We have all heard that the Indian stock markets have become extremely narrow – “7-8 stocks in the NIFTY driving returns”. I just wanted to flesh this out and analyze just how narrow. In that process I wanted to look at what the averages tell us.
I am going to look at stocks to determine how “close” they are to their 52 week lows – this is slightly subjective and to make it more objective, if a stock is 3 times as close to its 52 week low as it is to its high, then we say that it is indeed “close” to its lows. For example, if the gap between the high and low of a stock is say 10%, and currently the stock is just 2.5% (or less) above its 52 week low, then it is close to the lows. I look at the converse to classify stocks to be close to 52 week highs.
Based on this approach, if I look at the stocks in the NIFTY 200, about 40% of the stocks (~80) are close to 52 week lows. About 22.5% (~45) stocks are close to their 52 week highs. The rest are in between. For the whole universe of about 1000 stocks that I currently monitor, about 56% of the stocks are close to their 52 week lows, and only 11% out of these 1000 stocks are close to their 52 week highs. What does this tell us? Stock return distribution has indeed been skewed in the last year. 61% of the stocks from the universe which are close to their highs are a part of the NIFTY 200 universe.
The reasons for this skew are obvious, and for anyone not of top of the news – there is a shift to safety currently going on in the Indian stock market. This is the “return OF capital first, return ON next” syndrome. As a store of wealth, safer, larger, cleaner managed, lower debt companies will be more preferable. This is separating the men from the boys.
What do the valuations of these safety stocks look like? For valuations, I look estimate the Earnings Power Value (EPV) using last 5 year averages. What this means is that I assume that the company performs like it did on average for the last 5 years for perpetuity (without any growth) and calculate the Present Value of these perpetual cash flows (again without growth). This value allows me to break up the market cap of the company into 2 parts: 1. The no-growth EPV and 2. The residual that the market attributes to the growth of the company. An analogy of this is that the intrinsic value of the company consists of 2 parts: 1. The assets as based on the balance sheet and 2. The future opportunities available to the company. For a growth company, the market attributes more value to the future, hence part 2 is higher. For a cash cow or a dog, the market attributes more value to what the company currently owns (or how it can currently perform). This approach works for non-financial companies.
Coming back to get a sense of valuations, I look at the no-growth EPV of companies which are A) Close to 52 week highs B) Non-Financial companies and C) Part of NIFTY 200. This is a good proxy of stocks where money has diverted to in the last year – stocks close to highs and part of a liquid index. The average market cap of this basket is 105,000 Cr. What does the market think of this group? Average no-growth EPV of this basket is 33%. Which means that the market is assigning just 33% of the price to how the company has performed on average in the last 5 years and 67% to the growth of the company. Think about this for a minute. We have an average company which is already 100,000+ Cr in market cap, and which the market is saying will grow so fast and so much that it is willing to pay 67% (~67,000 Cr) for this growth. This is a bit like “irrational exuberance”. At the same time, lets remind ourselves – India in general is valued at a premium to other emerging markets for its growth. The question is – is this premium being valued correctly?
The mirror image to this basket is a group of companies which 1. Are close to their 52 week lows 2. Are not a part of the NIFTY 200 and 3. Are non-financial companies. This is a proxy to that part of the broad market which has received the short end of the stick. For this group, the no-growth EPV works out to be 125% i.e. the market is assuming that these companies will shrink from how they performed in the last 5 years. This group has an average market cap of just 1800 Cr, but the more striking aspect is that it accounts for about 30% of the universe (~300 companies).
On the ground we know that earnings growth is in single digits, private capex is still to take off, even as a lot more skeletons could yet be hidden in closets. Clearly, there is a discrepancy between how the market is valuing good companies and punishing the ones perceived to be “dirty”. In such a situation, the question then arises is - sure, we could buy a good company – but are we buying at the right price? On the flip side, has the market punished the “dirty” bunch so much as to create value. To me, the answer is a bit of both and obviously stock specific. Would I put pedal to the metal to buy fallen angels now? Nope. Because I cannot foresee which skeleton is still hidden. Would I be totally out of the market in cash? Nope here too. Because there are still a few gems that the market seems to be punishing excessively. Would I still participate in the relative out-performance of the large-caps. Not entirely. The picture is not clear enough and clearly requires caution and patience. The smart money lies in identifying the wheat from the chaff.