Don't increase your equity allocations

Amid the panic caused by COVID-19, crude wars and the YES Bank crisis, one thing is certain: Q4 (January — March 2020) will be worse than Q3 (October-December 2019). Corporate earnings will take a hit across the board. It’s safe to assume that Q1, 2020-21 will also be pretty bad.

Even if the pandemic is contained soon, it has already done enough damage to knock the global economy into a lower medium-term trajectory. The impact of China’s lockdown was felt across global manufacturing. Now, with the EU badly affected, cases in the US and other advance economies, and visa cancellations everywhere, global services will be impacted. Demand will surely be hit as well.

A few good quarters in the future may compensate for the lost manufacturing output. For example, fewer mobiles and cars are being manufactured this quarter. But, as and when demand rebounds, and the virus threat recedes, production may increase and make up for the current production cuts.

But quite a lot of the lost services activity will not be compensated. If someone has missed out on haircuts due to quarantine for example, he will not take multiple haircuts later! In the Indian context, given the vast army of day-labourers, there will be a lot of economic hardship for lower income groups, somewhat like there was during demonetisation.

The pandemic will also change the functioning of the global economy. MNCs will diversify supply chains to avoid being caught in a single-nation lockdown. Businesses will learn how to efficiently manage work-from-home paradigms. Travel, hospitality, entertainment, sports, conferencing, etc., will all take a hit along with labour-intensive industries like manufacturing, construction, and public transport. These changes will force investors to study new business models too.

Figuring out what valuations are reasonable will be hard in the volatile situation that will prevail until the post-COVID-19 economy settles down. The Nifty was trading at a price-to-earnings ratio (PE) of about 28.6 in late January 2020, when it hit an all-time high of 12,430. On last Thursday, it closed at 9,590, where the PE was 21.8 and on Friday, it hit a low of 8,550 before rebounding to just above 10,000. (The NSE calculates standalone earning per share (EPS) for the past four quarters, weighted by the market capitalisation).

The Q3, 2019-20 EPS growth was 7 per cent year-on-year for the Nifty. It’s reasonable to assume Q4 EPS growth will be even lower. The rush to safety has pulled down treasury yields to about 6 per cent as investors have moved into government paper.

Investors use PE, the PE to EPS growth ratio or PEG, and comparisons with available risk-free yields as valuation tools. At a PE of 23, the index still looks over-valued if we assume an EPS growth rate that’s around 7-8 per cent. The PEG would be roughly three – that is, thrice the “safe limit” of one. 

A treasury yield of 6 per cent is also roughly equivalent to the earnings yield of a PE of 17.  That’s well below current discount. If we assume a Q4 slowdown in earnings growth, the PE would rise, even if the Nifty held static at around current levels. The treasury yield could come down if the RBI cuts rates, and a yield of 5.5 per cent might justify a PE of 18-19.

Obviously, many individual companies are available a lot cheaper in valuation terms. So value investors will find decent picks at these index levels. But the index could fall a lot further. This crash is being compared to the 2008 financial crisis in terms of severity. The Nifty fell from a high of 6,357 in January 2008, to a low of 2,252 in October 2008. If we see a similar situation playing out in 2020, the Nifty could slide till the 6,000-zone. The index quickly recouped much of its losses, rising to 5,200 by December 2009.

History never repeats exactly. But there will eventually be rewards for patient investors. The valuations aren’t compelling yet. There’s a lack of clarity about the immediate future that makes it hard to recommend a buying spree. The post-COVID-19 world may be different in many ways.

Equity Investors need to follow a holding pattern. Continue systematic investment plans. If you fancy valuations of individual businesses, buy. But don’t increase your equity allocations yet. Better bargains may be available in the next few months.