Jul 2012 : Bear Market – from expensive to being cheap

The Indian equity market was down for most of the month, though it recovered towards month end to close down about 1% for the month. Our portfolios trailed the markets by a bit during the month.

It was in Jan 2008 when the Sensex hit a high of close to 21,000. After more than 4 1/2 years, the Sensex closed July at 17,236, down 18% from its peak level. During this period the Indian economy has done fairly well. The total GDP has increased from Rs 45,82,086 cr in FY2008 to 82,32,652 cr in FY2012, averaging a growth of 15.7% in rupee terms. In dollar terms too, the GDP has grown at 9% p.a. since FY2008 despite the steep depreciation of the rupee over the last 12 months. In the context of how the rest of the world economy has done in these circumstances, this makes one wonder why the Indian stock market has performed so poorly in this period.

The answer to that lies in the valuation of the market at the starting point and at the ending point. In Jan 2008, the Sensex was trading at close to 29x that year’s trailing 12 month earnings per share, which is quite a bit higher than the median 23x that it has typically traded at the top end since 1991. On the other hand, at its recent low of 15,750 the Sensex traded at 15.2x its trailing 12 month earnings per share. In observations over the last 21 years, this is very close to the median lows that the Sensex has traded annually. The key determinant of long term return for an investor is the valuation at the point of entry and we are closer to being cheap than expensive.

Moreover, as compared to nominal growth of 15.7% p.a. in GDP over the last 4 years, the Sensex earnings has grown at only 5.6% p.a. over this period. This compares rather poorly with the 14% compounded annual growth in Sensex earnings over the last 21 years. The point of throwing all these numbers is that not only is the equity market cheap from a valuation standpoint, but there is a potential reversion to the mean of the profitability, which should result in companies reporting higher growth rates over the next 4 years as compared to the last four.

Meanwhile, we continue our efforts in selecting high quality companies which have stood the test of time and are not only likely to perform better than the market average, but also do that with a lot less volatility in their earnings. We continue to remain excited with not only the quality of companies that we have selected but also the valuations at which they are trading.