Margins of safety

SMARTSHARE

Benjamin Graham once said the most dangerous statement an investor can make is "This time it's different". Indians have been hearing this on and off since 1991. Noises to this effect have become increasingly strident in the last 15 months.

The logic in 1991-92 was that the economy was freed from stifling policies. That was true. GDP growth during the 1990s was only a bit higher than in the 1980s. But it was more sustainable and brought far more tangible benefits.

But from the investors' viewpoint, returns through 1992-1999 were poor. The Sensex hit a high of 4,500 in April 1992 and wandered between 2,500-4,500 over the next eight years without managing to maintain values above 4,500.

In 1999-2000, we learnt it was different because the high-growth IT sector and the ICE stocks would bootstrap everything up. IT did pull Sensex values over 6,000 by February 2000 but it took five more years for 6,000 to be consistently exceeded.

Through 2004-2005, we've heard that infrastructure improvements, high investments etc, will raise average GDP growth. This is likely to be true. GDP growth seems to have hit minimum values of 6.5 per cent, which is far better than during 1980-2000.

But the Sensex could meander between say, 6,000-9,000 from 2005-2010. GDP growth is merely one of many requirements for high equity returns and it's not the most important. Two other crucial requirements are low (preferably dropping) real interest rates and a rising share of corporate profits in GDP.

The first requirement has been met and it's likely that real rates will stay low because inflation is outpacing rate hikes. The second also has been met in the past 10 quarters. The corporate sector is growing quicker than the overall economy "" thus presenting opportunities for investors to buy small chunks of growing businesses.

There is a fourth requirement for high returns. This is sustainable valuations. If valuations are high, all other factors count for naught. Valuations usually revert to the long-term mean.

The most reliable long-term measure of equity valuation is market value to net worth, which translates into book value per share at micro level. Net worth fluctuates less than earnings and rising net worth is thus a better ratio denominator.

On this count, Indian equity is very stretched. Sensex PE ratios are averaging around 18, which is acceptable with current EPS growth. But the Sensex PBV is at 4.2, which is very high.

At the peak of the 2000 bull-market, PE was much higher at 24 but the PBV ratio was below 4. Near market bottoms, the Sensex PBV ratio tends to be just about 2 and since BV grows slowly, we have a downside risk of almost 50 per cent at this instant.

More frustratingly, less than 5-6 of the 100-odd companies in the key segment cleared for derivatives trading are anywhere near a PBV of 1. This leaves little margin to create a safe portfolio of individual stocks. The high PBV ratios (among other things) make me extremely doubtful that passive broad investment will produce extraordinary returns.

What makes picks even more difficult is the lack of stocks with low PBV and high EPS growth "" the two appear to be mutually exclusive at the moment!

One of the few is Tata Steel, which trades at around 2.2 times book-value and has acceptable EPS growth. It's a cyclical and steel prices will fall through the next 12 months by all accounts. But there is a margin of fiscal safety.