When the Reliance Petroleum stock was downgraded by CLSA in early-November, its price tumbled by more than 20 per cent. The November 3, 2007 report titled Barrels and Bubbles observed that the stock was trading at a “50-70 per cent premium to even the most expensive refinery new-builds quotes,” at the then price of Rs 269. Similar companies were trading at almost half the valuations in the US. Ever since then, the market has been grappling with the big question of valuations: what is fair value?
There have been three gutwrenching corrections of over 1,000-points each since October 9, 2007, when the market first crossed the 18,000 mark. In fact, this 18,000-20,000-band is turning out an extremely volatile one. Both foreign and domestic investors have been booking profits.
Yet, even after the correction, the current market is trading at a lofty 25.07 times earnings and, by historical yardsticks, appears overstretched by 47 per cent from the market’s sevenyear average. Wherever you look in the market, the signs of overstretching are visible. Last month saw 143 companies hit 52-week highs out of 3,065 actively traded stocks. Even now, more than one in four stocks (about 28 per cent or 863 stocks) are trading within 10 per cent of 52-week highs.
The valuation numbers coming out of the market suggest that there are more areas than one where the stock prices have run ahead of their fundamentals. Brokerages have already begun to call some stocks overvalued and some are even reducing stock price targets. Recently listed brokerage company, Motilal Oswal, said that in its universe of stock coverage, the engineering and capital goods space appears to be the most overvalued.
Says Manish Sonthalia, Vice President (Equity Strategy), Motilal Oswal: “Though the space appears most promising from a 3-5 year perspective, prices have run up too soon too fast and it will be some time before these valuations can be justified.”
A bulk of the valuation run-up has been in the fancied sectors of recent times—real estate, oil and gas, engineering, metals, sugar and real estate. Large investments from foreign investors have chased stocks from these growth sectors over the past several months.
In the capital goods and engineering space, for instance, profit growth rates have been in excess of 40 per cent, but stock prices have more than doubled, thus, increasing faster than their growth rates.
The price earnings ratio of ABB has increased from 48.2 to 77.98 times, an increase of 61.78 per cent in one year. This suggests that investors are willing to pay more for some high growth stocks. But if the stock is to command the same valuation as a year ago, the profits of the company will have to grow even faster over the next twelve months.
Among the other sectors, some power ancillary stocks have also moved up faster than the earnings growth can justify.
The increasing liquidity in the stock market has been the main reason for the rising valuations. The power ancillary sector is expected to do well as investments in power distribution spur demand for transformers, towers, power cables. Adding to their appeal has been the increasing investments in capacities and the improving efficiencies.
But this growth is expected to materialise over the next 3-5 years and not immediately. The market is beginning to pay too early for this growth. It’s not to say that the entire power ancillary space is overvalued. There are pockets where the price is still below the average sector valuation. Yet, if there’s a consolidation in the sector, the pricing of the entire sector can correct.
Admittedly, many of the growth companies have been the favourites in the market as investors look for scalability and improvement in margins for an upside. But when there’s plenty of liquidity chasing a handful of growth stocks, the valuations tend to get overpriced. Says R. Sreesankar, Head of Research, IL&FS Investsmart: “When there’s a lot of liquidity chasing stocks, and particularly if they chase one segment, the prices tend to overshoot.”
What’s more, some stocks tend to run up faster than others because of stories running around them. Much of the stories revolve around the future growth potential of the companies. These companies tend to have assets—such as a new discovery or an allocation of an oil or gas block—that are expected to generate profits in future.
Market watchers reckon that companies will take a while before they can monetise these assets, especially as they will require investments in production and distribution. Many of these stories will fructify only in the next 2-3 years. Experts also admit that in such a scenario pinning down the exact potential is often speculative, and, more often, than not, the market rumours tend to exaggerate the short-term potential. It’s only after the actual discoveries that the true potential of these assets are possible.