Sunday, April 02, 2006

Reflections on Indian Stock Market Levels Revisited

John Galbraith once famously said:

"There are two classes of forecasters. Those who don’t know and those who don’t know they don’t know."

Claiming that I belong to the former class, I, nevertheless, wrote a blog on July 30, 2005, when the widely-tracked Nifty (Indian stock market index) had hit an all-time high of 2,312. Providing historical data pertaining to relative values over time, I concluded, by borrowing Mr. Buffett’s quote:

“Stocks are high, they look high, but they're not as high as they look.”

During the eight months that elapsed since I wrote that blog, Nifty rocketed upwards and on March 31, 2006, stood tall at 3,402.

That’s a rise of 47% in eight months.

The obvious question that I am being asked now is: “What do you feel now about where the Indian stock market is headed?”

Still believing that I belong to the former class of Galbraith’s forecasters, my answer is: I don’t know.

Not knowing what lies ahead does not have to result in paralysis, however. So let me go out on a limb and give my views on the current state of the Indian stock market, and their implications for investment policy.

The chart below traces Nifty’s P/E multiple over time. On March 30, 2006, Nifty’s P/E was 20.35. Although the P/E is much lower than the peak of 28 times observed in Feb 2000, it’s not very far from other previous peaks as can be seen from the chart.

Here is another chart which portrays an even bleaker picture (for bulls). This one traces Nifty’s Price-to-book value ratio over time.

On March 30, 2006 Nifty’s P/B stood at 5.17 which is an all-time high. The previous peak was in the tech bubble market of 1999-2000 when it hit a level of 5.07 in February 2000.

A simple look at the P/B ratio chart can easily lead one to conclude that Indian stock market levels are expensive, in comparison to the past. However, one must also see how well corporate India is doing in comparison to the past. The following table gives some clues:

All figures in the above table pertain to Nifty.

The table clearly shows that the rise in the P/B value is justified because corporate India is doing exceptionally well both on earnings growth and on return on equity. The important question is whether these trends are sustainable or will they reverse? If they reverse, for example, if return on equity falls to 20% level, P/B ratio will fall to perhaps 3 times. On the other hand, if earnings growth rate and return on equity continue to remain high, we can expect an even higher price-to-book value – perhaps 6 times.

The future, in other words, is uncertain.

Given this uncertainty, what is one to do? Here are some preliminary conclusions about investment policy going forward:

  1. Invest in companies that are significantly cheaper than the Nifty stocks.
  2. Identify stocks which are much more expensive than Nifty – for shorting. This will be necessary and desirable to protect the long positions in deep-value shares in the event of a market decline.
  3. Don’t leverage for straight equity investing (this was ok when markets collapsed in May 2004 – they have risen by 150% since then) but doing so in special situations is ok provided market risk is minimal.
  4. Allocate more capital towards special situations – probably 50% and keep the rest in deep-value shares.