investors took a view on individual stocks and acted accordingly.

HOW does a Sensex value of 7,200 sound? That would have been its value had Sensex been an equally weighted index since February 2000. In such an index, stocks carry equal weights.

This is in contrast to weights based on market capitalisation, which is the case with Sensex now. And as Sensex stocks have gained 20 per cent on an average, 7,200 would be Sensex value now.

In other words, the present Sensex value of 4,000 conveys an inaccurate picture on stock price levels compared to history. In fact, taking a view on the market based on Sensex levels, or even market capitalisation-weighted valuation multiples, is fraught with risk. It would be better and simpler if investors took a view on individual stocks and acted accordingly.

Stocks on a high: From February 2000, Sensex value has declined 23.8 per cent. The fall is mainly due to the decline in prices of stocks such as Infosys Technologies, Zee Telefilms and Satyam Computers. However, on an average, individual stocks in the Sensex gained 21.4 per cent since February 2000.

Importantly, this positive average is not because of the performance of a handful of stocks. The median (another statistical measure that is not influenced by larger numbers) return for Sensex stocks is 14.4 per cent. That is, half the stocks in the Sensex gained more than 14.4 per cent.

In fact, 17 of the 30 Sensex stocks delivered positive returns during this period. These 17 stocks account for 60 per cent of the market cap of Sensex now.

Similar results obtain when BSE-200 is considered. In the BSE-200, 181 stocks have a price history since February 2000. In these stocks, the average return is about 62.5 per cent.

The median return is 12.2 per cent — that is, half the 181 stocks gained more than 12.2 per cent.

These stocks account for 70 per cent of the market cap of the 181 stocks. In other words, in 70 per cent of the market by value, stock prices are higher than they were in February 2000.

Level of market: It is not that a particular Sensex level is completely meaningless. The Sensex value of 4,000, compared to 6,000 about three years ago, indicates that so much wealth has been destroyed. What it suggests is that, despite the rise in the Sensex value in the last six months, cumulatively, investors may still be in the red compared to February 2000.

The wealth of a section of investors in the market may have increased since February 2000. However, there is likely to be another segment of investors whose wealth would have declined. Specifically, investments in technology stocks continue to be in the red. Cumulatively, investors have lost value.

However, as a guide to valuation and as a measure of whether stocks have appreciated, Sensex or any market cap-based index may convey a misleading picture. That is indeed the case now.

Misleading calls: If market capitalisation-based index values are misleading, then market capitalisation-weighted valuation multiples are equally so. In this context, we cannot rely on such multiples to take a view on the market.

The implications is that any statements that Sensex is now trading at a price-earnings multiple of only 10 times compared to a higher number in the past are meaningless.

Indeed, there are voices professing that the market is undervalued. They cite the forward price-to-earnings multiple of Sensex or any other index to buttress their argument.

However, it would be better if investors do not buy such arguments. Acting on such advice and buying the market (that is buying indices such as Sensex, Nifty or Junior Nifty) could prove harmful to your wealth.

In fact, there are experienced fund managers who indicate that taking a view on the market is impossible. They suggest that it would be much simpler to take a view on individual stocks. They follow that approach. Retail investors would be well-advised to do the same.

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