Current market valuations leave little scope for profit-making

One-year forward price-to-earnings ratio at 16.4 times is above the historical average of 15 times.

Equity markets worldwide have witnessed major rallies since July 12 this year on the back of better-than-expected earnings for the June quarter. And the Indian market has already factored in a stronger recovery with price-to-earnings (P/E) multiples rising to over 20 times from around 10 in March 2009.

According to Morgan Stanley, foreign investors are a bit uncertain about India. They are worried about the rate at which the Indian market has risen after the last general election results, its high correlation with global markets, current valuations and the government’s reform agenda.

After the biggest fall in forward earnings in more than two decades, which happened in the March quarter, profit expectations are beginning to stabilise. According to a Citigroup analyst, trailing 12-month forward earnings estimates fell by 40 per cent over the 16 months to May 2009—a fall far greater than the last correction of 25 per cent earlier this decade. Since the lows of March 2009, forward earnings estimates have risen 9 per cent. Now it appears that these earnings have entered a recovery phase. Forward earnings expectations provide investors with a timely update on the outlook for profits over the next year.

Based on research reports of foreign as well as domestic equity research firms, the forward earnings data for 250 companies indicate that the corporate sector may show a 19 per cent increase in net profits in the remaining nine months of the current financial year. The earnings estimates of these 250 firms are important as they account for almost 77 per cent of the total market capitalisation of companies listed on the Bombay Stock Exchange (BSE).

The corporate sector’s net profit is expected to grow at 20 per cent in 2010-11. The sectors that are expected to post more than 20 per cent growth in their net profits in 2009-10 are auto ancillaries, capital goods, oil & gas, pharmaceuticals and sugar. Construction, steel, telecom, FMCG and non-ferrous metal companies are expected to post a double-digit growth, while banking, cement, fertilisers and power firms are likely to register a single-digit growth in their net profits.

Similarly, the sectors that are expected to show a decline in their net profits in the current financial year are finance, realty, consumer durables and mining & minerals. However, these sectors are expected to post a robust growth in 2010-11. The net profit of realty firms is likely to decline by around 25 per cent in 2009-10, but the same is expected to be up by 20 per cent in 2010-11. The retail sector, which is expected to make a turnaround in 2009-10, is all set to post a 44 per cent growth in its net profit in 2010-11. The net profit of software services companies is likely to remain flat in the current fiscal, but the sector is expected to show a double-digit growth in 2010-11.

The 250 sample companies are trading at a P/E of 16.4 times of FY10 earnings and 13.74 times of FY11 earnings. Nevertheless, their current P/E of 19.5 times, based on the trailing 12-month earnings for June 2009, has been more than double from a P/E of only 8 times just six months ago. Hence, the current valuations are expensive.

Based on the forward earnings, valuations of stocks are at their peaks in sectors such as auto, banking, cement, metals & mining, telecom and technology. Capital goods, hotels, logistics and power sectors do not seem to have immediate growth prospects. Retail, sugar, pharma, media, healthcare, aviation and real estate sectors are not fully priced, based on expected forward earnings for 2010-11.

Equities worldwide are over-valued with P/E multiples across emerging markets such as India, China, Indonesia and Brazil, and major developed market, including the UK, France, Germany and the US, hovering above their long-term averages. At 20.2 times, the Sensex P/E ratio is higher than the 15-year average P/E of 15 times. According to a Morgan Stanley analyst, for expected GDP growth of 5.8 per cent and 7.2 per cent for FY2010 and FY2011, respectively, an appropriate and stable ratio should be below 16.

At the current levels, MSCI AC Asia Pacific ex-Japan is trading at 15.3 times of the 12-month forward P/E, which is 76 per cent higher than the P/E of 8.7 times in November 2008. Historically, the current ratio is above its long-term average since 1992. Over the past 18 years, the market has traded above this level only three times, all during the major bull runs of 1993 (P/E 17.3), 1999 (P/E 20.9) and 2007 (P/E 17.4).

The global market capitalisation now stands at $46.71 trillion, up $21.01 trillion from March 2009 lows, but still $14 trillion below the January 2008 highs. On the other hand, the Indian market capitalisation has more than doubled from $506 billion to $1.17 trillion, but is still $720 billion below its all-time high. Equity markets have rallied significantly since their March 2009 lows with all global benchmark indices trading at historical P/E averages.

NUMBERS AT A GLANCE
	Growth in NP* (%)		P/E ratio
	FY10E	FY11E	Current	FY10	FY11
Automobile	27.35	11.86	27.00	21.20	18.95
Banking	4.05	18.80	12.22	11.75	9.89
Capital Goods	35.82	24.33	33.80	24.89	20.02
Cement	8.86	-6.73	9.83	9.03	9.68
Construction	11.62	17.16	25.47	22.82	19.48
Finance	14.80	17.68	24.98	21.76	18.49
FMCG	14.78	15.48	27.72	24.15	20.91
IT-Software	0.27	11.71	19.99	19.94	17.85
Non-Ferrous Metals	12.79	35.89	16.63	14.75	10.85
Oil & gas	42.64	18.78	18.69	13.10	11.03
Pharmaceuticals	90.57	20.91	37.92	19.90	16.46
Power	10.47	13.01	24.08	21.80	19.29
Realty	-24.96	19.63	24.77	33.01	27.59
Steel	18.96	30.41	16.50	13.87	10.64
Telecom	16.77	16.11	17.08	14.63	12.60
Total (250 companies)	19.14	19.11	19.50	16.37	13.74

Historical evidences show that investors who enter the equity market at lower levels get a return of over 50 per cent within six months. But investors who enter close on the heels of a 150 per cent rise in the market get a modest return after three-five years. The BSE Sensex and the Hang Seng have doubled, while other benchmark indices have appreciated by over 60 per cent from their 52-week lows.

According to a Credit Suisse report, if you buy after a 40 per cent drop in the market, the probability of making profits after three years is over 70 per cent. After five years, it goes up to over 80 per cent, against nearly 40 per cent if you buy after a long rally. The Sensex has appreciated by 102 per cent in six months from its low of 8,160 on March 9, 2009. So, the scope for any short-term upside is limited and one can only hope for long-term gains.