Great Indian Valuation Party continues. But…

One of the problems in raising concerns about valuations is that you can end up looking like a party pooper. And if future markets movements do not happen in line with what you are expecting, you can even end up looking like a damn fool!

But that’s fine. I don’t intend to predict anything here.

It’s just that if you look at the data, it does trigger some concerns. I am a simple investor who wishes to buy low (and maybe occasionally sell high too). 🙂

Unfortunately, the ‘buying low’ part doesn’t seem to be easily happening these days.

For Nifty50, the valuation of the index today is in excess of PE-26.

Now historically, this is rare! And has happened very few times in the last couple of decades. In fact, there seems to be a sort of hidden upper ceiling when it comes to valuations and markets have trouble keeping above that ceiling.

Have a look at the chart below.

The blue line is actual Nifty level. The red line is hypothetical Nifty level at PE24 at that time. The green line is hypothetical Nifty level at PE12 at that time.

Nifty PE Pattern Trend

Clearly, Nifty seems to have trouble staying above PE24 (considered overvalued) and below PE12 (considered highly undervalued). Whenever it reaches either of these two levels, it seems to bounce off in opposite direction! (read full analysis here).

Also, a move beyond PE 25-26 has been historically rare and generally resulted in steep falls. And as can be seen from tables below, markets do not spend a lot of time on the extremes:

Nifty PE Band Group Time

But does it mean a sharp fall or a full-fledged market crash is just around the corner?

I don’t know.

River water seems to be flowing above the danger mark. But will it flood the city or not is something that I cannot predict. And markets have this evil habit of surprising. So who knows they may remain at these levels for much longer.

Ofcourse every now and then, the valuations will be stretched and go where it hasn’t gone in last many years. But it’s important to consciously remember that sooner or later, the reversion towards mean happens. And this is what learning from history and identifying basic patterns helps you do.

I regularly publish index PE data and as many of you might have noticed, is showing a lot of red. Check here for the latest update in November 2017.

I have done detailed analysis earlier which shows (or seems like modestly predictive) that future returns tend to be low when investment is made at very high valuations. To summarize, it is something like this:

Nifty PE Ratio Return Patterns

(Please do note that above are average figures. And depending solely on averages and ignoring the actual deviations can be catastrophic. Read about the risk of depending only on averages and please… never forget about it.) 🙂

Now interestingly, the Nifty PE has remained in and around 24 for last one and a half year. And as of now, we have been flirting with PE26 and above(s) for the last couple of months.

I did some further slicing & dicing of data to see what happens to index returns (in next 1, 2 and 3 years) when investments are made in PE24 and above zones. Here is the data cut:

Nifty High PE returns historical

It’s self-explanatory and unfortunately, paints a sorry picture.

Do note that the correlation seems very strong but the number of data points is not very high.

All these hints towards something not being right. But the party still seems to be on…

Maybe, the earnings will surprise and bring down valuations without hurting market levels. Or maybe, the constant flow from retail investors is and will support the markets for longer. Or maybe this time it is ‘really different’ and we will continue to reach newer heights on the mountain of valuations. 😉

But like all bull markets where new highs are being regularly made, it’s very easy these days to write off valuations as something of an unnecessary botheration. Everything is moving up like there is no tomorrow. Investing in IPOs is once again perceived to be a quick way to make money. But trees do not grow to skies for a reason. And valuations matter. Believe it or not.

I don’t intend to predict a big crash here.

Markets have a mind of their own and will crash when they want and not when we predict. But I feel that we should not throw caution out of the window. We should be alert. Alert to the possibility of lower future returns.

But since I have used Nifty50 PE data as a representative of the market, let’s make note of few things which should be kept in mind:

  • Nifty of today is much different from Nifty of earlier years. Infact, there is a regular change in index constituents. So it’s easily possible that high PE is the new normal. After all, in earlier years Nifty was made up of low-PE companies while these days it’s populated with high PE ones (read this interesting analysis).
  • Another aspect linked to above point is that PE data provided by NSE is based on standalone numbers of Nifty companies. It would be ideal to use consolidated numbers as many Nifty companies have subsidiaries that have a significant impact on earning numbers. This has a much larger effect now than it would have had in yesteryears. But NSE publishes Nifty PE using its own set of criterias and decisions.
  • For all practical purposes, one cannot wait for investing when valuations are rock-bottom (like PE 12-14). If that is the case, the investor will end up on many bull runs that begin at 15 and end at 27. 🙂
  • Investing in individual stocks is a different matter altogether. You can always find undervalued stocks in overvalued markets. There can be stocks that continue to command high premiums and still deliver spectacular returns year after year.

I don’t know what the so-called smart money would be doing now. But moving out of equities completely is not something that I do. Ofcourse, focusing on asset allocation with an eye on valuation and operating in preferred tolerance bands is something that should help most people.

Nothing more to add from my side here. Here is an old tweet that acts as a sort of guide 😉

Let’s see how things pan out in near future.

Either we will make more money or learn a few new or relearn a few forgotten lessons. 🙂


Is Higher Cost of Active Management Justified in Indian Context?

Active Fund Management India

You know about index funds. Right?

Passively managed, these funds replicate the index at a portfolio level. So if the index has 50 stocks with different weightages, the index fund will have the same stocks in same weightages.

Since this type of portfolio maintenance doesn’t require any superior intellect or stock picking abilities (after all, it’s simple replication of an existing index), the costs associated with index funds are much lower than actively managed funds. Obviously, the returns of these funds mimic those of the index. So where most investors want to beat the indices like Nifty and Sensex, index funds don’t want to do that. They live by the motto – If you can’t beat them, then join them.

But we need to give credit where it’s due.

Index funds don’t beat a good fund manager. But surely beat the bad ones. 🙂

Now Mr. Buffett is a staunch supporter of Index Funds. And so are many other great investors and money managers.

In fact, when Google was preparing for its IPO in 2004, the company realised that a number of its employees were about to become millionaires.

Therefore, the company brought in a series of financial experts to teach them to make smart investment choices. Stanford University’s Bill Sharpe, winner of the 1990 Nobel Prize in economics said, “Don’t try to beat the market.”

Even he advised Google employees to park their money in index funds. And rightly so.

In developed markets like the US, 70-80% of actively managed funds fail to beat the indices. So, it’s really tough to find good fund managers ‘there’ who will beat the index on regular basis. Even if there were a handful of such managers, new money flowing into their fund coffers will ensure that their returns suffer when the fund swells up. Then again, it would be tough to find index-beating returns.

This is the reason that greats like Buffett advocate index investing.

Active managers can’t beat the index. And they also charge higher. So what’s the point of having active management? Isn’t it?

Investors should get a better deal.

In his latest letter to shareholders, Mr Buffett even talks about his bet that no person (whosoever) could select at least five hedge funds (high-fee investment vehicles) that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees!

Many investors tend to disregard investment fees. But when active management is not helping get higher returns, why pay higher fees for underperformance? Better stick with low-cost index funds. And in this age of robo-advisory, it’s possible to invest passively with minimal human interaction. And one look at any automatic investment fee calculator would highlight the amount of money that can be saved by going the robo-way. Low cost, potentially better performance. What else do the investors in developed economies need?

But here in India, the landscape is very different.

Many years back, I was of the view that I should be investing primarily in index funds.

But then I realized that index fund investing is not the best option for me. And for all those who are ready to take some additional (but not illogical) risk in need of higher returns.

There is enough proof available that active funds managed by good, skilled and capable fund managers in emerging markets (with not very mature equity markets) like India will outperform the indices.

In any case, if you tell someone in India that a fund will give you returns that match that of the index, they will be disappointed. Even if the index is giving 20% 🙂 Investors just want to beat the shit out of index returns.

But jokes apart, for most common investors it’s better to avoid index funds for time being.

A reasonably good proportion of mutual funds have been known to outperform the benchmark indices on a consistent basis over various time periods. In all likelihood, the index funds in India will be unable to beat some of the good actively managed mutual funds for some years to come. Here is an interesting analysis on active management (index vs actively managed funds) in India.

Some feel ‘Invest in the index for better returns and lower fees’ is Buffett’s Single-Best Piece Of Advice for common investors (who have no business picking stocks or fund managers).

It’s of course essential to control (if not eliminate) your investment fees. Uncontrolled investment fees can significantly reduce returns over time.

But given the Indian context, where the probability of finding index-beating funds is higher, the higher fund management costs seem justified. At least to some extent.

Finally, when it comes to index vs active discussion, I think we Indians have won the ovarian lottery (in words of Buffett).

We have quite a few options beyond index funds.

Index investing isn’t meaningful for most investors. At least not for me. At the current levels of market efficiency and size, I expect good actively managed funds to generate alpha atleast for next decade or so. Possibly after that, the over-performance (above index) might reduce as domestic equity markets become more efficient.

So as long as the party is on for some more time, keep dancing. 🙂