To Dance with the Bulls or Bears?

On 1st April 2023, BSE Sensex was at 59106 and closed at 67572 on 20th July 2023. The corresponding figures for NSE Nifty 50 were 17398 and 19979. This translates into an appreciation of nearly 14.5% in less than four months. Well, as is their wont, the stock markets have come off since then. So, will the investors dance with bulls or bears? The answer to this dilemma will have to be found in hard data rather than the narratives that are constantly changing as per the trading compulsions of speculators.

Given that over the long term stock prices align with earnings, it would make sense to carefully assess the earnings trajectory for the listed companies going forward. Based on the results 0f 1505 companies that reported results for the first quarter (Q1) of Financial Year (FY) 2024 by 9th August, the Profits After Tax (PAT) have risen by a handsome 50% year on year, as PAT margins have expanded by 303 basis points to 10.6%. However, caution is warranted as revenue growth has moderated on low volume growth, casting doubts on profit sustainability. As per Bloomberg consensus, earnings per share (EPS) for Nifty for FY 24 is estimated at Rs 985, a 19% rise over Rs 824 recorded for FY 23. But more often than not, future predictions tend to be optimistic. For instance, Nifty EPS for FY23 was estimated (Bloomberg consensus) to grow at 15% to Rs 884. The actual came almost 7% lower at 8%.

A look at the trailing valuations as given by Price to Earnings (PE) multiples highlights the fickleness of the valuation perceptions in the short term. Since the market low on 28th March this year, the Nifty trailing 12 month PE has expanded from 20.5 times to almost 24.5 times by the end of July this year. This is at premium to long term averages (10 year average of 22.6 and 20 year average of 20.3). The valuations in the mid and small cap segments appear even more euphoric as can be seen from the chart alongside.

For those statistically inclined, an analysis of Nifty forward PE in relation to historical “central tendencies” and probabilities of outcomes might provide some useful clues. Nifty 50, trades at 19.9 times one year forward PE, which is at a 4% premium to 10 year average of 19.1%. Standard Deviation (SD) is a measure of dispersion of data from its mean. Measured by SD, Nifty 50 trades at 0.32 SD above 10 year mean. This would imply that there is a 68/95/99.7 per cent chance of data points falling within 1/2/3 SDs above or below the mean for a normal distribution. At 0.32 SD above mean, the current premium is not significant. But these facile conclusions hinge on the expected one year forward earnings growth of 16%. When compared to the CAGR of just 8% over 10 years, this expected earnings growth seems unduly optimistic.

Confronted by the above bewildering maze of facts, figures and conjectures, what should the playbook be for the investors? For one, investors could consider more granular data rather than blindly dance with bulls at the current elevated valuation levels. While there are signals that mid and smallcap segments are overheated, there are segments like IT where long term investors could do some bottom fishing. L&T Technology Services and Affle India which have seen sharp fall in PE multiples could be looked at as their niche business models still hold out promise. Also sectors like pharma and auto, though at a valuation premium to the Nifty do offer opportunities to the discerning investors, as these sectors are getting re-rated given favourable developments. Then there are stocks, which are a good distance away from their all time highs and still offer value or, credible growth story. Even at the prevailing high market levels, 157 stocks in the Nifty 500 basket are a good 25 to 50 percent away from their all time highs and another 87 are even farther away. Investors could hunt for value in this group. Some such stocks that come to mind are, Triveni Engineering, EID Parry, Coromandel, and GSFC in the sugar and Fertilizer sectors and in the infrastructure sector one could look at PNC Infratech, KNR Constructions and HEG. At this juncture many PSU banks still offer good value. Other stocks that look promising are KRBL, Amara Raja Batteries, Mahanagar Gas and Sun TV. For those with low risk appetite and long term outlook a systematic investment plan (SIP) in a broad based passive fund like Nifty 100 Index Fund could be a good alternative.

For incorrigible traders, options offer a better toolkit to at least reduce risk and better control loss. The use of options, however, would require a clear understanding of the underlying concepts before resorting to ‘put’ and ‘call’ options to set up direction neutral strategies like “straddle” and “strangle”. But except for the excitement it provides, empirical data indicate that most such strategies end up in zero sum games and more often than not result in loss except when used for hedging purposes as in, say, “cashless collars”. A better strategy is to harness only covered options, where the positions are covered either by cash or deliveries. While this involves shorting (writing) puts and calls and requires substantial outlay of funds upfront to meet margin obligations, it can generate decent recurring returns with controlled risk. But the real challenge is that, this strategy calls for exceptional discipline which is exceptionally rare!

There is an instructive anecdote of a charismatic preacher who was trying to figure out his way (before the advent of Google Maps!) to the nearby railway station. On the way he asks a playful young boy for directions to the station and the boy explained the route with all the twists and turns that the preacher had to negotiate to reach the station. The preacher was confused, so he pulled out the note book and asked the boy if he could provide the sketch of the route. The urchin boy found it easier to walk with the preacher and along the way he asked the preacher; “You look well nourished and well to do. What do you do for a living?” The preacher answered that he showed people the path to heaven. The boy stopped in his tracks gave the preacher a quizzical look and said “Hey Mister, you can’t find your way to the nearby railway station; how come you are able to show the path to heaven which we can’t even see?”

Well dear investor, eventually you will have to find your own path to financial Nirvana. But to achieve that, you have to acquire a modicum financial literacy and carefully ascertain your risk profile and goals that you need to achieve at various stages of your life. That will enable you to choose the right investment products and vehicles. It is worthwhile to remember that there is no law that you have to transact in the market at all times despite the plethora of tips and tunes that you are inundated with in the print, electronic and social media!