ITC, HDFC Bank among top 6 portfolio bets based on CAPE valuation method: ICICI Securities

Ben Graham in ‘The Intelligent Investor’ said "Don’t take a single year’s earnings seriously".

Well, 2020 is that year when earnings of companies might not make sense because of the outbreak of COVID-19 that has impacted businesses across sectors.

FY21 consensus earnings projections are neither sustainable nor provide confidence of accuracy and hence, lose analytical relevance in valuing stocks.

In the “The Intelligent Investor”, Benjamin Graham lays importance on the concept of using average earnings for long periods in the past (5 -10 years) to iron out the ups and downs of business cycle and the volatility induced by accrual accounting to assess sustainable earnings of stocks.

Nobel laureate, Robert Schiller, introduced a formal model based on similar concepts, as emphasized by Graham, called the Cyclically Adjusted PE Ratio (CAPE) which along with using average earnings of the past also emphasizes using real earnings rather than nominal earnings, ICICI Securities said in a report.

COVID-19 outbreak has induced a temporary demand and supply shock which makes it highly uncertain to forecast FY21 Nifty earnings (downgraded 24% so far).

The report further added that going by consensus forecasts, India’s economy and Nifty earnings could rebound in FY22 which implies FY21 estimates are not sustainable.

CAPE based on ‘average real earnings’ of the past five years for Nifty at 20x indicates marginally below-average valuations for the market.

The most attractive stocks within the Nifty based on a combination of – a) Stable or improving average 5-year real earnings trend, and b) CAPE below -1 S.D.

Based on the filters highlighted above, ICICI Securities recommends six stocks - ITC, HDFC Bank, Eicher Motors, NTPC, Sun Pharma, and L&T.

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