One of the common questions that we get asked, when we meet with investors, is whether one should be concerned given that equity markets are at records high levels. Moreover, should one deploy additional capital into equity markets when markets are trading at near their all-time high levels. To understand this better, one needs to understand how markets have moved in the context of the growth in the economy.
Over long periods of time, since the 1950s, nominal GDP in India has grown at an average of about 13.5% pa. This is a combination of real GDP growth and inflation. Over the past 5 years, nominal GDP growth has slowed down to about 11.2% pa, partly led by lower inflation and partly due to a cyclical slowdown in real GDP growth. GDP was also affected by demonetization, GST roll out, RERA, etc. There is reasonable consensus that real GDP growth will pick up momentum, as some of the critical structural reforms, which had caused short term pain, are behind us.
Though the Nifty performed strongly in the current year (up 28.6% in CY2017), this was on the back of two consecutive weak years prior to 2017. In reality, the Nifty has delivered a CAGR of 8.3% pa over the past 3 years and 12.3% pa over the past 5 years. As one observes, Nifty has been growing in line with nominal GDP growth over the past few years. One needs to be concerned when there is a dramatic outperformance of the Nifty growth over nominal GDP growth (or become greedy when Nifty dramatically underperforms nominal GDP growth, but we can leave that story for another day). Though valuations are not exactly cheap, and in a few cases irrational, there are a reasonable number of large cap companies trading at rational valuations. Moreover companies should benefit as the economy picks up momentum.
On the other hand, the midcap story is quite different. The BSE Midcap Index, which we believe is a good proxy for the mid cap companies in India, has been averaging close to 20% pa returns over the past 3 and 5 years. The BSE Midcap Index has actually performed far ahead of nominal GDP growth. This is partly due to mid-cap valuation being exaggerated currently, as against valuations which were relatively cheap 5 years back. What is important to note is also that, over the past decade (since Dec 2007), the BSE Mid-cap Index has performed nearly the same as the Nifty. The Nifty has delivered an annualised rate of return of 5.5% pa over the past decade, compared with 6.2% pa for the BSE Midcap. Over the past 5 years, the Midcaps have been catching up for the weak performance over the prior 5 years to a large extent, and valuations in the mid-caps are well ahead of rational behaviour. We do suggest caution in this space, especially when 50 plus Price-to-Earnings ratio has started to become the norm.
It is a bit tricky to invest in the current equity market, especially with valuations beginning to look stretched and the cyclical economic revival yet to kick in. We do see some companies trading at valuations that are reasonable, but it is fewer than normal times. Moreover, with some of the key reforms behind us, there is reasonable hope that one should see a protracted period of strong economic growth. With lower expected returns in alternatives like fixed income and property, and reasonable prospects for an economic recovery, it does seem to make sense to invest in stable companies trading at sensible valuations.