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Business News/ Money / Personal-finance/  Buying stocks at high PE can make sense
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Buying stocks at high PE can make sense

If a market is trading at a PE close to historical highs, it doesn't mean that all stocks are expensive

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To buy or not to buy? A decision made tougher by the fact that despite earnings growth lagging, at around 17 times forward price earnings (PE) multiple, benchmark equity indices are trading at or just above the 10-year average. In other words, markets are at fair value even though corporate earnings aren’t firing yet.

The PE multiple tells you how much investors are willing to pay per rupee of earnings. A low PE multiple indicates that you won’t be willing to pay a high price to own a stock. A higher value usually indicates that there is a willingness to pay a premium for a stock. However, a high PE or high valuation can also make you question if you might be paying too much.

This gets highlighted during times of slower overall economic growth. Is the stock really worth what you are paying per rupee of earnings given that earnings growth is lagging? We spoke to experts to understand when it makes sense to buy stocks with a high PE or at valuations that may seem too expensive.

Market PE, stock PE

Don’t confuse market PE with a stock PE. The market moving up or down or being cheap or expensive is with reference to an index that is used widely as a benchmark for funds and performance of portfolios.

In case of domestic equities, the S&P BSE Sensex and the CNX Nifty are the two indices whose movement is loosely tracked as the market. However, the former is a basket of 30 stocks and the latter is made up of 50 stocks. While they represent many of the high market capitalisation (market cap) companies, many industries and businesses aren’t captured.

Moreover, stocks in indices aren’t all of equal weight. While some could be trading at a high value, there will be others available at lower PE multiples. Neelesh Surana, chief investment officer-equity, Mirae Asset Global Investments (India) Pvt. Ltd, said, “When you say markets are expensive, you are only looking at it in context to historical valuations. Today the ‘E’ or earnings is depressed and in some cases that means we look at normalised earnings rather than cyclical earnings. While there are pockets of overvaluation as we are yet to see mean reversion of earnings, there are other stocks that are reasonably priced."

If a market is trading at a PE that is close to historical highs, it doesn’t automatically mean that all stocks are expensive. One has to break into the basket to see where the overvaluation is coming from.

Economic cycle

Ultimately, it’s about individual stocks and their growth potential.

Ajay Tyagi, executive vice-president and fund manager, UTI Asset Management Co. Ltd, said, “High PE is not reason enough to shy away, just the way a low PE isn’t always good. It depends on assumptions and how close to the truth they are."

Valuations are always forward looking. What this means is that today you will be willing to pay a price that reflects tomorrow’s earnings growth potential. In today’s context, as policy reforms from the government go through and macro economic factors improve, there is an assumption that growth in earnings will return sooner than later. This is getting priced into stocks with clear visibility of earnings at a faster pace than in others where there is uncertainty.

Anand Radhakrishnan, chief investment officer–Franklin Equity, Franklin Templeton Investments–India, said, “Today, wherever there is visibility of earnings growth along with sustainability, the market has re-rated the stock; or, is willing to pay a high valuation. Where this isn’t the case, stock prices are getting punished."

Let’s take the example of Maruti Suzuki Ltd, which is trading at a trailing PE of 33 times. It recorded a net profit growth of 23% for FY16. The stock price has gained 38% so far this financial year. What’s important is whether analysts believe that earnings will pick up further and if market share can increase once the industrial production cycle turns positive.

The market is dynamic—things change fast. In the short term, there are a lot of factors such as liquidity flows, external influences, news and events, which impact stock prices. These don’t necessarily impact earnings growth assumptions for a particular company.

For example, today you might have a stock worth 1,000 trading at 40 times forward PE. A market correction over six months impacts the price, which falls 15% to 850. For the same level of earnings, your PE is now 34 times. Within a short period, the stock isn’t looking as expensive.

Let’s say that the earnings assumption for the next financial year start to get built in and if you are looking at, say, a 20% growth, then at 850, the forward PE is down to 28 times. A stock, which was looking expensive six months ago, looks reasonably priced now.

Sustainability matters

“Each company has its own appropriate valuation. A company at 15 times earnings multiple can be overvalued and another might not seem expensive even at 20 times. You have to focus on a company’s ability to consistently deliver earnings growth over a long period and sustain its profit margin," said Tyagi.

If a stock is able to deliver high return on capital, steady growth over years, is able to stay ahead of competition and sustain its growth, it is not surprising to find the stock trading at a high valuation. This is because investors are willing to pay a premium for quality and sustainable earnings.

Long-term economic cycles can also impact earnings. FMCG stocks, for example, were trading at relatively lower valuations in 2008 at the peak of economic growth cycle; a time when investors attached greater value to cyclical sectors such as infrastructure, power and so on.

Now FMCG stocks are among the most valued. One of the reasons is earnings visibility in an otherwise difficult economic environment. You have to keep evaluating the earnings growth against valuations.

Radhakrishnan said, “Stock values will get affected within multi-year cycles. One has to analyse how long-term earnings can get affected. Consumer staples have delivered in this cycle. While consumption as a theme will continue to drive growth, we have to differentiate in product categories."

While the focus may be on value of individual businesses, there are many factors that can impact this. Some of these are internal to the business, but external environment, interest rate cycle and general economic growth can’t be ignored.

Mint Money take

Experts were unanimous in saying that no single factor is responsible for valuations. Surana added that looking only at the PE isn’t appropriate to derive future value, as it doesn’t take into account cash flows.

Let’s also not ignore liquidity coming into equity markets from foreign institutional investors this year.

It’s not unreasonable to expect that stocks that have earnings growth visibility will be chosen over others. In an economic cycle that isn’t yet on an upward trajectory, this could mean more money chasing fewer stocks. As a result, in some cases, PE can look exaggerated.

“(Stock) ideas are always available. Sometimes there are many and at other times you have to choose carefully from fewer ideas," said Radhakrishnan. Today, the market PE looks expensive by itself, but other parameters—earnings cycle, price to book value, market cap to gross domestic product (GDP) ratio, among others—are different compared to the previous peak.

The answer to buy or not lies less in the overall market valuation and more within earnings quality of a particular stock. If you are a long-term investor, ignore the short-term change in PE that is influenced more by market noise and liquidity.

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Published: 05 Sep 2016, 08:08 PM IST
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