Neither bull nor bear: The real question is can you create an undervalued portfolio?

Of course, rather than focusing on market movements, for a scientific investor, it is always better to focus on the economy. India's economic growth is one of the highest across any major economy. Even for 2025, investor optimism is closely related to market action and that is not too high. However, India's real GDP is expected to grow at 6.5 percent and nominal 10.1 percent. So, the factors defining a bear market are not present.

We are expected to have high growth rates and declining inflation and interest rates.

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The PE math

Now that we are not in a bear market, let us look at a more important factor which is the price-earnings (PE) ratio. The Nifty50 is at 20.8. Is this high or low?

In the past five year, the Nifty has come close to 20 PE twice — once around June 2022 and before that during the Covid bottom of March 2020. Both times it was short-lived. In the past 10 years, this has happened once more time, in February 2016. It is clear that Nifty PE ratio is close to its 10-year bottom.

Combine this with a lower expected inflation and lower expected interest rates and one can reasonably conclude that we are unlikely to see much lower levels of PE ratio for the benchmark index for long.

We are looking at an inverse PE ratio, or earnings yield, of 5 percent. Expected nominal GDP growth of 10 percent, which should be a conservative estimate for revenue growth in Nifty 50 companies over the long term. The investor would get some portion of the earnings yield as dividends and buybacks or as inorganic growth. The investor should get long-term growth in earnings similar to the nominal GDP growth rate and revenue growth rates.

Finally, the investor would get any re-rating or de-rating in the PE ratio. Given the past five and 10 years of the Nifty PE and also the future interest rate environment similar to the last 5-10 years, it is likely that the Nifty PE would provide a rerating back to 23 or 25 levels. This would add another 10 percent to 20 percent to the base returns of 2-3 percent yield + 10 percent growth.

If the rerating happens within three years, we are looking at an expected return of 2 percent (distributable earnings yield), 10 percent growth, and 3 percent to 6 percent from rerating. So, the range for the Nifty expected returns over the next three years or so would be 15 percent to 18 percent.

The risks are that the earnings growth doesn’t match the nominal GDP growth or interest rates move higher, thus resulting in no re-rating or even a de-rating. This would, however, require very slow growth and high inflation, of which there is no strong evidence.

Thus, in our opinion, there is an upward bias in the Nifty for the mid term.

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A diversified portfolio

Now coming to the more important question for a scientific investor. Is it possible to create a bottom-up, undervalued, diversified portfolio of 20-30 stocks from different industries? The answer is yes. It is possible to create a flexicap portfolio of more than 25 companies with a PE ratio of 11-13. It would have nearly 35 percent largecaps, 24 percent midcaps and 41 percent smallcaps. One could also create a largecap portfolio of around 20 stocks with a PE ratio of 11-13. Similarly, reasonably diversified midcap and smallcap portfolios with a PE ratio of 13-15 is possible.

These portfolios are likely to deliver much higher returns compared to the Nifty, given that their earnings yields are higher and thus, the chances and quantum of rerating are higher. Many of these companies are also likely to have much higher growth rates compared to the nominal GDP.

Since it is possible to create bottom-up undervalued portfolios across different market caps, the scientific investor with a long-term investment horizon would focus on rebalancing into the portfolio of high growth, high yield companies with a high likelihood of rerating. He or she would make sure that there is sufficient diversification across industries and growth vectors so that the risk of a particular industry facing challenges doesn’t hit the growth in the whole portfolio.

Let us conclude with a timely quote from Warren Buffett:

“Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down.”

The writer is CEO & Chief Investment Strategist OmniScience Capital.

Disclaimer: The views expressed by experts on Moneycontrol are their own and not those of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.