Sensex and Nifty at record high: 5 stock mkt myths every investor must know

The concept of value investing, buying stocks trading below their intrinsic value, seems to be taking a backseat to predicting prices and using complex valuation methods to justify high stock prices.

The Indian stock market is on a roll with the Sensex and Nifty scaling fresh highs on Thursday. But with all this excitement, it's easy to get caught up in popular beliefs that aren't always true. Kotak Institutional Securities has released a note debunking some common stock market myths.

Myth 1: Strong economy equals strong stock growth (Not always!)

Some argue that strong economic growth guarantees high stock returns. However, history tells a different story. Even during periods of high GDP (Gross Domestic Product) growth, the Indian market has seen corrections (temporary dips). Remember, stock prices are more about future expectations than current economic conditions. While a strong economy is positive, it doesn't guarantee stock growth at all price points.

 

"In fact, India’s GDP growth has been in a tight band while market P/E has moved in a much wider band (linked to expectations about the future). In fact, forward returns of the market have inverse relationship with the price being paid (valuations). The correlation has weakened in the post-pandemic period though  due to expectations of high returns from equities at all price points among a section of the market (largely non-institutional investors)," said Sanjeev Prasad of Kotak Institutional Equities. 

Myth 2: Indian stocks are a bargain (Maybe Not Everywhere)

Investors often rely on the Nifty-50 index, a benchmark representing India's largest companies, to gauge the overall market valuation. However, this creates a misleading picture. While the Nifty-50's valuation might seem reasonable compared to historical data or current bond yields, a large portion of the broader market is experiencing significant price inflation. Imagine a supermarket where some items are on sale, while others are considerably marked up. Similarly, beyond the Nifty-50, many sectors and individual stocks might be trading at premium valuations. Careful analysis of individual companies and their true underlying value is crucial before investing.

" The Nifty-50 Index may be reasonably valued in the context of historical valuations and bond yields but most other parts of the market are trading at full-to-frothy valuations after a massive rerating in their multiples in the past 2-3 years. Even the Nifty-50 Index is a bit of a mirage. It is important to note (1) the growing contribution of ‘low’ P/E stocks to the Nifty-50 Index’s overall profits  and (2) derating in multiples of low P/E stocks (primarily BFSI), which have an increasing share of incremental profits of the Nifty-50 Index," said Prasad.

Myth 3: Stocks always outperform debt

A common argument used to attract retail investors to equities is the potential for higher returns compared to debt instruments like bonds, even after accounting for taxes. This argument, however, contains two crucial flaws:

Price Matters: Stock prices and their subsequent returns are inversely related. As stock prices rise, the potential future returns decrease. Therefore, buying expensive stocks could lead to lower returns than anticipated.

Risk and Reward: Stocks are inherently riskier investments compared to debt. This higher risk should be compensated for by the potential for higher returns – a risk premium. Simply comparing returns without considering the inherent risk associated with each asset class can be misleading.

"We have often heard the argument about higher post-tax return of equities versus debt as a reason for the strong participation of retail investors in equity markets. There are two obvious flaws with this argument—(1) it does not hold at all price points for equities; yields (returns) will be lower at higher prices and (2) equities have higher risk compared to debt and the difference in risk profile has to reflect in a certain risk premium for equities. Thus, it is important to compare risk-adjusted returns rather than returns only," said Prasad.

Myth 4 Earnings growth is guaranteed 

The assumption that Indian companies are destined for endless earnings growth can be a dangerous pitfall for investors. While several sectors are currently experiencing high profitability, these trends might not be sustainable. Past high-flying sectors have seen dramatic crashes due to various disruptions or changes in market dynamics. Investors should be cautious of relying solely on forecasts of future growth without considering potential risks and alternative scenarios.

"Investors believe that Indian equities are pre-destined to deliver strong earnings growth for a long period of time. We agree with the view but would not stretch this point (and assumptions). We note that most domestic-oriented sectors are currently enjoying elevated profitability, even as various disruptive forces have become stronger. Investors may want to remember (or forget) that several high-flying sectors have ‘crashed and burnt’ in the past including two of the current market favorites (electric utilities and real estate)," said the Kotak note.

Myth 5: Money flow predicts stock price 

Many investors believe that the amount of money flowing into the market (often referred to as "flows") is a key indicator of future stock prices. While investor sentiment can undoubtedly influence short-term price movements, it's crucial to understand cause and effect. Flows typically follow changes in expectations, not the other way around. Investors tend to buy when they are optimistic about future company performance and market conditions. Ultimately, the net amount of money flowing into the market at any given time is zero – someone buys what someone else sells.

" While previously the focus was excessively in decoding the mood of foreign investors, of late the same has turned toward deciphering the sentiment among retail investors. We do not have anything new to offer to these investors, except for reiterating that flows will follow expectations and market prices reflect change in expectations, not change in flows (the act of buying or selling follows a change in expectations)," said Anindya Bhowmik of Kotak Securities.

Focus on Value, Not Hype: A Call for Informed Investment Decisions

Kotak believes the ideal approach to stock picking involves understanding a company's core business and its potential for future success. This means analyzing how it makes money, its competitive edge, and its future growth prospects. Based on these factors, investors can estimate a company's true worth, or intrinsic value. The key is to buy stocks where the market price is much lower than this intrinsic value, essentially buying a good company at a discount. However, the market seems more focused on predicting short-term price movements using complex methods, often ignoring a company's true value. This approach prioritizes price forecasting over understanding the business, potentially leading investors down the wrong path.

Disclosure: Entities controlled by the Kotak family have a significant holding in Business Standard Pvt Ltd