At a glance
- While predicting market performance is nearly impossible, there are lessons to be learnt from looking at past performance
- We take the predictive power of three popular valuation metrics; Price-to-Earnings, Price-to-Book and Dividend Yield
- P/E as a valuation metric performs better than P/B and yield as a lead indicator of annual returns
- As of early Jan 2015, the Nifty is trading at 21.2x earnings, more expensive than 80% of all trading days in the last 16 years
- Higher the P/E at the time of purchase, lower the returns achieved for the Nifty
- Current P/E levels indicate marginally negative returns for the next year
The four most dangerous words in investing are: this time it’s different – John Templeton
History suggests, those who assume that good times or bad, will continue to persist indefinitely, typically “get schooled” by Mr. Market. Predictions about market levels and stock prices, like Niels Bohr said, are very difficult, especially about the future. But neglecting to atleast try to understand, what transpired in the past, is like packing for a vacation destination, while ignoring the weather report.
My last post of 2014, summarized the buoyant year for Indian markets in three charts. In another earlier post: ‘How to prepare for a market correction‘, I wrote how markets being up 40% YTD till November 2014, made the calm investor slightly uneasy. To an extent, that is the lot of the value investor, who’s most at ease during widespread doubts about the viability of equities as an investment avenue.
So, while investors (and companies) wait for the promised slew of reforms and return of confidence to boost corporate performance, should we keep buying Indian equities, taking the turnaround for granted, or risk missing out on the big bull run by being cautious and sitting it out for a while?
Some analysis of historic data might help. I tracked returns offered by the Nifty and CNX 500 over 15 years superimposed on how expensive or cheap the market was as defined by three common valuation metrics: Price-to-Book, Dividend Yield and Price-to-Earnings.
Finding #1: Nifty more expensive now than 80% of the time
In a previous post, I mentioned why it doesn’t make sense to look at absolute index values (since they are bound to go up as underlying companies grow). A normalized valuation metric like Price-to-Earnings provides a view on how (in)expensive the market is compared to historical trends. Chart above shows that as of Jan 2015, the NIFTY is trading at 21.2x earnings, making it more expensive than 80% of the time in the last 16 years.
Finding #2: Higher the P/E at purchase, lower the return
Since P/E represents the number of years of current earnings you are prepared to pay for a stock, a higher P/E represents higher expectations and optimism about where the earnings are likely to go. However, historically, the more optimistic a purchase, the higher the disappointment. Therefore, buying the index when trading at 13x earnings on average has given 60%+ returns in a year, while paying more than 23x earnings has typically resulted in erosion of 25% of your capital.
Finding #3: Price-to-Earnings a better predictor of returns
Running a regression on the 1 year returns against current values of P/E, P/B and Dividend Yield tells us the strength of the relationship between these three measures and the returns. The closer the R-square is to 1, the stronger the relationship. (Here’s a quick primer on R-squared)
- At the index level Price-to-Book (Ratio of stock price to Book value of assets) has a weak link with expected returns and should be ignored
- Both Dividend Yield (dividends earned as a percentage of the stock price) and Price-to-Earnings (Ratio of stock price to Earnings per share) show decent (note that they are nowhere near perfect) ability to predict the returns 1 year into the future
Finding #4: Current earnings unlikely to sustain returns
Charts compares actual 1 year return against predicted return based on Price-to-Earnings (P/E). Meaning plugging the current P/E predicts what the return will be 1 year in the future
- The predictor is far from perfect (no predictor can possibly be), but the red line broadly tracks the blue for both the Nifty and the CNX 500 indices over a 16 year period which is commendable
- Currently, both the benchmark NIFTY and the broader-based CNX500 project negative returns for the next year (Jan 2015-16), -1% and -10% respectively.
Therefore, for the calm investor, it will be vital to identify those stocks that currently trade at reasonable prices for quality and sustainable earnings.