The disillusionment of an average investor about equity as an asset class is understandable due to the losses they might have incurred in 2008. However, there is a danger in extrapolating recent history.

Investors might be ignoring equities just when it is about to become attractive again. So getting a longer and broader perspective on equity market returns might be a good idea. Over the past 34 years , the Sensex has delivered positive returns in 25 years. In 12 out of these 25 positive return years, the Sensex delivered over 30 per cent returns. Also, over the past 34 years, the Sensex has delivered compounded annualised returns of about 16 per cent, doubling investors’ money in a little less than five years.

Tax matters Most of us are programmed to think in nominal pre-tax terms. Now, consider the following facts. From 1980 to end-2013, equities delivered CAGR real returns of 8.7 per cent while the CAGR real returns for bank deposits (one-year deposit rolled over) were only 1.3 per cent (index: Sensex; bank: SBI). So, if you had invested ₹100 in equities and a bank deposit in 1980, the equities would be worth ₹1,698 in real terms by end-2013. The bank deposit, on the other hand, would be worth only ₹156.

In terms of post-tax real returns, ₹100 invested in March 2005 in equities would be worth ₹185 by end-December 2013 while the same amount invested in bank deposits would be worth ₹92 (that is, erosion of purchasing power). So, equity is a good asset class to grow purchasing power. However, barely 2-3 per cent of the average household balance sheet is currently allocated to equity, indicating a gross under-exposure to this asset class. Now, let’s look at how the market might behave in the near future, say the next 12 months (March 2014 onwards).

If you try to break down the sources of the 12 per cent returns that the Sensex has delivered over the past 12 months, you will find that about 8 per cent has been contributed by earnings progression. The remaining came from moderate valuation re-rating (as per Bloomberg Consensus Estimates).

Source of returns Despite the re-rating, the price-to-earnings multiple for Sensex is only at 13.8x on a 12-month forward basis, compared to the long-term average of about 14.7x.

While growth and inflation are still not comfortable, most observers believe these variables are getting better. The earnings expectations of corporate India have started looking up over the recent months. The Bloomberg expectation of 12-month forward earnings progression for Sensex companies a year from now stands at about 16 per cent, representing an accelerating trend. So, it is possible that the market might deliver returns in line with the earnings. However, if markets go back to the long-term average, a re-rating can happen.

At this stage, the equity market is poised to deliver higher-than-average returns. There’s even potential for a positive surprise if a stable reformist Government comes to power.

(The writer is Executive Director – Head Equities, JPMorgan Asset Management Ltd.)

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