Indices make you gravitate away from the fundamentals, Feroze Azeez, deputy CEP of Anand Rathi Wealth, said in a pre-Budget interaction with Moneycontrol.
Azeez was responding to a question whether stock prices are factoring in an implied growth that is highly optimistic. Moneycontrol pulled out reverse DCF data from Bloomberg that showed that the prices of more than 250 companies on BSE 500 suggest a 15-20 percent implied growth to eternity when nobody is expecting the nominal GDP growth to be more than 11-12 percent.
The numbers suggested that, for a good part of the market, the projection of nominal GDP growth and more have been factored into the stock prices.
Azeez agreed that implied growth is a "beautiful way" to see if the price of the stock is fair or not and added implied growth of 20-25 percent of large number of businesses is definitely expensive. Bloomberg data showed that the implied growth of 138 companies was 20-30 percent.
He then went on to explain how index-led investing could be causing this distortion.
Azeez said, "Unfortunately or fortunately, market is both valuation and how many people wish to own it." He cited the example of crypto currency which has zero intrinsic value but which derives its value from demand and supply.
A similar phenomena was playing out with stocks of large companies. Azeez said that chairpersons of companies that trade at 70 PE would say the expected growth is not more than 10 percentage but the implied growth would be 25-30 percent for years and that's because a lot of the freefloat is "gobbled up by the indices".
"If you look at the top 10 weights of Nifty, if EPFO invests Rs 2 lakh crore, you'll be surprised at the proportion of this that is going into the top 5 weights... Rs 70,000 crore and 80,000 crore needs to go to five stocks."
"So, if EPFO decides to put 15 percentage of its money, it is not going to apply rationality, fundamentals or DCF to understand if the top five weights need NIFTY allocation or not... indices make you gravitate out of the fundamentals," he said.
"That's why US market's top stocks are obscenely valued, not because the implied growth or valuation of the top stocks are achievable but because a large potion of the market, the index funds, are ignoring fundamentals," he said, adding, "as we move towards index fund investing we have to keep demand and supply and implied free float in mind."
Azeez said that they track implied free float extensively. He said, "Most of the free float is gobbled up by index funds which is as good as promoters because they are not going to bring it back to the market."
Azeez said that he believes that there is still some steam left in the liquidity rally in small cap space and therefore they still have around 20 percent exposure to the sector. He said that they will bring this exposure down to 5-10 percent, when they spot a reversal in this trend.
The signal for the reversal would be 15 to 20 days of continuous outflow from domestic small-cap funds.
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