The Hindu Business Line : Are valuations stretched now?

With the Sensex crossing the 7000 mark, valuations belonging to `mid-cap', `small-cap' and `value stocks', are at a high. But one must be practical in investing and not expect yearly returns of the kind seen in 2003 and 2004. For expectations of 10-12 per cent returns, equities are still the best bet.

ALMOST every one knew that the Sensex would venture beyond 7,000 this week. What else is to be expected when the Reliance controversy gets settled?

Many nurtured a lurking suspicion that a few operators would orchestrate the move as an ode to the Ambani family. The rally in a handful of large-cap stocks in the first couple of days seemed to confirm this suspicion. What else can be expected when stock price valuations already seem stretched? The rally in the later half of the week however has been more broad-based. On Friday, advances outnumbered declines by a ratio of 2:1. FIIs pumped in close to Rs 2,700 crore this week without counting their purchases on Friday. Mid-cap and small-cap stocks rose more than large-cap stocks. Euphoria seemed to have come back to the market. So, are we entering bubble territory now?

Such concerns are overblown as valuations, especially those belonging to `mid-cap', `small-cap' and `value stocks', are at a historic high. As Marc Faber, renowned investment guru, said on television, we might even be able to buy stocks we want to buy today at lower prices tomorrow. Still, the valuations are not totally unsupported by the performance record of Indian companies. A practical approach needs to be adopted. When marrying, nobody looks for a spectacularly good-looking spouse. In investing too, it makes little sense to want every year returns of the kind seen in 2003 and 2004. If your expectations are for returns of 10-12 per cent, equities are still the best bet. If the economy keeps growing at a robust rate, returns over five years may even touch 15 per cent.

Deeper and more valuable: The stock market is now much deeper than it was in February 2000 and January 2004 — the two other periods in recent times when the Sensex soared to all-time highs. At the end of January 2004, 147 stocks accounted for 90 per cent of the total market capitalisation. Now, the number is 214. (It was 85 in February 2000). The return on net worth of companies has improved considerably. The average return on net worth is now about 17.9 per cent — higher than the average P/E multiple of 15.5. Large-cap and mid-cap stocks are trading at P/Es of 16.1 and 19.8 respectively. (They traded at a P/E of 73.6 and 30.6 respectively in February 2000).

By no stretch of imagination can one term the present valuations as abnormal. It would have been better if prices had not risen as much as or more than earnings have. It is, however, foolish to expect such a turn of events. No investor will leave money on the table. The potential for excess returns in most stocks will be wiped out as investors price in expectations.

There are areas of concern that primarily relate to valuations of mid-cap, small-cap and value stocks. The top 70 per cent of the market (by capitalisation) represents large-cap stocks; the next 20 per cent represents mid-caps and the rest belong to the small-cap segment. Similarly, stocks with a price to book value higher than that of the market average are growth stocks. The rest are value stocks.

Mid-cap and small-cap stocks are trading at valuations that do not seem to offer the expected returns compared to large-cap stocks, given their present return on net worth. If they are to end up generating higher returns compared to large-cap stocks, their return on net worth has to improve.

Similarly, expected returns from value stocks do not appear to be substantially higher than that of growth stocks. Investors need to stay conservative in this asset allocation and remain invested more in large-cap stocks for now.

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