Price and prudence

SMARTSHARE

The commonsense method of investing is to assess and understand a business before becoming part-owner. The rewards will come eventually while the risks will be mitigated by intimate understanding.

This is not the only approach that works. Keynes once compared successful investing to betting on beauty contests; correctly picking the girls (or stocks) that other people think beautiful (or valuable).

It pays to remember the similarity to a beauty contest during bull markets. Prices are driven by liquidity and prices are pushed well beyond the bounds of prudence before liquidity peaks near the top of a bull market. In the long-run, liquidity follows growth and free cash-flows. In the short-run, liquidity can chase any fad that catches the fancy.

Every valuation-based model suggests the market is near the upper limits of prudence. There are many businesses with sound balance-sheets, excellent track-records and good growth prospects. Very few are trading at reasonable valuations.

The top 500 universe is largely available at PE to Growth ratios of 1 or more. The average Nifty PE of 19 translates to an earnings yield of 5.2. With 364-day T-Bill yields at over 6.6 per cent, a PE of 14 or less would be nearer to fair value. Defensive ratios like the Nifty P-BV (over 4.8) are well above "safe" levels. Dividend yields are low at an average of 1.4 per cent for the Nifty.

One symptom of stretched valuations is apparent in the new trend of 3-year projections. Normally "buy/sell" recommendations are justified on the basis of the next fiscal's estimates.

Many current recommendations are being made on the basis of 2007-08 or 2008-09 earnings prospects. That, to my mind, means prices can no longer be justified by 2006-07 estimates.

However liquidity remains very strong. The FIIs bought Rs 47,397 crore in calendar 2005. They have bought Rs 14,092 crore in the first 10 weeks of 2006. Indian mutual funds have bought Rs 11, 700 crore since April 2005 and over Rs 1,200 crore in the past 10 sessions. Operator and day-trader liquidity is also high given overall record volumes. The high liquidity could drive stock prices well above fair-value.

If you want returns through the next phase of the run, you may have to compromise on prudence and chase the liquidity. There is little point in seeking decent valuations in isolation during this period. Low-valued industries such as banking, shipping and steel carry specific risks, which is exactly why they are low valued.

For fast returns, it may be worth studying the fads and stories driving this market with the aim of distinguishing fact from pie-in-the-sky. The stories which carry genuine growth prospects could offer a big payoff.

Construction and ancillaries like construction equipment could be one of those fads. The scenario is very fragmented with dozens of listed companies. But it's undeniably high-growth. There are huge risks but also drivers such as higher infrastructure spending, easier FDI norms, retail and housing booms.

"Construction" could turn into a catchword in the recent future in much the same fashion that "infotech" became a catchword in 1999.

Hindustan Construction and Nagarjuna Construction would be two beneficiaries if this happens. Both are mid-sized businesses with high growth rates and reasonable financials. There is a degree of safety in that neither has an outrageous PE ratio.