How expensive is the market?

The Indian markets, while expensive, have delivered among the highest returns on equity, and a better record of earnings growth.

Everyone is worried about valuations at the Indian stock market. Any new investor I speak to is concerned about potentially coming in right at the top, and even the smart money locally is by and large cautious.

Most of the old-time and experienced India hands have been underweight or at best neutral about our markets for quite some time now. Prime Minister Manmohan Singh has also talked of "irrational exuberance", words made famous by Alan Greenspan. Some people have started wondering whether we are in the midst of some type of bubble in the equity markets, which is bound to burst and end in tears for all.

It is of course quite obvious and understandable why everyone is so concerned, for the markets have been on a real tear over the past four years. The Sensex ended 2006 up about 46 per cent, and this is the fifth calendar year in a row of positive return. The market is up more than four times since the rally really began in 2003.

The Sensex has delivered a compounded return of over 33 per cent since December 31, 2001, way above the 19 per cent compounded return delivered since its inception in April 1979.

Given the above numbers, you can be forgiven for automatically assuming that the markets must be very expensive, and valuations in nose bleed territory.

Let's look at the facts, to test this assumption.

First of all, if we look at the earnings to bond yield (earnings yield/g-sec yield), it is currently at about .7, after hitting a low of .14 in 1992 (markets very expensive) and a high of 1.8 in 2003 (markets very cheap). The current reading is just about at the 15 year average (post-liberalisation period) of .7. Thus while on this indicator markets are not cheap, they are not insanely expensive, either, especially when compared to India's own long-term history.

The markets (using this metric) have been more expensive than today, and were so all the way from 1991 till 2000. The markets look expensive when compared to the reading of 1.8 in 2003, but that was a period of extreme undervaluation, and probably as ridiculous and irrelevant as a point for comparison as the reading of .14 in 1991.

Secondly, if we look at PE multiples, we can come to a similar conclusion. While the market multiple has swung around quite violently, from a high of 60 plus (91-92) to a low of sub 10 times in 2003, the current multiple of 18 times is at the 15-year median of 18.2. Once again not cheap, but this is not the top of a dotcom bubble, either.

Also if you believe that with trend GDP growth at 8 per cent, corporate earnings can grow at 20 per cent and that the listed sector can keep RoEs at or near 20 per cent, even on an absolute basis, multiples do not look outlandish. One should look at PE multiples in the context of long-term earnings growth, sustainable RoE (return on equity) and
risk-free rates.

A country delivering visible 20 per cent earnings, and sustaining RoEs of 20 per cent plus (as India is today) will get a high valuation; the issue is rates. To the extent interest rates keep rising in India, they have the potential to drag down both growth and multiples. This is something we all need to keep an eye on.

As an aside, the PE mentioned above is for the Sensex; as we broaden the universe, PE multiples fall significantly to about 15-16.

When we compare India across emerging markets, the oft-quoted statistic is that India screens as among the most expensive on PE multiples. While this is true, it is also linked to the fact that India has consistently delivered among the highest RoEs, and also has a much better record of delivering earnings growth than most of its emerging market peers.

It is also simplistic to compare multiples across countries, without adjusting for the sectoral composition of the respective markets. Many of the larger emerging markets have large sectoral weightings in banking, property, low value-add manufacturing and commodities; often these sectors make up the bulk of the earnings.

These are fundamentally lower PE sectors and drive their market averages down. India has higher sectoral weightings in sectors like IT services, higher value-add manufacturing, FMCG and pharma-sectors which I think command fundamentally higher multiples.

This different sectoral composition is reflected in the higher RoE India delivers (especially adjusted for the commodity cycle) and also drives a higher structural rating than most other emerging markets. Thus there seems to be some basis as to why India trades at higher multiples than many other emerging markets.

Another interesting statistic, highlighted by a friend, is that from December 1991 (post-liberalisation) till December 31, 2006, the Sensex has delivered a compounded return of 14 per cent, despite the 33 per cent compounded return since 2001.

He points out that in this period (from 1991), M1 (which has been a good proxy for nominal GDP growth and earnings) has compounded at 14.8 per cent; thus the markets since liberalisation have pretty much moved in line with nominal growth, and the huge gains of the past few years may be just a catch-up from an environment of deep under-valuation.

Be that what it may, the fact is that while the markets are no longer cheap, this is not Nasdaq of March 2000, either. We may have certain pockets of bubble-like behaviour (property and embedded property stocks come to mind), but it is by no means across all sectors or of a big enough magnitude to bring the whole market down.

India is like a mid-cap stock, which has transitioned to large-cap status. It has gone from being unloved, ignored and cheap to being on most people's radar and much more visible. The easy money, in terms of a multiple re-rating, has already been made, but as long as growth is strong and visible, the market does not have to go into a deep bear phase or collapse.

Growth expectations are embedded into the market and we cannot afford to disappoint, and hopefully our policy makers understand this.

The market obviously will not keep delivering 33 per cent type returns, and we have to be realistic on our return expectations (even assuming some multiple compression, long-term mid-double digits look realistic) and we will obviously have some negative return years as well.

As always, buyer beware; but the market does not seem so overdone on valuation that we need to worry about years of negative return being the most likely outcome for someone entering today.