Finding value at 21,000

R Shree Ram        Print Edition: November 2010

There is festivity on Dalal Street. The economy is energised and bustling with activity. The macro picture has a rosy tint. Everybody is raving about the India growth story. So why is the investor worried?

It's not just the rising food and fuel inflation that is giving him sleepless nights. The prices of stocks are witnessing an even faster rise, mostly because of the money being pumped into the Indian equities by foreign institutional investors (FIIs). Between 4 January and 6 October this year, FIIs bought Rs 93,405 crore worth of stocks, the highest they have ever invested.

This has pushed stock prices to multi-year highs. "The market has witnessed a strong uptrend during the July-September quarter, gaining almost 13 per cent. This rise has been due to the strong inflows of around $7-8 billion per month in the equity market," says Dinesh Thakkar, chairman and managing director, Angel Broking.

With the economy projected to grow at a fast pace during the next couple of years, foreign investors seem to have sensed the opportunity far before the domestic ones. The latter have preferred to sit on the sidelines after getting their fingers singed by the downturn in 2008.

As the Sensex scaled above 20,000 and equity prices moved closer to historical highs, the investors who had bought stocks at the height of the market boom in early 2008 began booking profits. From the beginning of this year till 6 October, Indian mutual funds have sold stocks worth Rs 22,663 crore. However, during the same period, the broader market index, the BSE-500, moved in the opposite direction, gaining 18 per cent.

The reason for the cautious approach is understandable. Along with the recovery in the global economy, benchmark indices have seen a steep rise in values. The 150 per cent growth in the Sensex from the lows of March 2009 to the high of 6 October 2010 has been the fastest recovery in the past two decades. In the previous bear markets of 1997-98 and 2001, the markets had spent 80-115 weeks in the troughs before a structural uptrend. This time, the slump lasted only 63 weeks.

Another factor is the steep rise in valuations. According to Motilal Oswal Research, at the current valuations, the Sensex is trading at a price to earnings ratio (PE) of 17.3 times. This is 20 per cent higher than its 10-year average PE of 14.4 times. This sharp increase in valuations in such a short span of time is keeping investors on tenterhooks.

Investing at Peaks can be Risky

The investors who had bought real estate stocks, such as DLF and Omaxe, during the previous bull run are yet to see their stocks reach the purchase price. These stocks are still trading lower than the highs that they had witnessed in 2007-8. Most good stocks are already pricing in the near-term positives, leaving little room for a further upside.

According to a study by the Bank of America Merrill Lynch, some large-cap stocks, such as India Cements, Nalco, Mahindra & Mahindra, Lupin, Gail India and Bank of India, are trading at a premium of more than 36 per cent to their historical five-year average price to earnings multiples.

The report states: "The stocks that have outperformed the market sharply are most vulnerable in a correction. This includes many stocks in the financial space, such as SBI, ICICI Bank, HDFC Bank, HDFC, and other large-cap stocks, such as Bajaj Auto, Ambuja Cements, Bharti and ONGC. We are not negative on these stocks from a fundamental point of view, but they could tactically underperform in a market correction."

The correction, if it happens, is expected to be more severe in such stocks because the FIIs that have invested huge amounts are likely to reduce their holdings drastically at the first sign of uncertainty. So investors should be cautious about buying stocks that have seen a sharp rise in FII holdings.

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