BS Number Wise: Taking stock of Indian markets' valuation premium

Professors Benjamin Graham and David Dodd, two of billionaire Warren Buffet’s gurus, noted in 1934 that stock market investors once required a company’s earnings yield to be higher than prevailing bond yields as stocks were considered riskier than bonds.

Investors banked on dividend income then. And this was broadly the equivalent of insisting that you earned more from your dividend than your fixed deposit, because share prices can fall.
 

This approach was already considered old-fashioned when they described it in their seminal work, Security Analysis. Inflation, interest rates, the tumult of the Great Depression, and a world war eventually established a new market paradigm. The earn­ings yield in the US changed from being twice the prevail­ing interest rate to being its equal in recent dec­a­des, noted a paper that looked at the relationship between 1871 and 2017.

India is different.

Data shows that bond yields here are significantly higher than the earn­ings yield. A larger gap indicates that the stock market is overvalued or it is trading at a premium. India’s yield gap has traditionally been large and rem­ains higher than many other emer­ging markets, as well as develop­ed ones like the US as seen in chart 1.

One factor that is argued in favour of a higher premium is India’s strong earnings growth. The trailing 12-month earnings per share of the Nifty 50 index has been at record levels. However, an analysis of data of corres­ponding indices for other countries shows several examples where earn­ings are at a similar record level. In fact, March quarter earnings were at or near their highest in at least 20 yea­rs for multiple countries (chart 2).

The 12-month trailing earnings per share grew at a slower pace than emerging market peers like Brazil, South Korea and South Africa bet­ween March 2020 and March 2022. But investors so far seem willing to pay more for India’s earnings (chart 3).

The economic shifts of the early 1900s changed the prevailing invest­ment outlook. People began to dep­end less on established companies with stable earnings and bet on those that had the potential to improve their earnings, noted authors Valeriy Zakamulin and John A Hunnes, from Norway’s University of Agder, in their 2020 study cited above and entitled, “Stock earnings and bond yields in the US 1871–2017: The story of a changing relationship”.

It also noted the shift away from requiring higher earnings yield on shares.

“The breakdown of the equilibrium relationship in 1932 is explained by the stock market crash in 1929 and the following severe depression that forced the Fed to start conduct­ing an expansionary monetary policy by lowering the short-term interest rate to nearly zero and substantially decreasing the long-term interest rate,” said the study.

Can another era of changing inf­l­ation and interest rate dynamics again alter investor perception? Would retail investors continue supporting mark­ets if performance is disappointing for years, as it was during the 1930s?

Food for thought as foreign port­fo­lio investors in India head for the exit.