Valuation | Portfolio Yoga

How long will you Stay Invested

In November of this year, my personal portfolio made an all time high. The previous time I had seen an all time high was way back in early January of 2018. A couple of months, it would have been three years since I last made an all time high for the portfolio (not inclusive of dividends though).

Equity returns are lumpy in nature. Unfortunately most of us don’t have the patience to hold through the worst of times in preparation for the oncoming best of times. Fear has a way of playing its tricks on our mind at the worst possible times.

Markets loathe giving free money to one and all. Before the 2008 financial crisis led crash, Indian Markets used to crash once in two years on an average. When I say crash, I mean a drop of at least 30% from the previous peak.

In 1996, Nifty 50 rose from 800 to 1200 by the middle of the year but by the end, it was down 800. In 1997, it once again rose to 1300 just to fall back to 950 by early January 1998. The bounce 1200 odd before jettisoning all the gains and falling back to 800 by late 1998. From there started the Dot Com bubble rally that took Nifty 50 to 1800 levels before the crash took it over time back to 920 in late 2001.

Then we had the crash of 2004, 2006 and of course, the crash of 2008. Post 2008, Markets drifted lower for a considerable length of time only once – 2011 and even then did not go below the 30% mark. In fact, after 2008, March 2020 was the first time we saw a drawdown greater than 30%.

The financial crisis and the way the Federal Reserve responded has changed the behavior of the market. Just when it seemed the normalcy of balance sheets of the Central Bank will be restored, we were hit with Covid which has resulted in an unprecedented flow of liquidity.

While the recent rise in Indian Equities thanks to the generous inflow of funds from FII’s, do note that India is the only country into which liquidity is pouring. For most other emerging markets, its the other way round. To me, this is indicative that much of the flow may not be speculative in nature and at least a large part could be because of a change in perception with regards to the future growth of the economy.

Markets are expensive, goes the headline. Most measure the valuation of the market by using Nifty 50 Trailing Price to Earning as the proxy. But why Nifty 50 and why not Sensex or the Nifty 500 or the Price Earnings of the market as a whole. Is it because we all have fallen prey to availability bias?

In 2020, Sensex went up by 15.8%, Nifty 50 by 14.90%. Sensex Price to Earnings on the other hand went up by 28.80% while Nifty 50 PE went up by 35.90%. At the end of the year, Nifty PE stood at 38.45 vs Sensex PE of 33.50. Would you say Sensex is cheaper than Nifty?

No one knows the future but one can be pretty confident that the earnings of companies for the financial year 2021-2022 will be way better than 2020-2021. How much better would make it easy to get a fix on how expensive the market really is. Oh, by the way Nifty PE is Standalone earnings while the true picture will be shown by using Consolidated earnings. But since NSE doesn’t provide it, we don’t bother with it.

Then there is Authority Bias. We stop questioning things just because someone with authority says so and if he says so, how could it be wrong. So, when claims are made using a single example of who SIP is better than Lumpsium, we don’t stop to question the stupidity of comparing an Apple with a Pineapple.

Questions are always asked of a bull market – be it at the beginning, the middle or the end. There will always be some indicator or parameter that can be used to defend a bull case or make a bear case. In Statistics, one school of thought says that if you have at least 30 independent samples, it can be used to make some decent predictions. We end up making predictions with a sample size of two or three and then wonder why we went wrong.

Equity is Risk when looked at a short term time frame. There is no getting away from it. If you invest money today, the risk to capital exists at the very least for one year if not more. But as time passes, the risk moves on from the capital invested to the gains and as one moves even further, it’s just part of the gains that will be at risk.

The longer you stay in the markets, lower the risks of ruin (unless of course you are leveraged in which case, the risk of ruin may never go). But to stay longer, you should invest only so much that allows you the comfort of good sleep regardless of market conditions. A secondary requirement of course is to invest in something you deeply understand or trust. The reason I could stay with the strategy during its long drawdown had more to do with my trust rather than any superior skill sets. Building that takes time but once built, it serves you for the lifetime.

Getting carried away

Way back in 2007, a good friend of mine called me to ask me to check out a company by name Jindal SouthWest Holdings Ltd. He said that he had heard from some one that it had quite a nice value and was currently trading at pretty discounted rates.

Checking on what I could, I saw that the Intrinsic value of the company (based purely on what it held) came to around 2500 – 3000 per share and the company was trading around 500 bucks (though a couple of years ago, one could have had it much cheaper). While in US, most holding companies are valued at pretty low discount rates, in India due to the fact that most of these holdings will never be sold, holding company valuations have never been aggressive to begin with.

Yet, the deep discount did entice me to invest into the same. The timing of my entry in hindsight proved to be one of great acumen as the stock straight away started to move substantially higher. At 2000, I decided to get rid of half my quantity but the stock showed no signs of weakness. At 3000, I got rid of the rest of it as well (to fund some other idea which ultimately ended up eating both my capital & profits :P).

But before I sold, I did a revaluation of the holdings and voila, instead of the 2500-3000 which was there before this rally started, the valuation had now changed to 5000-6000 🙂

This is not a story to boast my stock picking ability (which I have none anyways) but to remind one not to get carried away with the momentum. Some months back, I got into another stock – a very small quantity but one that has been moving pretty strongly on the back of a report of a small cap fund manager initiating a position in the said stock. While there has been no change in the fundamentals of the stock, the hype given the story and the person who picked it up has meant that the stock is now 300% above my purchase price.

But this cannot really last unless there is really a pot of gold at the end. I do not know when this will end, but the ending generally is not good either. A stock that moves up in Buying freeze generally comes back in selling freeze making it tough if not impossible to exit such stocks.

While not everyone can have a deep understanding of the DCF / SOTP), as a investor, its essential that you know what you are paying for. There is no point in paying 5 times the price just because of some hidden quality which may or may not materialize in the future.

Even in this bull market, there are plenty of stocks that are moving down and hence its always pays to be cautious and fearful than let the greed of easy money carry us away. I am a guy who can be called a perma-bull, but just because the long term is good and the road ahead is a path of roses, there will always be thorns that can cause significant damage to those who are unprepared.

Are US Markets Over-valued

One of the constant thesis I hear about US Markets is that they are way over-valued (and hence should fall anytime soon). This mantra is accompanied by a chart of the long term cyclically adjusted price earnings chart (CAPE), with data from Robert Shiller.

But I wonder, is the long term average really meaningful. The data starts from 1881 (1st data point for CAPE) and for the next 91 years, the currency was pegged (more or less) to Gold. Its been 45 years from the time Nixon de-linked US Dollar from Gold.

If one calculates the Average and Standard Deviations of both those periods, one finds that while based on pure long term CAPE, we are bit above the 1 Standard Deviation, if we were to split the period, we actually end up below the 1 Standard Deviation.

While CAPE more or less peaked out at 27.50 in mid 2007, the average for the period between 2003 and 2007 (Dec) comes to 25.91. Anyone who felt markets were expensive in relation to the historical past would have had to miss the entire rally.

Nifty Performance vs. PE Ratio

One of the key numbers I look at regularly is the PE ratio of Nifty to have a idea as to the valuation Nifty currently commands and whether markets are cheap, expensive or neither of the two.

For quite some time now (since mid 2011 to be precise), Nifty PE ratio has been moving around its long term average. Only once did we see a major dip which brought the PE to its 1 Standard Deviation on the lower side.

As on date, the current rise has meant that we are closing in on the 1 Standard Deviation on the upper band though even that is bit far away. But what is interesting is how does the PE compare to the return of Nifty.

Since 2008 low, Nifty has appreciated by 150%, Nifty PE has appreciated by just 85%. But more interesting is the way this has been accomplished. Lets first take a look at the chart;

After the markets bottomed out around October 2008, we witnessed a steady recovery post the bottoming of the Dow in March 2009. But even as the markets were dipping in the first couple of months of 2009, PE was already starting to move higher indicating the impact of bad results which were pushing up the valuation of Nifty even as Nifty itself did nothing.

This can be seen till the early part of 2011. Nifty doubled from the lows, the PE out performed it (in essence markets became pretty expensive in a very short span of time). To get a handle on how expensive Nifty was, do note that the high point was above the 2 standard deviation (which was seen earlier in 2008).

But from that point on wards, things have changed tremendously. Markets started to outperform the valuations (in other words, even as markets went up, quality of earnings meant that valuation wise, markets were still cheap).

I believe that unless we have another major global meltdown, this gap will only increase further. In hind-sight, markets seem to have been a buy on dips since early 2011. Question though is, is that strategy still a valid one? I for one believe so.

Are the markets expensive

With Nifty rising by nearly 23% from the low registered in late August, the question on top of the mind is whether markets are way over-valued compared to historical values.

One way to measure valuation is by PE and here I have plotted the CNX Nifty PE since 2000 with Standard Deviations (1,2) on either side. As on date, we are still at average valuations suggesting that while markets are not expensive, they aren’t cheap either.

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