2022 started with a bout of volatility in all global markets. First came the news about omicron, which has been mostly mild in its impact and the high vaccinations over the last year have definitely helped keep hospitalisations and deaths low. As this good news about the pandemic flowed in, the market was strong in the early part of the month until mid-month we had the release of the consumer price inflation (CPI) for the US, which came in at 7.0% – inflation has been trending higher through the year on the back of a rise in food prices globally, rise in industrial commodities like oil and metals and some part of the inflation is also blamed on the supply chain dislocations because of covid. US inflation at its current level is the highest in 40 years and although some of it can be explained by temporary factors, it has become a worry for the US Federal Reserve (Fed) which is tapering its quantitative easing program to end by March 2022 and an intended interest rate increase around the same time. This signals a change in monetary policy as the Fed moves from an accommodative policy to a more hawkish tone.
The Fed is committed to a target of 2% inflation and as inflation in the US trended higher than that over the last 9 months, the Fed explained it away as transitory – however over recent months, the trend in inflation has remained persistent leading to a change in stance from the Fed. What is also perhaps worrying for the Fed is persistent wage inflation in the US. Meanwhile we have seen a spike in inflation in Europe and UK as well – Europe’s December inflation print is at 5.3%, while UK is at 5.4% which are multi decade highs.
The intrinsic value of a business is the sum of all the free cash flows that you can get from the business until eternity discounted back to today at an appropriate discount rate. This discount rate has a large relationship with the prevailing interest rate in the economy and this is why interest rates prevailing in the economy play a large role in the valuation of equities. Higher the interest rates, lower would be the multiple that one would use to value earnings.
The higher inflation figures out of the US, Europe and UK have had an impact on equity markets across the globe – the effect was most visibly noticed on “growth” stocks, stocks which are expected to grow their revenues at a high rate and have been of late, trading at high valuations in the market place. In India too, we have seen over the last few years that companies reporting good growth numbers in an otherwise weak economy, have been bid up considerably and valuations for this sub-set of stocks are high.
We did a study among the BSE500 constituents with the following criteria – 10-year median Return on Equity (ROE) above 15%, revenue growth over 10 years above 8% per annum and current Debt/Equity less than 0.2 – the criteria are some measure of a high-quality company. Totally 58 out of the 428 non-financials made the cut based on longevity, trading history and the application of criteria listed above. The below graph looks at the premium over the 20-year median PE that the current Price to Earnings (PE) based on trailing 12-month earnings is trading at on 28-Jan-22.
|Premium to Historical Multiple of Earnings – Non Financials|
|Premium||Number of Companies||Proportion|
|100 – 200%||11||19.0%|
|50 – 100%||11||19.0%|
|0 – 50%||18||31.0%|
As one can see, 19% of the sample is trading at a greater than 200% premium to the historical median; together the top 2 buckets constitute 38% of the total and only 12% of the sample is trading at a discount to its historical median. Admittedly, trailing 12-month earnings may be slightly depressed because of the impact of the second wave of covid, thus overstating PE to some extent. Yet it does paint a picture of how valuations in the Indian market are stretched in many pockets in relation to their historical median.
We ran the same exercise for the banks and NBFCs in the BSE-500 – when we applied the criterion of 10-year median ROE greater than 15%, and gross non-performing assets in each of the last 3 years less than 5%, 15 companies made the cut. For this set we looked at Price to Book Value to gauge valuation of the different companies and calculated the premium that they are currently trading at, to their historical median. The results are below, which indicate that a majority of the better quality banks and NBFCs are trading at a discount to their historical valuations.
|Premium to Historical Multiple of Earnings – Financials|
|Premium||Number of Companies||Proportion|
|100 – 200%||3||20.0%|
|0 – 100%||3||20.0%|
The above analysis, particularly for the non-financials, indicates that this is a market in which one should tread carefully and we have been trying to do that – we have been reducing positions in some of our “growth” stocks which had gotten ahead of historical valuations significantly and we have been trying to deploy the proceeds in other quality stocks which are trading at a discount to their intrinsic value. We expect to continue with this discipline.