Ground Realities are Simply Ignored During Good Times
Valuations Stretched Without Earnings Support
Returns in Last 3 Years are Mostly Due to PE Expansion
|Returns are mostly due to PE expansion|
The returns shown in above figure have been almost entirely because of PEx expansion and that is also inversely proportionate to the size of the companies. Worse is that the earnings growth has also been inversely proportionate to the returns. Simple average returns are stellar for small cap companies. If you had invested equally in the small cap companies beyond the top 500, you would have returned 356% (i.e. multiplied your investments by 4.56x), whereas if you had invested equally in the top 100 companies, the returns would have been only 73%.
Where Are We on the Risk Graph Now?
|Net Profit VS PE Graph|
As you can see in the above graph, currently the PEx is closer to the highs, but the margins are closer to the lows. Hence the risks are balanced given that possibility of PEx contraction can be counter balanced by either margin expansion or topline growth or both. We had seen the margins expanding over the last year (reaching 5.4% from trough of 4.6% reached in FY15) and gaining momentum in the first two quarters of FY17
Currency Replacement Broke the Momentum of Margin Expansion
Below are some reasons to support:-
• Increased focus on tax compliance would mean tax avoiding informal sector (accounting for 75% of employment in India) to shrink resulting in widespread job losses before the economy evolves a new ecosystem. Only fraction of these jobs would be absorbed by the formal sector.
• In a weak demand environment, commodity prices (20-100% increase over last year in industrial metals and rubber) have jumped and in this environment the ability of companies to pass on the cost increase is limited. Low commodity prices had helped companies improve gross margins in the recent few quarters. There is risk of this benefit reversing.
• In an evolving environment, companies would postpone their investment plans thereby slowing job growth. Capacity utilization has been near historical lows at around 70% and this had impacted investment cycle even before the recent disruption. Reduced money supply generally has negative multiplier effect on the growth.
• Government seems to be serious in dealing with tax evaders and cash hoarders. Assets such as properties and gold were the hiding places for such wealth. With many having to pay significant taxes on hoarded cash and at the same time physical assets like properties loosing value, wealth of many would be destructed. This along with many having to face tax scrutiny may have negative wealth effect thereby impacting spending for some time.
• GST rollout is also potentially disruptive in the initial phase. There will be de-stocking of the channel in many sectors where taxes are expected to drop. This will happen just before the implementation of GST and it may take time for many smaller companies to be ready with the backend needed to handle the new tax system, thereby delaying growth.
Massive Opportunities Await in the Long Term
2. GST roll out is expected to make India a uniform market without state border bottlenecks in terms of time and cost
Above two are the biggest reforms in India’s modern history and have the potential to make India extremely competitive in the global manufacturing chain and help create global scale businesses.
With transfer of wealth from informal to formal economy, government tax collections would significantly improve and if they allocate that capital efficiently (subsidy, infrastructure spend) India could transition into a much higher growth trajectory. Formal and transparent business practices would incentivize foreign investments and boost capital expenditure thereby employment growth.
Conclusion on Valuation
It is time to be extremely careful in picking the right businesses and absolutely not the time to overpay. We have to be open to the possibility that sometimes what’s good for the country and overall population may not necessarily be rewarding for the stock market. Historically we have seen best of market returns under worst of governments and vice versa.
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