At present, equities seem marginally better than debt but not terribly exciting
The fourth quarter results of 2009-10 have confirmed several trends visible in Q3. Earnings continued to grow quickly year-on-year but less quickly than in Q3. Raw material input costs rose as commodity markets rebounded through January-March 2010. Inflation also caused upwards pressure in rates.
Operating margins were on the flat side. The gains were due to top-line volume expansions. A BS analysis of 268 companies including most of the Nifty population indicates that Q4 OPM grew 1.04 per cent compared to Q3 OPM growth of 5.2 per cent. Sales grew 33.6 per cent in Q4, compared to 11.7 per cent in Q3. That comfortably outpaces inflation. If Reliance is included in the sample, the numbers are skewed higher unrealistically because RIL initiated full operations in KGD6 in the last fiscal.
Most analysts have upgraded earnings expectations across the board for 2010-11. The Nifty full-year earnings for 2009-10 (weighted by the respective market capitalisation of companies) have seen a rise of about 12-13 per cent so far. This might get a little better but it's a reasonable benchmark for judgements.
We are in the middle of a global correction triggered by the crisis in Greece. That has the potential to get worse if the Euro 110 bn bailout doesn't work and panic infects markets. Plus, there's political uncertainty in UK, which is heading for a coalition. So there could be a significant price correction.
If such a correction occurs without the real economy's growth prospects seriously affected, we'd have the best of possible worlds for an investor: prices drop while growth has an upside. Is that likely to happen? No definitive answers are possible, yet.
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How does the equity market measure up with respect to valuations? The Nifty has a current PE of about 21 at the 5,000 mark. It has a corresponding price-book value ratio of 3.6 and a dividend yield of just below 1 per cent (all weighted by market-cap). It has delivered YoY EPS growth of about 12.5 per cent and consensus expectations are 2010-11 will see EPS growth of 20-25 per cent.
Nominal interest rates are rising but probably negative. The benchmark 2022, 8.2 per cent GoI paper is trading at a yield of 7.9 per cent while the last T-bill auctions saw the 364-Day bill at cut-off yields of just above 5 per cent. Given that March 2010 WPI was up about 9.9 per cent YoY, the current debt yields appear inadequate.
While inflation and rising rates are never pleasant, buying equity during periods of negative real rates is usually profitable. On balance, the interest rate situation seems to favour equity. Debt funds could give negative returns for a while as rates continue to rise.
Both from the value investor perspective as well as that of the growth investor, the current Nifty valuations are just acceptable. On a PEG basis, if we accept next year's EPS growth projections, the market is fairly valued or possibly, a buy, if you're on the optimistic side. If we look at the current T-Bill yields, the PE is again near fair-value at PE 20-21.
If we look at the historic performance of the Nifty over the past 10 years, it has been a strong buy only when three key ratios have been at certain levels. It is safest to buy when the PE is below 18, (ideally when the PE is below 16). It is also best to buy when the PBV is under 2.5 and the dividend yield above 1.5 per cent.
We are nowhere near these levels. Roughly speaking, assuming no major changes in EPS, dividend payouts or book values, it requires a correction till the 4,300 level before the PE is in the target zone. The market would have to drop far lower (below Nifty 3,500) for the PBV and dividend yield to hit desired levels.
A PE of 18 would require a downtrend of about 15 per cent from current levels. Since the market has already lost about 400 points from its 2010 highs, it would mean a 20 per cent correction overall. It would take major bad news to spook the market in such a fashion and bad news of such an order may mean that growth rates are genuinely affected.
In the absence of such bad news, equity seems marginally better than debt but not terribly exciting. PE, PBV and dividend yields are all mean-reverting ratios. That means the market is likely at some stage to come back to the desirable levels we mentioned above. Until then, don't go grossly overweight in the stock market.