We would like to bring to your notice the recent developments in the market as many of you would rightfully panic if not advised in the right hour. Year of 2013 so far has left those investing money in stocks with deep scars to their portfolios. Be it speculators, traders, investors or mutual funds there are none left without deep cuts to their portfolios. We make an attempt to reason out the factors that contributed to this mess in stock market investing.
Loss in Nifty for the period January 1st to July 31 is only 4% and looks quite normal for an outside eye. More than 90% of investors in India admit that their losses were far above 20% in the same period and often wonder what led to their predicament. There ought to be a strong reason that is not clear from the surface. Large cap stocks, which form part of Nifty are most aggressively researched, followed and invested by large corpuses. Because of this, Scope to grow is often limited for large cap stocks, though we cannot rule out such chances. Although by nature mid cap stocks have a high beta and give higher returns than index in bull markets. In the present context, mid cap stocks have retreated far faster than its counterpart in Nifty and hence we notice major drop in portfolio values.
Let us look at the way three main indices of NSE, Nifty, NSE500 and cnxMIDCAP have performed in the same period with a hope to unravel the truth behind this position. Nifty, as is well known, has lost only 3.5% in this period while NSE500 which is more broad based than Nifty and can be interpreted as true representative of corporate India suffered a loss of 8.5%. Midcap index has lost a whopping 21% in the same period. Attraction from retail investors to this segment is a well known secret for quite some time. Therefore, to some extent the reason for more profound loss by investors is explained with midcap meltdown.
Discovery of share prices is done based on either operating results for the latest period or based on future expectations from the stock. An analysis by ViVeKam for last 13 years has established irrefutable evidence that 82% times the stock prices have their roots in reported operating performance. Hence it is natural for someone to conclude that the falling profits of corporates may have led to the disappointing performance of stock portfolios. Before we embark on an exercise to determine the facts behind this argument, let us look at the stock performance analysis and the factors that influence stock price.
We all know that EPS stand for Earning Per Share or profit per every share. The number of times a stock price quotes above this EPS is called PE ratio or Price Earnings ratio. For instance, if ITC is quoting at 340 and its EPS is 10, we say its PE ratio is 34. Put in other words the equation looks like “Price = EPS * PE Ratio”. From the above, we can safely state that estimates of EPS (or profits) and PE ratios are essential to forecast the prices. When you multiply the EPS with total number of shares in company, you derive total profit and when you multiply share price with the same, you get total market capitalisation of the company.
We built a model portfolio of NSE500 with 50 crore rupees and read the price behavior of its constituents between January 1 and July 31 of 2013. During this period only 87 companies have recorded price rise while an overwhelming 413 companies or 83% have lost values. Among those that rose, only 23 companies (less than 5% of total) have gone up by more than 25%. And only 49 companies or about 10% of the total sample have appreciated by more than 10%. On the contrary when we looked the losing companies, 15 companies have lost more than 75% of their value and 236 companies (about 50% of sample) have lost more than 25% of their values. On the whole over 70% of stocks have lost 10% or more in this period. Given this set of facts, it is hardly surprising to note that an average retail investor’s portfolio has eroded more than 20%.
It is required to study the reason behind the price fall. One must ascertain whether lesser profits or lower PE ratio contributed to this stage. In these 7 months 290 companies out of NSE500 have improved their profits. Yet, prices of only 67 out of them have risen. Despite having reduced profits or increased losses, 20 companies have appreciated in price. This goes on to prove that the lower PE ratio contributed to the price fall more than reduced profits. Hence it is essential that we focus our attention to the PE factor and its destabilizing role. In order to be more accurate we will broad base our study from the last seven months to last 7 years. The following graph depicts the profits of 50 Crore NSE500 portfolio basket and its PE ratio. From a peak level of 33 recorded in 2007 November, PE ratio for NSE500 slid to a low of 10 by October 2008 following global financial crisis. It crawled back to around 25 by October 2010 only to slip back again to around 15 by the current time of July 2013.
When we compare the profits of the NSE500 basket, they rose from a level of 1.09 crore in 2007 to about 2.83 Crore by July 2013. It means that the prices fell despite increased profits, which can only happen by shrinkage of PE ratio, being on one side of equation. Stock market journey is always a roller coaster ride and those aware of this will worry very little with the latest developments. So long as the stocks included in their portfolio are reporting better results, they stay firm and stay invested waiting for the next big move of expanding PE multiple. When the broad sentiment improves, PE multiple expansion alone will fetch them an appreciation of at least 30 – 40%, even if the profits stay at the same level.
Since the Midcaps were seen to have melted down, let us scan the behavior of Midcaps from 2007 onwards. From the graph below, you would notice that the profits of Midcap basket portfolio improved from 1.37 crores in 2007 to 3.05 crores by July 2013. The PE ratios which topped at 37 in November 2007 has slid to a low of 9 by October 2008 and then recovered back to 25 levels by 2010 October. With FII withdrawals gathering pace in 2013, it slipped back to the level of 13. Considering the fact that the circumstances of 2008 financial crisis no longer present now, slightest recovery in sentiment could make this multiple seek a level of 18 – 20 soon. This being long term average of Midcaps, it could mean an appreciation of 40% in portfolio values.
Though the prospects for recovery looks brighter by every fall in PE rates, one must remember to retain only profit making companies in their portfolios. So long as the investment decisions are driven by the logic of undervalued growth stocks, one need not worry about the short term trends in market. When the sentiment turns good, all companies may fetch higher prices but the ones with improved profitability will witness accelerated rise in prices. Hence it is ideal for retail investors to focus on their stocks individually and make sure they keep only profitable stocks. This calls for unloading of less profitable stocks, irrespective of the entry price for the investors. Profitability of your stocks should determine the continuation of the same in portfolio and not your entry price or cost price of such stocks.