Despite the earnings contraction, the margin of safety is in the equity investor’s favour.
Cynics say that equity analysts never make “sell” recommendations. Although like most generalisations this is an exaggeration, it is also broadly true. There are a variety of reasons for the reluctance to write “sell” on a company report.
One reason is likely loss of access to the target company’s management after making a sell recommendation. Another is the fact that the client who is being advised to sell has usually bought the same stock on the same advisory’s recommendation. So a “sell” is often seen as an implicit admission of error.
A third factor is that if the “sell” is wrong, the client will never let the advisory forget it. For some reason rooted in behavioural science, investors are more forgiving about wrong buy recos than about wrong sells.
“Hold” is equivalent to “sell” in many financial advisories. If you think about it, a hold is almost redundant as a recommendation. After all, a stock is worth holding only when it is likely to generate respectable future returns. If that is the analyst’s opinion, why not give the stock a wholehearted buy reco?
Even when analysts are honest enough to offer sells, they tend to prefer euphemisms such as “avoid” or “reduce”. Rare as they may be, the timing of sells is also often wrong. The sell recos tend to come close to the bottom of bear markets. It is almost unheard of for a sell reco to be made until a stock is one-third down from its peak or even more.
There could be many reasons for mistiming. One is the fact that things need to get really bad before financial service providers are willing to recommend sells. But the key factor for mistiming is probably that stock prices are a leading indicator. Fundamental analysis suggests selling when earnings visibility is poor through the next financial year or beyond. By the time this earnings breakdown becomes obvious, falling prices may have already factored in a large proportion of the likely downside.
A single “sell” recommendation doesn’t make for a bear market bottom. But a market where analysts are putting “sell” (or reduce or avoid) on many leaders across many industry segments is likely to be a market where prices are close to the bottom.
There has been a spate of sell recos across most sectors in the past couple of months, ever since the Q2 results came through. Almost every Nifty major from Infosys to Reliance to Hind Unilever to Tata Steel to L&T to ICICI has seen a sell reco placed by some advisory or the other. Coupled with that, there have been several advisories from different houses, suggesting that investors cut back total equity exposure and change their asset allocation patterns accordingly.
It is undoubtedly true that earnings across most sectors are likely to be flat or declining through much of 2009-10 as well as through the second half of 2008-09. However, the stock market has already dropped over 50 per cent in the past 11 months.
Share prices may drop some more during the election period – that is extremely likely. It is also likely that share prices will not see significant recovery through much of 2009 and maybe 2010. To my mind, rather than waiting to try and catch absolute bottoms, investors should utilise the coming 12 months as an extended buying opportunity
In terms of asset allocation, anybody with a three-year perspective should be increasing equity exposure right now. Few assets promise positive returns in 2009. Apart from the classic counter-cyclical, gold, most asset classes are deep in slowdown. It is difficult to conceive how debt funds, real estate and non-precious metals could rise without a corresponding bounce across the equity market.
In the last auction, the cut-off yields for the 364 T-Bill dropped to 6.3 per cent. Inflation is down, crude oil prices are down. In valuation terms, at a T-Bill yield of 6.3, the market could sustain a PE of 15-16. The Nifty is trading at a PE of 12.
Despite the chance of earnings contractions, the margin of safety is in the equity investors’ favour. The earnings weakness is due to lack of demand. Until demand rises, nothing is likely to generate big returns. Once demand is apparent again, equity is liable to outperform every other asset.
