Benjamin Graham had introduced the concept of a mythical “Mr Market” to describe how sentiment or emotions drive markets in the short term. His analogy cautioned us in getting swayed into making an incorrect decision because of Mr Market’s emotional make-up. Mr Market is prepared to make us an offer to buy or sell a piece of a fractional ownership in common equity every day. In doing so he indirectly informs us about the assumptions on growth (in sales or earnings) that are being built in the valuations. In a strong bull market these assumptions might be overly optimistic and vice versa in case of a bear market. The choice to transact at a particular price (and valuation), Mr Graham tells us, is ours.
In December 2007, the narrative was India growth story driven by infrastructure boom. The valuations were capturing, especially in the infrastructure space, high growth for a significantly long period of time. Similarly in March 2009 valuations suggested that the global financial crisis was going to kill the India growth story and all hope is lost. Well, none of the two panned out to the extent the market had factored. Focusing on the narrative, as against paying attention to the extreme valuations (both on upside and the downside) and the implicit assumptions, would have most likely led the investor to take a wrong decision from a behavioural perspective.
Today we are similarly faced with a point of extreme valuation. The chart below represents the median ratio of monthly Enterprise Value /Sales (EV/S) of all Non-Financial index constituents of BSE 500. We believe EV/Sales is a measure that captures normalized valuation as compared to Price-Earnings which could be impacted by short term profit margin volatility.
Mcap weighted EV/Sales is not used as that hides what is happening at the broader level. Median of monthly EV/Sales is used instead of average to reduce the impact of outliers.
What is the market narrative today?
We believe the current market narrative is that India is seeing structural improvements on the ground through various initiatives taken by the government which are going to trigger a “V shaped” recovery in corporate earnings.
If we look at the current EV/Sales of ~3x as of 30 April 2018, this is significantly above the long term average of ~1.6x. We can reverse calculate what the market is factoring to justify the current valuations using the current EV/Sales multiple and estimating how much sales have to grow in the next 3 years so that we end up at the average EV/sales multiple of 1.6x (mean reversion). If sales grow at a 3 year CAGR of 23% and valuation multiple reverts back to the mean, you would end up not losing any money (though also not making any). If you would like to earn the risk free rate of ~8%, using the same calculation the sales have to grow at ~33%. As an equity investor, if you would want to make atleast the cost of equity of ~13% going forward from the current valuation, sales would have to grow by a least 39% CAGR! The average 3 year CAGR of the same BSE 500 constituents historically has been ~16.6% while the highest 3 year CAGR ever was ~31% in 2005-2008, a period that co-incided with a major credit boom.
Source: ACE Equity, BSE 500 Ex-Financials, Above chart represents Median of 3 year rolling Sales CAGR of the BSE 500 Ex-Financials.
We are currently below -1 SD from sales growth perspective as the chart above shows, thus a cyclical recovery in sales and therefore earnings is not an outrageous assumption. But if you again run down through the implicit assumptions; in the super best case assuming sales grow at faster than ever seen in history at ~39% which would be like 3.5 standard deviation above long term average, an investor is likely to make only the cost of equity. If the sales grow closer to the fastest in history ~33% an investor is making only the risk free rate. In the base case assuming the sales grow at historical average rate and valuation multiples also go back to historical average an investor would lose around -5% on a CAGR basis i.e. an absolute loss of ~15%. In the worst case, well you can guess !
But what if we never go back to Historical Average Valuation multiples? i.e. there is a structural shift in valuations.
A possible narrative given to justify the current high EV/Sales multiple is that Operating Margins have/are going to structurally shift upwards. If you see the chart below, EBITDA margins have been moving in a range; except in two extreme instances-that of of 2003 and 2010. Also we see no fundamental reason to foresee a structural shift in margins going forward.
Another common justification given for today’s higher valuations is a drop in the cost of equity. A cyclical movement in interest rates should not change the normalised cost of equity of businesses. But what about the argument that there is a structural shift in Cost of Equity downwards? As plausible as that maybe, similar arguments were also being made in 2007 (to justify the overvaluation at that time). Currently we have no evidence that suggests there is a structural shift happening. The real cost of equity has more or less remained constant since 1991. For a major shift to happen, we need to see big structural reforms that reduce barriers to entry (and exit) of capital, a la 1991. But be aware that in such a structural shift in cost of equity there is a big one time jump in equity prices as an asset class (similar to one seen in 1991). Once that onetime shift completes, the prospective returns for an equity investor comes down structurally. Thus if we have already gone through a reduction in cost of equity to justify current valuations, prospective equity return expectations have to be moderated as well by investors.
As Benjamin Graham put it – “Mr Market is there to serve you, not to guide you”. It is up to you now whether you buy the narrative of “Mr Market”. At least we are not buying it!