Stick to a defined asset allocation plan

Benchmark equity indices closed at record highs on Friday (August 13), with the S&P BSE Sensex crossing the 55,000 level for the first time and Nifty scaling the 16,500-mark. The current run has extended amid sustained FII flows, better corporate results, waning inflation concerns and increased retail participation.

A look back at the previous bull-run reveals that the Nifty 50 grew about 6x – from 1,100 levels in January 2002 to 6,300 in January 2008, and delivered a return of 33 per cent CAGR.

The interesting part is that this seemingly secular run was marred with multiple corrections. In that 6x journey, Nifty 50 recorded seven falls of more than 10 per cent, two of which were more than 30 per cent.

In the period beginning May 2014 till August 2021, Nifty 50 has grown nearly 2.5x, from 6,695 to 16,500, registering a growth of 13 per cent CAGR. This journey has witnessed five falls of over 10 per cent in seven years, two of which were 20 per cent drawdowns, including the 40 per cent correction in March 2020.

Why is this important?

As explained by Howard Marks, investor behaviour gyrates like a pendulum swinging between extreme pessimism and euphoria.

The fear of losing everything amid Covid induced lockdown, experienced by investors in March 2020, is replaced by excessive greed – where every other IPO is getting oversubscribed multiple times over. At these levels, the instincts of ‘freeze’ or ‘flee take over.

There is a school of thought which dictates exit from all equity investments and switch to the safest option. The other predominant thinking among investors is to wait on the sidelines for a correction and try to time the market.

The fundamental problem with both approaches is that neither can you call the end of bull-run nor can you time an intermittent fall. One may then ask, What is the best way forward?

Well, let us go back to the basics, Earnings Growth.

FY22 Resembles FY02

The nascent recovery in corporate earnings growth seen in the third and fourth quarters of FY21 will need to sustain into FY22 and beyond. In terms of valuation, market P/E is higher than the long-period average. But this can be explained by way of low-interest rates and expected high growth rates. Further, even in terms of Market Cap to GDP, India is at around 100 per cent. Many countries are at much higher levels.

Corporate profits have fallen from 7.8 per cent to 1.8 per cent of GDP over the last decade, led by destruction in profit pools of several businesses, including Commodities, Telecom, Industrials, Corporate lenders and US Generics, to name a few.

Most of these profit pools are in the process of getting rehabilitated. Analysts predict that even if corporate profit to GDP reverts to the long term averages, we could sustain strong earnings growth of over 20 per cent versus the 5 per cent that have witnessed for the last decade.

A host of other complementary factors besides corporate profit growth, viz., i) benign interest rates, ii) robust FII flows, iii) stable rupee & health forex reserves, iv) Capex Growth and v) higher savings & investment rates are a lot similar to 2002.

The trailing P/B went from 2.0 in mid-2002 to 6.6 by 2008. There were multiple corrections through the journey, as has been highlighted in the data above. The trend seems to be similar currently, with trailing P/B rising to around 3.9 from the lows of 2.2 made in March’20.

This, coupled with corporate profits returning to mean, consensus estimates suggest a Nifty EPS growth of 24 per cent CAGR through FY25 resulting in a possible Nifty price Compound Annual Growth Rate (CAGR) of 23 per cent.

It shouldn’t look unbelievable because the same had played out in 2002-08 with Nifty Earnings Per Share (EPS) growth at 24 per cent CAGR and Nifty Price Growth at 29 per cent CAGR.

The inherent risks to the above hypothesis are a) subsequent covid waves, b) an earlier than expected increase in interest rates & hence bond yields, and c) rising commodity prices.

The current journey started in January 2020 with Nifty at 12,000 levels, and we have scaled only 16,500 yet. A lot of money is lost in waiting for corrections rather than staying invested.

Investors would do well if they stick to a defined asset allocation plan and appreciate that, in the long run, stock prices are a function of earnings growth.

Stay safe & stay invested.

(The writer is Head-Sales, MOAMC)