Moneycontrol
Apr 26, 2017 04:39 PM IST | Source: Moneycontrol.com

Market looks overvalued and it’s nearly May: Should we sell and go away?

Nifty 50 seems to be moving towards its peak PE ratio. But Nifty 500 PE ratio surely seems to be indicating that it is bubble time and a new peak has been reached!

Market looks overvalued and it’s nearly May: Should we sell and go away?

Vikas V Gupta

The markets have been running up from the beginning of 2017. Nifty 50 is up by nearly 11.5 percent and Nifty 500 is up by 15 percent from Jan 2017 opening. Most people think the market is overvalued. It definitely looks so if one looks at the PE ratio.

Nifty 50 PE ratio currently (21 Apr 2017) stands at 23. Now, that definitely looks expensive. But wait till you look at the PE ratio of Nifty 500. Nifty 500 PE ratio is currently at 27!

Now let us look at the PE ratio for Nifty 50 and Nifty 500 on Jan 2008 at the peak. Nifty 50 was at a PE ratio of 28 and Nifty 500 was at a PE ratio of 27.

Nifty 50 seems to be moving towards its peak PE ratio. But Nifty 500 PE ratio surely seems to be indicating that it is bubble time and a new peak has been reached!

Should one sell in May and go away?

Wait a minute. Why don’t we look a little deeper? Let us also look at the price to book ratio (PB). Nifty 50 PB is at 3.48 and Nifty 500 PB is at 3.27.

In Jan 2008, Nifty 50 PB was at 6.55 and Nifty 500 PB was at 6.32. Now it looks like we are a long way off from the bubble peak?

When was Nifty 50 PB similar to the current PB of 3.48? In May 2004, Nifty 50 was at a similar PB of 3.48. In June 2005, Nifty 500 was at a similar PB of 3.27.

Is it time to panic and sell or be rational and invest? Which ratio to trust?

While no true value investor would recommend deciding on investing or selling based on the market level valuation ratios, most people do try to form judgements about investing based on those. But the clear dichotomy between the two valuation multiples clearly shows that unusual is going on and it is not correct to decide based on such simple criteria. In fact, most dynamic allocators have probably been out of the equities or underweight equities for quite some time.

Price to earnings ratio definitely seems to say that the market has moved way ahead of earnings growth. Based on this many fund managers too seem to be saying that it looks like a bubble. But a look at the PB ratio clearly revealed that while the earnings might yet not have arrived, there are ample assets to back the prices.

So what is going on?

The answer lies in capacity utilization. Currently, the assets are still underutilized, resulting in lower profit margins and hence low ROEs. Current ROEs are still around 14 to 15% as opposed to a long run average of about 20%. As the economy grows, demand increases and assets start getting utilized fully, the ROEs start going towards their long-run normal of 20% and from there to their peak values of about 25% at the peak of the next economic cycle.

The earnings are likely to accelerate when the capacity utilization goes higher and hence the markets start looking cheaper not only on the PB ratio basis but also on the PE ratio basis. Of course, the correct way to decide to invest or not should be based on whether you can find 20 to 25 high quality stocks selling at a discount to intrinsic value through bottom-up stock picking. But the valuation indicators of the markets seem to be saying we are very far off from the next bubble.

While the market maybe just starting to gather steam as indicated by the price to book ratio, it is time to take a pause for most investors and review their portfolios. Investors who are directly investing in equities should look carefully at the fundamentals of their holdings. Companies with weak balance sheets should be removed from the portfolio unless one has a very strong reason to keep them and understands the risks. Similarly, companies with losses should also be looked at very carefully and if one does not have a very strong reason to believe that a turnaround has happened, one should remove these as well. Finally, one should look at the PE ratios and PB ratios of the portfolio companies. If they are all high PE ratio companies and also the PB looks very high then one should consider exiting these and finding new companies as mentioned above.

Similarly, the investors investing through a professional fund management service, such as, separate accounts advised by investment advisors or PMS managers or in pooled vehicles such as mutual funds or AIFs, should also review their portfolios. If you are in sector funds then review fundamentals of that sectors, such as, earnings growth, debt to equity ratios and valuation ratios, such as, PE and PB. If the quality of the sector is high then one can consider exiting if the PE ratios are too high to justify; especially take this seriously if the sector is of low quality and has already run up a lot on speculations of future growth.

Similarly, for the midcap and smallcap funds, be extra cautious and make sure that the PE and PB ratios of the companies in the fund’s portfolio are not too high. If they are, exit and find a more conservative fund or separate account portfolios. One can possibly consider moving from midcaps to largecap funds or separate account portfolios as these might be more undervalued. But always make sure that the portfolio of whichever fund one is considering for buying is not already overvalued.

The writer is CEO & CIO of OmniScience Capital.
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