Finding value at 21,000

The market is looking full priced at this level. However, there are still some pockets of opportunities. Here's how to spot them.

Rajkumar Subbareddi Rajkumar Subbareddi
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.

The Way Out

Though the benchmark indices are trading above their 10-year average valuations, they are not, as yet, close to their all-time peaks. The Sensex is trading at around 17 times the 2011-12 estimated earnings, which, though not cheap, is not too expensive either, given that corporate earnings are expected to grow at 20-25 per cent between 2010 and 2012.

"While the Sensex is nearing the earlier peak of 21,000, it is about 24 per cent lower than it was in terms of valuation. Any significant upward movement on the bourses due to strong inflows could lead to an RBI intervention to control liquidity. So, it is probable that the markets will consolidate at these levels before moving up further. Currently, the risk-reward ratio is favourable for long-term investors," says Thakkar.

However, Indian equities are still considered the best option as the long-term prospects for the economy are robust. "Concerns are part of the system. Except in a few pockets, the valuations are not stretched," says K.K. Mital, head, portfolio management service, Globe Capital.

However, one needs to be selective while buying stocks. At the sectoral level, the BSE FMCG Index is trading at 31 times the 12-month trailing price to earnings multiples, while at 26 times, the healthcare and information technology indices are the next most valued. Though high valuations do not necessarily mean a correction, the investors who are entering at this stage might have to bear with long periods of belowaverage returns.

"Usually, the first sector to witness a correction is the one that was the last to rise during the boom period. This is because a lot of momentum players are invested in such stocks," says Sharmila Joshi, co-head, private client group, Emkay Global Financial Services.

The rally over the past year has been more in the large-cap stocks. While mid-cap stocks have selectively participated in the rally, experts see more value in them rather than in the large caps.

Make a List of Stocks

The best way to move forward is to make a list of stocks one would like to buy and track them. As the Indian markets are closely aligned with the global market sentiment, a bout of bad cues can result in a correction.

This can provide frequent opportunities for investors to pick stocks. Experts opine that investors can aim to generate a return of 10-15 per cent per year if they remain invested for 5-10 years. "Investors would have made money even if they had invested during the peak in 2008. Most of the stocks that provided good alpha returns earned high returns on equity, rather than the high-margin commodities. There are stocks that meet these criteria currently too," says Thakkar. Reliance Industries, United Phosphorus and Electrosteel Castings are some of the stocks he prefers.

"Investors should buy stocks that have proven track records and should do so in a staggered manner at every market dip, rather than go for bulk purchases. They must avoid speculative stocks," says Jyoti Roy, research analyst, Fullerton Securities and Wealth Advisory.