Markets this quarter and a game of dominoes

At a glance

Indian markets have just ended their best quarter in five years – Valuation metrics tell differing stories – Nifty P/E say “expensive” but P/B say “fairly priced” – History suggests the interplay between the two reveal prevailing themes of investor expectations – Current expectations count on a bunch of interconnected things going right – Overly optimistic short-term investors might be rudely shocked – “Watchfully optimistic” should be the theme for calm investors


After the frothy action in May, June 2014 saw some semblance of normality return even though the direction of the overall index remained the same, UP.  That didn’t take away from the best quarter the Indian markets have had in over five years. Which begs the question, is this too much too soon?

I’d expected to put up two graphs and be able to say “markets are expensive, tread carefully, thank you“. But it turned out to not be as simple as that.

In the ‘when to buy‘ post, I looked at three easily-available valuation metrics (Price to Earnings, Price to Book Value and Dividend Yield) that indicate how expensive or cheap the broad index is at a point in time,  relative to the past. I intend to revisit these metrics on a monthly basis to form a sense of where they are from a 15 year perspective.

June and some sanity returns

At 20.37 times earnings, Nifty is trading just below the 75th percentile of 20.7, meaning, over the last 15 years, 75% of the time, the Nifty has been cheaper than this level.

Simply put, the markets overall are starting to look expensive. But read on before selling every stock you own and locking yourself into your panic room.

What I missed in the earlier post was the discrepancy between P/E and P/B levels on the index. The 2nd chart shows that the Nifty is trading at 3.43 times book value, which is marginally lower than the median (50th percentile) value of 3.46, significantly below the 75th percentile value of 4.04.

According to the P/B metric, markets, while not inexpensive, are more or less fairly priced.

While long-term Nifty P/E suggests  markets are expensive, P/B suggests they are fairly priced and below historically high levels. What gives?

The only way to make any sense was to look at the relationship between P/E and P/B over time. Chart shows movement of P/E and P/B on a normalized scale where they both start at 100 on 1st Jan 1999.

What P/E and P/B ratios reveal about investor expectations

pe_versus_pb

Points to note from the above comparison:

  1. P/E and P/B have largely moved in sync over the long-term, with similar percentage changes. P/E and P/B stand at 75% and 65% higher respectively than they did 15 years ago
  2. The notable exception in their lock-step movement is the period from 2004 to the peak of the bull market in early 2008. During this time, increase in Price-to-Book value outpaced growth in Price-to-Earnings by a large margin. This expansion in P/B also of course pushed up the overall median P/B
  3. The credit crisis in the latter half of 2008 brought them back together in relative terms. Since 2009, they have moved similarly, however, this time P/E growth outpacing P/B growth, albeit by a smaller margin

Does this help explain current levels where Nifty P/E is close to 75th percentile while P/B is only around the 50th percentile? To some extent:

Consider what P/E and P/B mean. The former is a multiple of earnings the business generates while the latter is a multiple of the “liquidation value” of the business or the assets with which it generates those earnings. “Book” value of a business as a metric has several weakness: it can be significantly different from the “market” value, is more applicable to asset-intensive businesses and means little for service businesses etc, but since in the longitudinal sense, we’re interested in relative changes and not absolute values, it’s a valid metric in this discussion.

Another way to think of these metrics is that a rising P/E represents investor expectations of growth in earnings, while not necessarily focusing on the efficiency with which that growth is delivered. While a rising P/B means the expectation that the company will generate higher earnings by better utilizing its asset base, in other words, improving Return on Invested Capital (ROI).

While a company won’t see strong stock performance unless it manages asset utilization in addition to growth and profitability, there seem to be prevalent themes at any given time that impact how these two metrics move in tandem. The current theme seems to be an impending increase in demand across sectors that will supposedly, first improve capacity utilization and bring improvement in efficiency and productivity thus bringing immediate upticks in earnings followed by capacity expansion heralding a 2nd phase of earnings upgrades.

The bottomline

dominos-fallingThink of an elaborate system of dominoes in place, with the first piece signifying a change in investor sentiment arising out of a change in political regime followed by an increase in demand and so on until the final piece signifying favourable returns in the short-term (12 months).

If the expected increase in demand shows up in company results and if consumer inflation shows a downward trend (somehow we seem to be attuned to relative values much more than absolutes), interest rates could then decline. Only then would the expected investments in capacity expansion actually happen providing potential for further expansion in corporate earnings and therefore market levels. All this based on the assumption that the credit-fuelled US markets don’t implode, sucking liquidity out of all markets, deserving or undeserving.

The risk is that markets have already priced in the expected increase in demand and then some. Those expecting triple-digit returns by straight-lining returns from the last couple of months might be in for some surprises, not all pleasant.

The Calm Investor can afford to stay watchfully optimistic and stay invested without making additional commitments, especially to the “darling” sectors of the moment, i.e. capital goods, consumer durables, power. Stay open to accumulating (not bulk buying) the good companies from the out-of-favour sectors like pharma and IT.

 

 

 

 

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