Markets are up by about 20% over the last financial year and by about 10% from the beginning of the calendar year less than 3 months ago. There is a perception that the markets have run up significantly and are in bubble territory. Value investors view markets and investment decision-making from a highly sophisticated though simple framework: can a diversified portfolio of 20-25 stocks be created with a margin of safety?
The answer is yes. Our analysis of the nearly 700 stocks of market cap Rs1,000 crore and above shows that a diversified portfolio of stocks can be created with a margin of safety. In FY2007, India’s nominal GDP was Rs43 lakh crore; in FY2017, this was Rs152 lakh crore—a compounded annual growth rate (CAGR) of 13.5%. In FY2007, the market cap of Indian stock markets was Rs35 lakh crore. In FY2017, this was Rs120 lakh crore; a CAGR of 13%.
We can conclude that the markets have grown in tandem with the economy and fundamentals. As Warren Buffett says, growth in intrinsic value of companies is closely related to the growth in net worth.
In terms of growth in net worth of companies during the same time period, in FY2007, the net worth of Indian stock markets was Rs7.6 lakh crore. This went up to Rs35 lakh crore in FY2017—a CAGR of 16%.
The fundamentals of companies have grown faster than the markets and the economy. So far it doesn’t look like anything is seriously amiss.
The net worth growth of 16% seems in line, considering the tough times the economy went through post the financial crisis.
The price to earnings (P-E) ratio FY2007-end was 17.36 and price to book (P-B) ratio was 4.6. The P-E ratio looked benign. But the P-B ratio was probably indicating mild overvaluation.
Dividend yields also looked fine at 1.32%. The 10-year G-sec yield was 8%. At the end of FY2017, the P-E ratio is 23.77, and P-B ratio is 3.47. The latter looks benign, but the P-E looks alarming, indicating significant overvaluation. Dividend yields are 1.21%; and 10-year G-sec yield is 6.8%.
We have seen that the net worth growth of Indian companies has been strong at 16%. But the markets were pricing those assets at a mild overvaluation in FY2007 with P-B at 4.6, hence giving 13% returns. But now the situation is reversed, with assets probably at fair value at a P-B of 3.47.
The growth in net worth should be reflected in the growth in market prices. Then why a high P-E ratio of 23.77?
Return on equity (ROE) tells us that assets are severely underutilized. Currently, the ROE is 15%. The long-term average ROE is higher by one-third at 20% with peak ROEs going to 26%. As economic growth continues, the low ROE of 15% should continue adding to the net worth of companies.
The higher demand will continue utilizing the assets better and the P-E should start looking more and more benign.
The progression of ROE and P-B ratio should be tracked carefully. To create the portfolio of 20-25 stocks, follow the scientific alpha approach of: stable business models, safe balance sheets with low or no debt, and a value creating track record of profitable growth. And, only buy companies at a discount to intrinsic value, i.e., buy moats at a discount.
Vikas Gupta is chief executive officer and chief investment strategist, OmniScience Capital.