• Investment World
• eWorld
• Catalyst
• Mentor
• Life
• Canvas
• Praxis
• Urban Pulse
• Brand Quest

Suresh Krishnamurthy

ARE equities attractive at current levels? The question assumes relevance with the Sensex moving past the 6,000 mark and inflows into mutual fund schemes peaking. It is worth bearing in mind that we are also approaching that time of the year when stock prices usually tend to languish.

In March 2000, the Sensex witnessed a mind-numbing crash, after touching an all-time high. No wonder, the voices suggesting that prices are peaking are getting louder. Investors need not panic, though.

Analyses of trends in stock price valuations, past profit growth rates and present financial performance along with profitability suggest that equities are still reasonably priced if the return expectations are 10-12 per cent.

Rising values

There is a substantial difference in quality between the market rally of 1999-2000 and that of 2003-2004, the latter being substantially more broad-based. This is reflected in the price-to-earnings multiple of the market. The average PE of stocks at about 18.7 now is lower than the PE in 1999 and 2000.

At the height of the market optimism in February 2000, the average PE (average of PE multiples weighted by market capitalisation) was a mind-boggling 150. It seemed more of a casino than a market then. The PE levels now are more rational and closer to the levels of March 1998.

The PEs of mid-caps and small-caps too are ruling at a premium to that of large-cap stocks. As of now, the price-earnings multiple of large-cap stocks rules at about 17. In contrast, the price-earnings multiple of mid- and small-cap stocks are about 24. Contrary to popular perception, the phenomenon of the PE of small and medium cap stocks quoting at a premium to the PE of large-cap stocks is nothing new.

The PE multiple of mid-cap stocks has generally been higher than that of large-cap stocks. The PE of small-cap stocks, though, has been more volatile. Their valuation, which was higher than that of large-cap stocks at the end of March 2000, slumped thereafter but has risen sharply now.

Reliability of values

The question, however, is whether the current levels of profits (based on which the current PE is arrived at) can be sustained, even grown? They can, at least in large-cap non-banking and non-oil stocks. These large-cap stocks have generally reported income growth every year. The earnings of mid-cap and small-cap stocks have, in contrast, been volatile.

Even in the nine months ended December 2004, the financial performance of larger companies has been substantially better than that of smaller firms. Relative to financial performance, profitability and profit growth seen till date, the valuation of mid- and small-cap stocks does appear demanding.

This valuation tells its own tale. What is factored into the valuation of mid- and small-cap stocks are expected gains from restructuring within the economy and gains from their foray into the global economy. There is nothing in their record to justify such valuations. Still, the stock market is attaching more value to Indian entrepreneurship than it did in the past.

Ordinary retail investors, who do not have access to information that would justify pricing in such developments, cannot afford to be as sanguine. They have no option but to stick to safer candidates. Largely, they fall within the domain of large-cap stocks.

In the case of mid- and small-caps, the PE values can be considered reliable only in companies with strong profit growth and with a reasonable return on net worth.

In other words, investors need to be conservative in pricing in benefits due to a change in the nature of the company and the promoters.

Case for equities

So, if we cannot price in such changes, is there still a case for investing in equities? There is. And it is built strongly on the prevailing low interest rates and favourable taxation policy.

High net worth investors pay a tax of 30 per cent on income from debt and earn post-tax income of about 5 per cent on their investments in debt. Equities will easily earn/fetch more than 5 per cent per annum over the next three years considering that the gains are tax-free.

The case for equities is strong even for those smaller investors who pay no tax on debt investments and earn about 8 per cent. Only, the time that they need to stay invested, would be longer — at least five years.

The current stock valuations confirm that such expectations are justified. For instance, the average earnings yield of a set of 400 profit-making stocks is 5.3 per cent. If the annual growth were only about 5 per cent, even then the total yield to investor would be about 10 per cent. If investors were, however, eyeing annual returns seen in the recent past, then it would be better to stay away from the market.

Such performance-chasing investors may have already entered the market, though. And there is a danger of such monies pulling out of the market at the first sign of flagging returns.

For instance, the recent initial public offers of mutual funds collected record sums. Investors in these IPOs may be disappointed and redeem funds, triggering a bear rally. Investors looking for returns of 10-12 per cent should not be perturbed by such volatility. They should consider it an opportunity to invest in stocks whose prices are attractive relative to the expected returns.

Returns relative to price

Finding out what stocks offer attractive risk-reward ratios is not easy, though, especially for ordinary investors. They have no option but to focus on simple tools such as price-earnings ratio and dividend yield. These ratios need to be judged relative to profit growth seen in the past and the return on net worth.

A simple model that factors in such ratios suggests that investors can, on an average, expect returns of 11.8 per cent per annum from stocks. The model involved dividing the earnings yield by two and adding a growth factor to arrive at the total expected returns.

Earnings yield is the inverse of the price-earning ratio. For the growth factor, half of the return on net worth or past profit growth was considered.

The derived total return was divided by the price-earnings multiple of the stock to judge its attractiveness.

Some non-oil large-cap stocks that emerged attractive on this basis were Tata Steel, Sun Pharma, State Bank of India, Hindustan Lever and Neyveli Lignite Corporation.

Some mid-cap stocks that were preferred on a similar basis were IndusInd Bank, GE Shipping, Moser Baer, Asahi India Glass and Marico Industries.

Attractively valued small-cap stocks include Federal Bank, Ucal Fuel Systems, Seshasayee Paper, First Leasing and FDC.

Stocks that appeared expensive included a number of hotel stocks. Hotels are, however, in the process of consolidation and on a rebound from the abysmal depths their operations had plumbed in the past few years. Other stocks that appeared expensive include Bharat Earth Movers, Titan Industries, Orchid Chemicals, Bombay Dyeing and Pfizer.

These stocks are not necessarily sells. The earnings growth required to deliver attractive returns from their present price levels is much higher than what these companies have delivered.

Investments in these stocks can, however, be somewhat risky.

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
United Breweries: Accept

Copyright © 2005, The Hindu Business Line. Republication or redissemination of the contents of this screen are expressly prohibited without the written consent of The Hindu Business Line