Every bear call is a comment that the market is looking a little expensive and valuations are extremely high compared to historical trends. Even as we sit on yet another record high, where do you think the market is deriving this bullishness from?
The small cap index has almost tripled since March. The markets went through a pretty tough phase in the pre-Covid period and it is natural for everyone to feel a little jittery about markets. In 20 of the last 30 years, we have had at least a 15% correction. For 17 months now there has not been any such corrections and it has almost been like a smooth upside.
I find the fear to be pretty genuine and one has to be cautious in the market but one of the factors which is under-appreciated is how the cash flows are and how the balance sheet is. The PE multiple that we have seen at the highest level historically is about 30 times trailing multiple. I am not talking about Nifty50 but the top 500 companies. Their medium PE multiple is around 32 times which was pretty high even in 2008 or any of the last peaks. We have not gone to those kinds of levels. But if one looks at the enterprise value to cash flow, the debt has gone down and it has gone down because of the cash flow that the companies have generated and most of the companies have taken a call that they want to be debt free.
It will be surprising to see how many companies have become debt free in the last 17 months and that is where the cash flow multiple, which is enterprise value to cash flow, at about 15.8 times is below the historical average of about 16 times over the last 20 years.
Now compare this with the 2018 peak. It was at about 25 times and even in 2008, the peak was about 25 times. We are still 60% away from that peak. At the same time, look at the balance sheet. The debt to equity ratio today is at 0.16, which we have never seen in India’s history.
The third thing one has to look at is how do the cash earnings yield compare against the bond yields. The bond yields today for India 10-year Gsec is about 6.2% and when you inverse the enterprise value to cash flow from operations which gives you the cash yield, it is at about 6.3% which is higher than the bond yield. Rarely in the last 20 years, have we seen higher cash earning yield than the bond yields and if you compare this with 2008, the bond yields were at 8% and the cash yield was about 4%. So, a 50% discount. Look across all peaks — whether it is in 2000, 2011 or 2017 — the earnings yield used to be at least 30% to 50% below the bond yields and that also gives you an indication that relatively speaking, it is not that worrisome in terms of the valuations.
Very interesting point so instead of looking at valuations from the P&L perspective, we are looking at it from the balance sheet perspective and yes balance sheets have been repaired very well over this last one-one and a half year. Cash flows have improved. Then why would you still be a little cautious on the market? Would you stick to those sectors where you have seen an improvement in balance sheets?
Yes, the balance sheet repair has happened across sectors — whether it is commodities stocks, material stocks or real estate stocks. Anyway consumer stocks never really had an issue. so I am just being little cautious because of the kind of relentless rally we have had and you know there is high probability that someday, we will get that 15% correction which has a two-third probability in a year and that is the only reason.
In the long run, if one is able to take that 15% correction, a lot of mid and smallcaps can correct double or even more than that. That is the only reason for caution but we do not know when this correction will happen. It can come next week or it can come two years, three years down the line. There is no way to predict that. There are certain pockets, in terms of IPOs, where there is frothiness and that does give some reason for worry. But when you look from a two to three year perspective, in terms of the government finances, consumer finances, corporate finances as well as export potential, the conditions are favourable for all. This is probably the first time I am seeing that happening.
So many companies are applying to double their capacity over the next three to four years and almost all of them do not want to take any leverage. They are all relying on internal approvals. With such strong balance sheets, I do not really fear a crash kind of scenario.
Who would have thought that India would be collecting taxes which are beyond the budget for this year? GST collection as well as the income tax collection is almost at all-time high and well beyond anyone’s expectations during Covid times. Also look at the consumers. About 95% of the population would be mostly spending on necessity items and that kind of consumption does not really change. But the salaries of the top 2-3% or maximum 5% of the population have gone up. The June quarter salary levels on an annualised basis compared to a year ago have gone up by Rs 1.3 lakh crore. That is a pretty large sum.
Salaries have grown across the sectors. IT, pharma companies are finding it difficult to get employees and if they want to get employees they have to pay 30-40% higher. Government finances are strong and that means that they will probably need their infra spending of 1.4 trillion which is higher than what the US has announced and we speak so much about the US infra spending. I feel as government finance is strong, they should be spending. Consumer is strong with salary increases plus wealth increase.
In the last one year, the overall market cap of Indian companies have gone up by Rs 100 lakh crore and that is $1.35 trillion and out of that, 30% is probably owned by the non-promoters or the Indian public through mutual funds or direct investments — so that is 30 lakh crore. Now, Rs 30 lakh crore is not even the budget of India for the entire year. That is the kind of wealth creation we have seen and that will aid consumption. There is big capex move coming up and there are companies who are wanting to spend. So, there are many factors which give me much more confidence today where out of a crisis, the balance sheet of everyone — the government, consumer, corporates plus foreign exchange reserves — are probably in the best conditions.
It has been a parabolic move for the markets, Nifty alone has risen 10,000 points since the pandemic lows. We have had virtually no correction in the last 17 months. If indeed a correction comes, which part of the market will be affected and how steep could it get?
For a market to crash, it has to be more than 25% fall. But if you look at the last real bull market we had from 2003 to 2007, we probably had at least a 15% correction almost every year during that time, sometimes twice a year. So 15-20% correction is possible even in the best of the bull markets. One has to be ready for that and probably a lot of new investors may not have seen it but I feel even the newer retail investors are pretty smart. They are pretty well read and we should not underestimate them. They are pretty much aware of the risks of the stock market and there is too much literature and talk available for retail investors today which probably was not there in the previous cycle.
The retail investor today is much more educated and well aware of the risk but when the market is going through a correction, irrespective of theoretical knowledge, everyone will probably learn through that experience and I feel it is needed for the market. The markets have to correct at least that 10-15% that keeps everyone in sanity and generally those are the shakeouts which are needed because that generally takes out the weaker players. We need the market to stand on a strong foundation because if it keeps going up, it will be supported by a lot of weak investors and then the more you let it go up, the bigger the crash will be. So, a good 10-15% kind of a correction would be really welcome.
Do you think there is a big overhang that when interest rates rebound or turn the tide, so would the markets?
That is a general perception but in my recent memo I presented a table for US market which shows how the S&P 500 did when the Fed was increasing rates versus when the Fed was decreasing rates and across cycles. It was a very direct relationship. So the rising Fed rate cycle results in good results for the S&P 500 because it is natural.
Most often, the Fed increases the rates when the economy is doing well and reflects moderate inflation. If that is the case even this time that the markets are positively correlated, it should do well. In the short run, one could get a shock when the news comes out but when one looks from the bottom to the top of the interest rate cycle, the markets tend to do really well. It seems logical to me because in a rising interest rate cycle, typically the competition to equities are bonds. Now, bonds would lose value in a rising interest rate cycle. So typically a larger investor would want to over allocate to equity rather than to the bond market.
There will be a shock suddenly if the Fed announces a taper which is much higher than what the markets are expecting, but it should not really matter in the entire cycle. Risk comes in when the Fed rate cycle peaks and the downtrend starts. That is when the markets really correct. Rising interest rates are generally good for the equities market. It is when they peak and that is where the real risk of crash comes in. I feel we are nowhere close to that and are at least a year, two years, three years away from that because we do not know how long this tightening cycle will last.
In the longer term historical perspective, over the last 10-11 years, our dollar annualised returns probably are just 3% to 4% compared to like 15% for the US market. A lot of broader markets have gone up much more than the Nifty in the last 17 months, since Covid. But from the peak in January 2018 to the bottom in March 2020, the Nifty smallcap index had fallen by 67%. So, just to recover that loss, it had to triple. The small cap index was around 9,700 in January 2018. Today, it is probably near 11,000, which is almost flat in a three-and-a-half-year period. We have a lot of catchup to do to reach a longer term return profile of India.