Markets have had a run up of about 20% this year and there is a sense of bonhomie. Animal spirits have returned to the market. I don’t mean to be a spoil sport, but this is the time to exercise caution.
Here is why:
Current P/E for NIFTY is close to 21 and this year there are a lot of stocks have seen a significant run up. But this also means finding the right opportunities for value investors is going to be that much tougher.
Let’s look at some fundamentals: Returns from stocks come from 3 sources.
- Dividend, which is the most tangible component. Dividend yield (dividend divided by the price of the stock), has always been modest in India for most stocks. With the recent run up in prices dividend yields can be expected to be a bit lower, esp for the investors who are acquiring the stocks now.
- Earnings increase: Business value is typically expressed as the number of times the current profits the firm is generating (P/E ratio). As the earnings go up, the prices are expected to increase (assuming the P/E ratio remains constant). The current P/E ratios are already factoring in a decent growth in earnings and the number of companies that will exceed this will be limited.
- Expansion in valuation: This means that the P/E ratios going up as the new investors are ready to pay higher multiples for the same business (usually they are assuming a greater growth rate in the future). Recent run up in prices for the most part have been without a corresponding increase in the earnings, so the P/E ratios have already expanded and the scope for further expansion may be limited.
What is going well:
Businesses in India seem to have a significant resilience and are able to generate growth irrespective of the government and this trend can be reasonably expected to continue. A good government will definitely create a more conducive environment and enable more rapid growth.
Need for caution:
Valuations of the many companies are fairly high and an expectation of good returns may be a bit optimistic. There are stocks that have a fair amount of opportunity for upside for the investor but finding them will be a tougher than what it was a few months ago.
The music may have just started but I believe only the cautious will be in the best position to enjoy “Achhe din”.