The Hindu Business Line : Risk, returns and disciplined investing

If earnings growth stays low over the next five years and the PE also declines, then annual returns would not be attractive. If the decline in PE were sharper, you may wish you had never invested in equities.

IT IS a sign of the times that Suzlon Energy's price to earnings multiple (PEM) has risen six times in less than 18 months. Citicorp and ChrysCapital bought into it at a PE of 5 in March 2004 and Suzlon is now demanding a PE of 30 from prospective investors in the initial public offer.

Given the record of IPOs in the past 12 months, Suzlon Energy's offer may indeed attract a rush of investors. Suzlon's valuation level is no exception. The price-to-earnings multiple of a set of 400 stocks, weighted by market capitalisation, is now at about 30. The PEMs certainly look forbidding and many analysts forthrightly say so.

The final message to investors is, however, not so forthright. Analysts, including from Business Line, do advocate buying into stocks even at these prices while, in the same breath, asking investors to be cautious. It is finally up to the investor to design his strategy in accordance with his needs.

Growth and value: Two kinds of investors would not mind buying into stocks at these prices. The first kind is the `growth' investor. Growth investors expect earnings growth to exceed the expectations factored into stock prices. He probably expects earnings growth to remain high at 15-20 per cent annually for over three years.

The other kind would be the low-return seeking investor. For such investors, equities as an asset class will always beat debt and inflation. Even if expected returns are between 7 and 8 per cent after tax they are good enough for these investors. They cherish the low volatility of equity returns when stocks are held for over five years. They expect the relative low-risk nature of long-term equity investing to remain unchanged.

Apart from the speculators, the greedy and the misguided, these are the only two sets of investors that are present in the market with large, fresh funds. Investors hunting for value have now been pushed to the periphery. Value investors may be churning their portfolio but they will not be introducing new money into the market. As long as demand from these two sets of genuine investors is sustained, stock prices will stay buoyant.

World of probabilities: For a number of retail investors, investing fresh money every month and staying invested in a diversified portfolio still appears an appropriate strategy.

This is because most would fall in the low-return seeking investor group. They do not need returns of 20 per cent. After-tax return of 8 per cent from equities would build a strong case for investing in equities.

Will they, however, get even this 8 per cent? For this, they would have to delve into the world of probabilities. If they assign a high degree of probability to earnings growth of 12-15 per cent over the next five years then their expected returns would still be 8-12 per cent.

If, however, they assign a high degree of probability to growth in earnings of 4-8 per cent, they might not get the expected eight per cent per annum.

What if you assign a high probability to 12 per cent earnings growth and earnings growth turns out to be low? That represents the risk involved in the investment.

Measuring risk: If the risk of low earnings growth does materialise, there would be a double-whammy waiting for investors. This is because, with lower earnings growth, the PEMs could also decline. The PEM, based on three-year average profits, has increased from 11.1 in September 2001 to 16.9 in September 2003 to 19.4 now. If earnings growth stays at 8 per cent per annum over the next five years and the PE also dips to 15 then annual returns would not exceed 2.5 per cent. If the PE declines to less than 15, then you will be wishing you never invested in equities.

Earnings growth of 8 per cent is, however, an unrealistic assumption.

If we assume a realistic earnings growth of 13 per cent (assuming a growth of eight per cent in the industrial and services sectors and an inflation of five per cent) of and a PEM of 15 five years from now then expected returns for the next five years rises to a relatively attractive 7.3 per cent per annum.

This will still beat returns from debt by an attractive margin. So, there is a case for equity; but investors should never lose sight of the possibility of lower earnings growth and an increase in risk perception of investors, which would reduce the PEMs and returns from equity.

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