Stagnant earnings but boom-time valuations

Investors should be careful with mid-cap stocks trading at rich valuations, says Dhananjay Sinha

The current flood of inflows into mutual funds could be reversing soon, says Dhananjay Sinha, Head of Research, Economist & Strategist, Emkay Global Financial Services. He has based this prognosis on an analysis of household income flowing into shares and debentures since 1955. Excerpts from a chat with BusinessLine:

You have stated that the flows into mutual funds being witnessed now are cyclical and not structural. Can you explain your reasoning?

There have been considerable inflows into mutual funds in recent times. Since 2015, net monthly inflows have been ₹5,500 crore, post-demonetisation the sum increased to ₹10,000 crore and in recent months, it has exceeded ₹18,000 crore.

We tried to see if this was structural. We tried to put it in the context of long-term history, dating back to 1955. If we see the proportion of household saving that comes into mutual funds, the structural component of this flow is just half.

We also found that the proportion of money invested by households into shares and debentures is strongly linked to market valuation. If you see the linkage between the price to book or PE multiple with these flows, you get a correlation of 0.82 since the year 1990.

There is also a causality between valuation and participation of households in equity markets. Once households start participating, stock prices rise, this then gets into a self-fulfilling virtuous cycle between household savings, equity mutual fund flows and valuations. Higher valuation attracts more flows and more flows push up valuations further and this spiral continues.

We have seen since 1990 that if any trigger pulls prices down sharply lower in a short duration of time, then participation plunges. That has happened two or three times in the last 25 years.

You have been a market observer since 1990s. How is this cycle different?

The biggest upsurge in flows into mutual funds was in the period between 1992 and 1996. Incremental growth of household savings going into equities averaged at 10 per cent then, but it peaked at 15 per cent in 1992. Participation increased during the dotcom boom in 2000 too, followed by a sharp fall.

If you see the monthly data, from February 2008 to May 2014, there was consistent redemption in bluechip funds. After that, when the new government came to power, smart money started coming into the market. But unlike the previous cycles, the fundamentals this time are quite weak. We have had four years of almost no earnings growth but valuation multiples are at peak levels.

Valuations were a bubble in the 1992-94 period at 42 times. If we exclude that, current valuations are close to peak levels. So we have a recession-like trajectory for earnings and boom-time valuations.

We are also seeing that the turnaround since 2014 has resulted in markets giving a significant premium to mid-caps. Historically, we have seen that the mid-cap index has traded at 15 to 16 per cent discount to large-cap index, given the lower liquidity on these counters, but now, it is trading at 92 per cent premium to the large-cap index. While the large-cap index is trading at 24 times, mid-cap index valuation is about 46 times.

How long do these upcycles in MF inflows continue?

If we look at the cyclical component of flows into the stock market from households, there are periods of above-average flows that continue for three years at a time.

For instance, in the period between 1992 and 1995, we witnessed strong flows into equity markets. Between 2005 and 2008 too, a similar surge was seen. In the current cycle, it is three years already, from 2014. But unlike previous times, earnings growth is not strong this time, compensation paid to employees is not rising rapidly this time either.

What is your view on global liquidity? Will that help growth, going forward?

Global central banks are moving towards monetary policy normalisation. So we think that global excess liquidity will come down in the next 6-18 months. So that is a risk to portfolio flows. We have seen since 2015, FIIs’ overweight position has come down from 4.5 per cent to 1.5 per cent since the Modi government was elected. FPI flows have been volatile recently. If you see the bull run from 2009 to 2014, it was led by FII buying. Mutual funds and retail are late entrants who entered after 2014.

So as excess liquidity recedes, if FII flows start to decline, it can cause correction in the prevailing lofty valuation and trigger redemption pressure on mutual funds.

What does this mean for investors? What should they do now?

Investors should be careful with mid-cap stocks trading at rich valuations and buy stocks with good earnings visibility. We notice that companies with weak growth in earnings and weak balance sheets have rallied more. So that is a risk for those investing trying to make a quick buck by buying multi-baggers. This is a risky scenario to be in.

But it is quite difficult to call a top to this market, isn’t it?

You are right. But a few things need to be understood. The upsurge that has happened since demonetisation is temporary. Idle money has been channeled into markets by businesses; this will be required by them at some point. Domestic surplus liquidity is also being sucked out by RBI’s open market operations.

In the next three to six months the surplus domestic liquidity will begin unwinding. Global liquidity will also reduce with global central bank actions and increase in sovereign yields. That will lead to normalisation of flows as well as multiples.

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