If the market goes down, when should you step in?
Except under abnormal market conditions, the Sensex moves in a P/E band of 13-22. When the expected earnings growth is strong, investors rush into stocks, bidding market P/E to 22+. When there are tremendous headwinds to corporate earnings, earnings may still grow, but stock prices would come down and the Sensex P/E will get compressed to around 12-13.
In case of extreme mania, the P/E can shoot to double these levels too. It happened during the Harshad Mehta scam in 1992 and again in 1994 when the foreign institutional investors ‘discovered’ India and threw all caution to the winds taking the market P/E to 57. Conversely, when pessimism is extreme, or there is an extraneous shock, the market P/E can come down to below 10 based on the expected EPS. It has at least happened thrice in the past 20 years—in November 1998 (during the Asian crisis), in May 2004 (when the BJP-led government was voted out) and once in October 2008 (during the US meltdown).
Where are we now on the valuation count? For FY11-12, we expect the Sensex EPS to be around Rs1,150, based on a 10% rise in EPS next year, factoring in all the current macroeconomic problems. This translates into a P/E of 16.1. The market is not expensive but is not cheap either, especially since earnings growth will be only 10%. Expect the Sensex to be trading in a band of 23,000 (P/E of 20), if earnings seem to bounce back to a 20% range and 15,000 (P/E of 13), if things worsen further.
How inflation, economic growth and stock prices are interlinked
Markets are influenced by human behaviour acting in herds; so it is tough to formulate laws that can explain market action, much less predict it accurately. But Ed Easterling has an interesting theory which he calls ‘financial physics’. Financial physics explains the interaction among the principles of economics and finance as the drivers for secular stock markets. In the financial physics model, two elements of economics—economic growth and inflation—drive the two financial components of the stock market, viz, corporate earnings and stock prices.
In the first set of correlation, economic growth is the fundamental driver of earnings growth which, in turn, is the primary driver of the stock market over the long term. Higher growth and higher inflation should increase corporate earnings. If inflation only bumped up earnings, the stock market would respond accordingly and move higher; but it does not.
This is where the second factor comes into play. While inflation increases earnings, it also affects the price levels of financial assets and the price level of a financial asset influences subsequent returns. Rising inflation increases the level of returns required by investors, thereby causing prices to decline. Stock prices fall as the present value of future earnings declines. To get a higher rate of return from stocks, investors tend to pay a lower price for future earnings (i.e., lower P/Es). In effect, inflation drives down P/E and, thus, offsets the inflation-driven growth in EPS.
Historically, the years with higher inflation and deflation tend to have a low P/E. When inflation is high, investors should expect that P/E would be low. If we are in a situation of higher-than-average-P/E, prices will fall—often, despite growing GDP and earnings. Similarly, in a scenario of deflation, the future growth rate for earnings and dividends turns negative and the value of stocks falls. Thus, both higher inflation and deflation cause P/E to decline. Higher inflation also reduces the purchasing power value of an investment portfolio. Thus, high inflation brings in low returns and lessens the value of what’s left. Easterling’s market valuation theory firmly makes the market level relative to the inflation rate—not a level that is arbitrarily anchored to a long-term average. This is precisely what is happening in the market today.
There are fears of rising inflation which are reflected in P/E compression—despite rising EPS (earnings per share) and GDP growth.
The stock is valued low now, given its strong growth prospects
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