How you can still make money in stocks

If you have sold out your shares early this year thinking that the market was getting overheated, bad luck. But don't fret. The market took even the best of fund managers by surprise with it fast and furious pace of gain.

In less than three months, the Sensex has gained 1000 points without giving enough time for investors to think. But every cloud has a silver lining.

Firstly, you have learnt by now that market timing may land you with nasty surprises. Secondly, the two vital factors that influence stock prices - corporate earnings growth and valuations - are poised at levels from where gains are possible.

One can't predict when these gains would trickle in. But a Smart Investor study proved once again that taking a long-term view can significantly reduce your chances of losing money in equity.

Markets take several years and months to make up their minds, but once they do, they reach their destination in double quick time. Sample this:

• Between December 1984 to February 1986, the Sensex gained about 150 per cent from 260 to 650
• From May 1988 to November 1988, within six months, the market gained 53 per cent
• Between February 1991 to March 1992, the market gained over 260 per cent from 1200 to 4460. The Sensex movement from 2000 to 3000 happened in just 44 days, aided by big-bang reform measures announced by the government.
• From December 1998 to February 2000, the market gained about 80 per cent during the technology boom
• In less than three months, the Sensex has once again gained about 1000 points climbing from 7000 to 8000

An earlier study on market timing done by The Smart Investor revealed that in the 24 years between September 1979 and August 2003, two-thirds of the market's entire gains came in just 10 months.

• The Sensex journey: From 1000 to 8000
• The rise of the Indian stock markets

During this 24-year period, the Sensex gave a compounded annual return of 15.90 per cent as it surged from 116 to 4004. When we eliminate the best months, the returns fall dramatically.

For instance, if you missed the best 10 months over 24 years or out of the 288 months, your return would have fallen to 5.54 per cent. Eliminate more best months, say 20, and your annualised return would even have turned negative.

Similarly, if we eliminate the worst months, say the top 10 of them, then your annual return would have been 23.79 per cent over the same period indicating that one-third of the losses also came in just 10 months.

In August 2003 - the tail period for the study - the Sensex was still at 4000. Extend this to date when the Sensex has pierced 8000 with rapid fire gains in a brief period, the study should only strengthen this case. What is the chance that you would have identified the best 10 months correctly?

But then, the point to be noted is that over the history of stock market gains, these 10 best and worst months are spread out through several boom and bust cycles. You miss one does not mean you are doomed forever. The key is not to lose patience.

Risks are a lot less in the long term

According to a study by The Smart Investor, the risk to investing in equities reduces over the long term. A study of Sensex gains since inception till date shows that volatility in stocks reduce considerably as the holding period increases.

For example, if you invested in the Sensex for any one-year period since April 1979, you could have nearly tripled your money, pocketing a 274 per cent gain in the best possible scenario.

In the worst scenario, you would have lost 49.40 per cent. If you consider a five-year period instead, you could have made a cool 56 per cent annualised returns in the best case; and lost 8.77 per cent annualised in the worst case.

As the holding period increases, the volatility or the variance in returns keeps diminishing. And after a 13-year holding period the risk of loss in stocks vanishes completely - that is, your chances of losing money is close to zero.

So you could make your millions in a very short time period if you get lucky, but if you hold stocks for the long term the risk of equities reduces systematically and your chances of making money improves tremendously.

The best way to create wealth, then, is to buy at bargain prices and stay invested for as long as you can. In the past several years, several companies have hit life-time peaks several times. What if you ran to sell stocks when stock hit their peaks? You may have simply missed all the big moves.

All you need to ensure is that you don't buy stocks at bizarrely high prices. So, is there a reasonable chance of making money in stock markets if you enter today? The answer is yes if you are willing to wait it out.

Are stocks cheap or costly?

Despite the pyrotechnics of the last few months the market does not seem overheated. For more than a decade (till this rally began in May 2003), the stock market index lagged behind economic growth rate as investors confidence was at the lowest ebb, hit by two stock market scams, political upheavals and changes in the economic climate.

However, the post-liberalisation era changed all that. Corporates emerged successfully out of the bad times, economic reforms pushed forward slowly but steadily, there was a structural change in interest rates and of course there was an improvement in regulatory framework.

These myriad factors have created a scenario wherein stock markets are not just profitable, but also safer to invest in. That should explain the dramatic re-rating of equities in the past couple of years.

"But then, stock markets tend to front end growth," says S Naganath, president and chief investment officer, DSP Merrill Lynch Investment Managers. Markets have an incredible ability to sniff future prospects ahead of time and some times they could get carried away too.

"For a brief period, driven by momentum, stocks can get pushed beyond proportion" he adds. So what is fair value today can actually get costlier if stock prices keep rising at a faster clip than earnings, making a retracement inevitable. No one can predict how long a rally could last.

If corporate earnings keep falling with stock prices keep rising, stock will get dearer - again, at some point stocks may lose their attractiveness compared to other asset classes.

At some point in time, savvy investors would emerge and exploit this opportunity. But if corporate earnings keep rising and stock prices do not, then stocks as an investment class will keep getting cheaper. Again, savvy investors would come in for arbitrage gains.

However, what makes the equity game tricky is that while corporate earnings grow in a linear fashion, stock prices do not. Stocks could languish for a long period of time to quickly run past fair value and into gross overvaluation.

For instance, from here, the Sensex could well move to 10000 by year-end if more investors get drawn in allured by the recent gains. Common investors, however, are still gripped by fear. And several professional managers also feel that stocks are overheated.

Conventional wisdom tells us that when there is extreme greed and no fear is when markets are ripe for a fall. Since that is not quite the case now, could this mean further upsides? Behavioural finance would answer in the affirmative.

But we can go by what is at the core of investing - earnings growth rate and the price the market is willing to pay for that growth.

Can earnings growth keep pace?

Currently, India is in a growth phase. "Combining a real economic growth rate of 8 per cent in the economy and a 4-8 per cent inflation, the earnings growth one can expect is 12-18 per cent over the next three to five years," says Prashant Jain, chief investment officer, HDFC Mutual Fund.

And if one agrees that the Sensex is correctly priced today, that is pretty much the returns one could expect from equities.

In the past three years, profits grew at around 25 per cent per annum driven by significant savings on operating costs apart from lower interest and depreciation expenses.

However, analysts do not expect this to continue going forward. Jain says, "Over the next few years, growth rates will be lower because the incremental cost savings will be relatively small." Capital spending is coming back as new capacity needs to be created which will result in a gradual but steady rise in fixed charges.

Interest rates have bottomed out and there are cost pressures from higher prices of basic materials and wage inflation. An appreciating currency is also not good for margins on balance. A cyclical downturn in commodity prices cannot be ruled out as well.

Assuming an average 15 per cent growth per annum over the next three years, corporate earnings should grow by 50 per cent and should nearly double over the next five years.

The valuation angle

Given this scenario, how are stocks priced? There are several ways to look at this. But whichever way one looks, stocks do not seem too overvalued. But they are certainly not going cheap either.

See what history tells us. Post-1993 high, the average Sensex P/E has been around 17, pretty much the level at which the Sensex is trading now. Based on FY06 estimates, the P/E is 14.73 and on FY07 estimates, it is 13.7.

During the IPO boom of 1994 when the Sensex touched 4600 levels, the benchmark index P/E was trading at 42 times earnings. Similarly, when the Sensex was driven by the tech euphoria its earnings multiple was around 25 times.

When the Sensex was at its lowest ebb in May 2003 - the period which marked the onset of the bull rally that still continues with just a couple of intermissions - it was trading at trailing 12 month P/E of around 12 and forward multiple of less than 10. So Sensex P/E at 16.7 times trailing earnings and around 15 times one-year forward earnings is probably fair.

The second way to look at it is in the context of the prevailing interest rates or risk-free returns. The 10-year benchmark government security currently has a yield of 7 per cent. The comparable figure in equities is what one calls the earnings yield, which is the inverse of P/E, and is currently is at 5.98 per cent.

This means that stocks are actually a bit more expensive than bonds. Put another way, at current prices bonds will provide better returns than equities if earnings do not grow but continue to be what they are. But assuming there will be growth, this valuations may not be unjustified.

The third angle is to look from the point of view of foreign investors who are spoilt for choice given the umpteen emerging markets vying for attention. Compared to peers, India does not look that cheap.

According to certain estimates, Indian markets are close to being overvalued. In the basket of emerging markets, India ranks second in the descending array of P/Es. Based on 2006 P/E Hong Kong trades at 14.6 times, Singapore is on a par with India, while South Korea (9), Taiwan (11.1) and Thailand (10.2) are cheaper.

Considering that India is likely to be among the top three in terms of growth estimates, and that the quality of earnings are also better in Indian equities with a return of 16 per cent, a premium may be justified. However, margin of safety is diminishing.

A scenario analysis combining earnings growth and P/E at different levels shows that the Sensex still has huge upside (see table). The numbers may sound ambitious. But the favourable demographics, corporate fundamentals and today's stock prices may make that a distinct possibility, though there is no assurance on how these gains will flow in.

Sure, stock markets have been driven up in the past two years by the flood of money that has flowed in from foreign investors. Worries about money flowing out and causing a reversal may be valid. But if fundamentals are in place, stocks will do well. And the money could come domestic investors.

Even if one per cent of the India's savings finds its way into Dalal Street, it could mean an inflow of over Rs 7,000 crore (Rs 70 billion) - enough to keep the Sensex rising.

Jain adds that the risks to earnings today are not as much across the board - they are more sectoral in nature. For instance, a cyclical downturn in commodities will be a negative for commodity stocks.

A decline in interest rates could hit small-sized firms and companies with high borrowings. A stronger rupee could hurt exporters, especially in sectors like software services and pharma. The answer lies in diversification.

Sensex 8000

What great investors have to say:

• The average long-term experience in investing is never surprising, but the short-term experience is always surprising. We now know to focus not on the rate of return, but on the informed management of risk - Charles Ellis
• Observations over many years has taught us that the chief losses for investors come from the purchase of low-quality securities at times of favourable business condition - Benjamin Graham
• I think you have to learn that there's a company behind every stock, and that there's only one real reason why stocks go up. Companies go from doing poorly to doing well or small companies grow to large companies - Peter Lynch
• The market, like the lord, helps those who help themselves. But unlike the lord, the market does not forgive those who know not what they do - Warren Buffett
• Don't try to buy at the bottom and sell at the top. It can't be done except by liars - Bernard Baruch