Stock valuations and market returns are inversely correlated; retail investors can make this work for them
One theory that investment sages have been pressing on us for a long time now is that investors should buy stocks when they are inexpensive. If you want to build long-term wealth, stocks should have a net of lower prices, and they must be seized when their prices are dipping. But how has this theory actually worked out in practice? Have investors made returns buying at lower levels?
Asia-based equity broker and investment group CLSA did an interesting analysis recently regarding the ‘buy-on-dips’ theory. The study concludes that it is not just theory that buying cheap delivers better returns and buying expensive diminishes returns, but that it is one of the most practical options.
An analysis of the last 10 years’ consensus price-to-earnings (P-E) ratio and 12-month forward returns suggests that whenever the Nifty P-E has been 14 times or above, returns have been in single digits. Market returns decrease when the buying P-E increases.
At a P-E of 14 times or below, investors have made double-digit returns the following year. When the index PE has been less than 14 times, average one-year returns have been more than 20%, notes the study.
The analysis does not end there. Further number-crunching shows that at even lower P-E levels, the market can provide double-digit returns. Sample this: whenever the P-E has been around 11-12 times, average forward returns have been around 34%; at P-E levels of 10-11 times, returns surged to 59%.
At present, the forward consensus shows that P-E levels are around the 17 times mark. At this stage, returns are likely to be in low single digits next year. Of course, there could be exceptions, i.e., returns could be higher if there is a pick-up in earnings growth or if the investment cycle improves.
This introduces us to a more important point. How can investors best put their money to work when the market is inexpensive? Investors hoping to craft stronger safety have to be disciplined while investing when the market is sliding or when prices have been pared. When stocks are on a ‘fire sale’, this theory works even better.
For most investors, however, that discipline of buying low has sadly not been well implemented.
Just a few months ago, when stocks were trending lower, investors were hardly making big purchases in the market. Inflows into equity mutual funds were trickling down, when they should have actually become more robust.
As always, retail investors get on the fence when the market starts to “correct”, and jump on the bandwagon after it has surged.
Even when scores of studies have pointed out the inverse correlation between the market’s estimated returns and its P-E, investors are making the avoidable mistake of “buying higher”. It points out that there is a -64% inverse correlation between equity valuations and returns, which is respectable.
Indians in general love to buy things when they are on sale. But not so when it comes to stocks. This works contrary to what investment gurus have been advocating, and does not make for efficient investments.
Retail investors also tend to fear volatility in the equity market, but the market has demonstrated in the recent past that volatility is likely to be a common theme. While markets are volatile in the short term, they can offer good returns over the long term.
The Indian economy is at a stage where the seeds are being sown for a revival in the longer run. A large part of the corporate sector is sitting on spare capacities and, therefore, an investment-led uptick is still some time away. Although there is consumption demand, corporate earnings growth is likely to be slow and gradual. Earnings growth is increasingly skewed towards a few sectors.
However, some of these sectors may find it difficult to expand margins when commodities are bottoming out. Hence, this also calls for investors to make appropriate tactical calls within sectors and stocks.
At the same time, market volatility is likely to provide buying opportunities to investors. You would not want to miss out buying at lower levels, or switching out to debt at higher levels.
However, knowing when to switch into and out of equity for any investor on her own can be difficult. Investors will need to keep track of equity valuations all the time to know when conditions make for good entry points. At the same time, they have to make investment-worthy allocations.
Dynamic asset allocation funds may work well for investors of all kinds. These have an in-built mechanism that helps in comfortably navigating the ups and downs of the market. These funds cut ‘emotion’ out of stock investing, and do not fear when stocks are falling, or succumb to greed when stocks are rising.
These funds also factor in equity valuations at all times. They follow a preset formula of price-to-book value that considers equity valuations, and then make decisions to invest. If the stocks are inexpensively low, dynamic asset allocation funds add more equity.
These funds automatically switch to debt when equity becomes expensive. These work well for investors as they do not chase runaway prices or miss opportunities on dips. So, with these funds in their investment tool boxes, investors are robotically and easily following investment gurus’ principle of buying low consistently.
This article was published on May 26, 2016 in Mint