The unravelling of the US subprime crisis has sparked off panic in India. The flight of $13 billion plus of the foreign institutional investors’ (FII) capital has led to the collapse of stock market prices. After a very long time, the value investor could contemplate buy-and-hold strategies.
Near the bottom of bear markets, broad buy signals are generated by several rules-of-thumb. Those check out positive. The first buy signal is that the earnings yield is higher than the yield from risk-free instruments.
The Nifty is trading at a 2007-08 price-earning (PE) ratio of 11.4 – this is equivalent to an earnings yield of about 8.8 per cent. In comparison, the 364-day T-bill was last auctioned at a cut-off yield of 7.4 per cent.
Second, the price-earnings growth (PEG) is reasonable if you trust revised consensus earnings estimates. Most corporate entities reckon that they will manage full-year earnings per share (EPS) growth of around 10-15 per cent. The average PEG is therefore at 1 or below it. Of course, the slowdown could lead to another downward revision of earnings estimates from all and sundry.
The third set of buy signals are price-book value ratio and the dividend yields. These are now at levels that are usually seen close to market bottoms. The Nifty’s price-book value (PBV) ratio is about 2.3 and dividends yields are above 2 per cent.
While passive index investing should be profitable in the long term, smart money will try to minimise exposure to the most vulnerable sectors. There could be a lot of pain left, especially in specific sectors. Until a new government is sworn in, both in India and in the US, real investor confidence will not return. By then, there could be further price declines, particularly during the horse-trading period, when accommodations are made (assuming the Lok Sabha elections result in another hung Parliament).
One obvious area of vulnerability is stocks with high FII exposures. The flush-out in those stocks should however be more or less complete by January. Another obvious area is banks –provisioning for both domestic non-performing assets (NPAs) and for mark-to-market (MTM) losses in overseas exposures is likely to continue rising.
A third obvious area is real estate – land prices are likely to drop through the next 12 months and that fear has already had an exaggerated effect on real estate stocks.
These are known risks and they have already been discounted to some extent by the markets. A downside still seems probable however. It may appear unlikely that there will be a systemic collapse. But it may just happen if a big real estate developer goes bust and that takes down a major bank or housing finance major, which has exposure to its projects.
Can you buy the Nifty while excluding stocks that fall into the above (overlapping) categories? Well, while real estate and banking/finance businesses can be avoided, you will have to take a call on the level of FII holdings that is safe. Pretty much every company in the F&O list has some level of firangi holdings. You can set a cut-off on the basis of December 2008 shareholding patterns if you wait that long.
There is another concern that has not really been ventilated yet. The debt burdens and forex exposures of companies that have tapped the FCCB market could explode through the next couple of financial years. This will depend on their respective stock prices when the time for redemption or conversion comes around. Many balance sheets will be stretched if conversion is not a possibility at that moment.
Far more noise has been made about derivatives exposure in forex contracts, but FCCB exposures could actually prove to be far more dangerous. The quantum of exposure is far more for one thing. The only way to assess this is on a case-by-case basis.
Many pivotals fall into one or more of the above categories of highly vulnerable. That reinforces concerns that the bear market could continue even if overall valuations now seem to be attractive.
If you can avoid stocks that have these vulnerabilities, whatever is left behind in the filtered set should be out-performers. A mechanical dividend-specific approach of picking up the highest yields could work. Several other methods could work. But you must be prepared to hold till end of 2009-10 at the very least.
