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How to bet safely on 2011

Returns from stocks are most dangerous to bet on. But not if you use a benchmark like Nifty. MONEY TODAY tells you how to bet safely on stocks.

By Devangshu Datta | Print Edition: November 16, 2006

An old saying goes, “When you assume something, you may end up making an ‘ass’ out of both ‘u’ and ‘me’.” Unfortunately, you cannot invest without some assumptions about the future. Those assumptions should be conservative and based on solid logic. For example, we may wish to know the likely returns from longterm investments in the Nifty (National Stock Exchange’s 50-share price index) so that we can compare these returns with those from other assets. How do we make projections about the Nifty over the next five years?

One way is to use that familiar valuation tool, the price-earnings (PE) ratio. Just like an individual stock, the Nifty has a PE ratio. The 50 stocks that form the Nifty have individual earnings per share (EPS). The Nifty’s price is determined by taking a weighted price average of these 50 stocks.

Similarly, we can take a weighted average of the EPS to generate a composite EPS. Then the Nifty’s daily price divided by the EPS will give us the PE ratio. In fact, the NSE is kind enough to calculate and provide this data on a daily basis on its website (www.nseindia.com).
Choose your investment style and see how much you can make by 2011
(All investments in Nifty index funds or Nifty ETFs)

THE OPTIMIST: Invests at highs

Min annualised return 6%
Max annualised return 14%

THE CONTRARIAN: Invests in lows

Min annualised return 14%
Max annualised return 23%

THE METHODICAL: Invests systematically

Min annualised return 11%
Max annualised return 19%

Data on the Nifty PE is available since 1999. If we examine the annual lows, the Nifty has generally bottomed below 14. It has tended to peak above PE 20. The lowest discount registered since 1999 was PE 11 (in September 2001). The highest PE was registered in February 2000 when the Nifty hit a high of 1818 points and a valuation of 27.3 PE. The PE valuation tends to oscillate within fixed boundaries.

But prices can rise (or fall) indefinitely because EPS may rise (or fall) by indefinite amounts. Hence, the index may also rise or fall indefinitely even if the PE discount does not change. For example, if EPS rises by 10% and share prices also rise by 10%, PE remains the same. That leads us to our first assumption: The Nifty will continue to be valued roughly the same in 2006-2011 as it was between 1999-2006. If it does behave consistently, then the Nifty will bottom below PE 14 and top out above PE 20.

If valuations stay inside the 14-21 range, the returns must come from EPS growth. How do we project earnings growth? Here comes another assumption: The Nifty’s earnings will grow by 15% per annum between 2006-7 and 2010-11. Assuming that the GDP continues to grow at 8% till 2010-11 and inflation stays at around 5-6%, the Nifty would have to grow slightly faster than the overall economy if it maintained a 15% compounded annual rate of growth (CAGR).

This is a very conservative assumption. In the past seven years, the EPS has grown at a CAGR of 15.5% while GDP grew at about 6.5%. The first-half results of 2006-7 suggest that EPS may grow by closer to 25% this fiscal. GDP growth has also accelerated to above 8% in the past three years. Recap. It is assumed that between 2006-7 and 2010-11:

  • GDP will grow at 8%
  • Inflation will run at 5%
  • Nifty EPS will grow at 15%
  • Nifty valuations will remain in the same PE range of 14-21.

Given these assumptions, the rest is a straightforward numbercrunching exercise. We can derive earnings estimates and multiply those by expected PE discounts to estimate the possible range of Nifty prices till 2010-11.

Even if the market stays bearish, the Nifty would still rise over this period because the EPS would double. We estimate that, even in the event of a catastrophic bear market where the Nifty stays at 14 PE, the index would still hit the 5000 level by 2011. If the market stays bullish, we could see prices well above 7000 Nifty by 2011.Nifty instruments

To sum up, by 2010-11:

  • The Nifty will have a weighted EPS of about Rs 356 (Rs 177 in 2005-6).
  • If it’s a bear market, the index will be at 14X EPS, that is, 4981 points.
  • If it’s a bull market, the index will be at 20X EPS, that is 7115 points. Just for reference, the Nifty is right now at 3677 points (PE 20.8).

Now, these are crude linear projections. The Nifty’s EPS could be much more volatile. There could be periods when the Nifty drops to 11 PE and it’s possible that tops will come at well above PE 20. But we are making conservative assumptions and as such, the index is more likely to exceed them than to underperform.

If we ignore speculation in index derivatives, you can invest in Nifty through two types of instruments. The NSE website lists several Nifty Index funds. There are also exchange traded funds (ETFs) based on the Nifty.

These index funds and ETFs are managed in a way that they mimic the returns of the Nifty as exactly as possible. Index funds are special since they will, by definition, offer returns within a narrow band. Costs must therefore be very competitive.

Index funds are benchmarked on “tracking error”—how closely does their performance mimic the index movement? The less difference the better—in this case, we may even sacrifice the possibility of excess returns for the sake of predictability.

ETFs are exchange-issued instruments that can be bought and sold like stocks—so even intra-day trading is possible. Usually an ETF, like the Nifty Benchmark ES has its value set at 1/10th of the index. There are no loads to ETFs but there is a brokerage cost. The ETF almost exactly mimics the index so, there is almost no track error.

How much return can you expect from investments or trades in the Nifty? The answer depends on your investment habits. We’ve tracked three investment styles with the likely minimum and maximum returns. A contrarian value-investor, will buy the Nifty heavily if it is at lows of PE 14 or less. A momentum investor will buy when the market is up (like now) and close to a PE of 20. A systematic investor will use SIPs and buy the Nifty at an average of around PE 17.

The momentum investor does worst in terms of returns; the contrarian does best if he can time the market properly. The systematic investor receives between 11-19% depending on how high the PE valuations rise. Perhaps, the best practical method would be to invest systematically and keep a lump sum in reserve for times when the index PE drops to around 14.

The SIP would guarantee that average costs of acquisition stayed around PE 17. And by buying heavily when the market dips to 14, you lower the average cost some more. This strategy should generate minimum returns in the mid-teens.

The curious reader may also wonder about the possibility of trading the Nifty with a simple rule: Buy if the PE is below 14 and sell if it is above 21.

Well, that’s possible if you’re confident of keeping track of the market and possess the discipline. It means keeping large sum in liquid assets. There may be long periods when the Nifty PE moves in a band of 15-19 and your investible surplus just sit in your bank account earning minimal returns. It’s safest to be systematic!

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