Samit Vartak is an instructor at Asian Investing Summit 2017.

To start with, let me admit that even though I have done professional business valuation for many years, valuation in the stock market is a very different ball game. Here it entails some science, but a whole lot of art and when you talk of art, it involves a lot of subjectivity and with that a wide range of possibilities. So let me provide my “subjective” views on current valuations with support of few factual data points. Again to repeat, the views I had presented in October 2015 and January 2016 newsletters are still applicable as nothing significant has changed since then other than the increased uncertainty about the near term. Please do visit the ‘Newsletters and Presentations’ section of our website in case you are interested in reading those or you want to read the latest valuation study (see Appendix II at the end of this letter for a summary) released in November 2016.

Valuation Multiples Have Expanded in the Last Three Years without Earnings Support

If we analyze valuation levels since the peak of previous economic cycle in 2008, the rise in multiples started from the last part of 2013. During 2009 to 2013, valuations were reasonable in most of the sectors. Few anecdotal evidences are in NBFC sectors where many high quality companies were available at trailing P/B multiples of below 2x. If you compare now, those multiples have moved upwards of 3x and many above 4x. Similarly if you look at some of the branded building materials/commodities or quality auto ancillaries or specialty chemicals with ROE/ROCE > 20%, many were available at trailing PEx of at or below 20x. Now most of them are trading at multiples upwards of 30x. I can talk about many such sectors where in reality the growth has significantly gone down over the last 3 years but the multiples have expanded by 20% to well above 200%.

Let me substantiate the above with some statistics and evaluate how the entire market has done over the 3+ year period since PM Modi was selected the BJP candidate in September 2013. Even though I am picking just one starting point, valuations were similar or more attractive during most of the 2009 – 2013 period. If I were to analyze the performance (Aug 30, 2013 to Dec 16, 2016) of the roughly 1700 daily traded companies and rank them by market capitalization as of August 30, 2013 the picture looks as below. I have excluded the banks given that some of them have reported huge losses and they tend to skew the valuations.

As you can see, the returns have been almost entirely because of PEx expansion and that is also inversely proportionate to the size of the companies. Worse is that the earnings growth has also been inversely proportionate to the returns. Simple average returns are stellar for small cap companies. If you had invested equally in the small cap companies beyond the top 500, you would have returned 356% (i.e. multiplied your investments by 4.56x), whereas if you had invested equally in the top 100 companies, the returns would have been only 73%.

Last 40 months have rewarded one in proportion to the risk he/she has taken and very few have lost money given the broad based nature of stock returns. Money follows returns and domestic money has followed the non-large cap stocks. Many domestic investors are first time investors in the stock market as returns from fixed deposits, real estate and gold have fallen and equity investment has caught the fancy. Many fund managers have been claiming that they have beaten the indices and though it’s factually true, it hides one big parameter. “How much was the risk taken to get those returns”? In good times these facts are ignored by the investors and undue credit is taken by the fund manager.

Risks to Current Valuation Levels

There are two key factors for stock values viz. earnings and PEx. Risk comes from either of the two contracting. Earnings contraction can occur due to topline de-growth or margin contraction. When margins reach peak levels during economic boom the risk of contraction increases from those elevated levels. Similarly PEx contraction risk increases the further it moves above the averages. Case in point are two extreme instances, first in Jan ’08 when PEx as well as margins were at historical highs and second in Mar ’03 when both were at near historical lows. Accordingly risks were the highest in Jan’08 and lowest in Mar ’03.

As you can see in the above graph, currently the PEx is closer to the highs, but the margins are closer to the lows. Hence the risks are balanced given that possibility of PEx contraction can be counter balanced by either margin expansion or topline growth or both. We had seen the margins expanding over the last year (reaching 5.4% from trough of 4.6% reached in FY15) and gaining momentum in the first two quarters of FY17, but the currency replacement action has broken that momentum and has in fact increased the probability of margin contraction. Margins are vulnerable to increase in commodity prices (industrial metals, agriculture and energy) as well as operating deleverage from possible drop in capacity utilization.

Rise in Uncertainty

I believe that cash replacement is just the beginning of crackdown on unaccounted income/cash and many more steps would be needed to seriously reform the corrupt system. This backdrop and changing global scenario has increased the uncertainty for the markets. We need to closely watch for upcoming headwinds such as:

  • Increased focus on tax compliance would mean tax avoiding informal sector (accounting for 75% of employment in India) to shrink resulting in widespread job losses before the economy evolves a new ecosystem. Only fraction of these jobs would be absorbed by the formal sector.
  • In a weak demand environment, commodity prices (20-100% increase over last year in industrial metals and rubber) have jumped and in this environment the ability of companies to pass on the cost increase is limited. Low commodity prices had helped companies improve gross margins in the recent few quarters. There is risk of this benefit reversing.
  • In an evolving environment, companies would postpone their investment plans thereby slowing job growth. Capacity utilization has been near historical lows at around 70% and this had impacted investment cycle even before the recent disruption. Reduced money supply generally has negative multiplier effect on the growth.
  • Government seems to be serious in dealing with tax evaders and cash hoarders. Assets such as properties and gold were the hiding places for such wealth. With many having to pay significant taxes on hoarded cash and at the same time physical assets like properties loosing value, wealth of many would be destructed. This along with many having to face tax scrutiny may have negative wealth effect thereby impacting spending for some time.
  • GST roll out is also potentially disruptive in the initial phase. There will be de-stocking of the channel in many sectors where taxes are expected to drop. This will happen just before the implementation of GST and it may take time for many smaller companies to be ready with the back end needed to handle the new tax system, thereby delaying growth.
  • Globally, with new regime starting in the US there is huge uncertainty regarding trade policies that could disrupt global trade flow and force countries to evolve new models for growth.

Massive Opportunities Await in the Long Term

  • The incredible growth in cash component (30% CAGR vs. less than 14% CAGR in nominal GDP) during this century had inflationary effect on many hard assets such as land and property. Inflation also kept the interest rates elevated. Both these have acted as added cost burden on companies who want to invest thereby impacting capital expansion and employment growth.
    • With government’s intention to reform the cash economy, the hope is that land/property prices would come down significantly
    • GST roll out is expected to make India a uniform market without state border bottlenecks in terms of time and cost
    • Above two are the biggest reforms in India’s modern history and have the potential to make India extremely competitive in the global manufacturing chain and help create global scale businesses.
  • With transfer of wealth from informal to formal economy, government tax collections would significantly improve and if they allocate that capital efficiently (subsidy, infrastructure spend) India could transition into a much higher growth trajectory.
  • Formal and transparent business practices would incentivize foreign investments and boost capital expenditure thereby employment growth.

Conclusion on Valuation

Valuations in the non-large cap stocks are discounting a lot of hope. I believe that the uncertainties have increased over the past two months and resultantly the re-start of growth phase for corporates is pushed out. In such environment, there is risk of not only multiples but also earnings contracting. It is time to be extremely careful in picking the right businesses and absolutely not the time to overpay. We have to be open to the possibility that sometimes what’s good for the country and overall population may not necessarily be rewarding for the stock market. Historically we have seen best of market returns under worst of governments and vice versa.

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This post has been excerpted from a letter of SageOne Investment Advisors.

Read a related article by Samit Vartak.