Valuations are high but fundamentals are improving

A recurring theme in my letters since the market crash of late March 2020 has been to remain invested in the market with high weightage to blue chips, particularly in sectors with high earnings visibility. Another consistent suggestion has been to invest in the mid-small-cap space through the mutual fund SIP route. Even though Nifty is up more than 100 percent from the 2020 March lows; there is no reason to change the strategy.

India has been the best performing large market for the past several months. The resilience of the market despite the Covid-19 second wave and the consequent impact on the economy has surprised even the incorrigible optimists. Even after sustained FII selling from early April to mid-May, the market continued to soar and Nifty is at record highs having risen around 12 percent YTD.

This has pushed valuations to very high levels. Market cap to GDP (a ratio regarded as hugely important by Warren Buffet) is above one or 100 percent. FY22 PE ratio, assuming optimistic outcomes, is around 21, which is excessive. This is a cause for concern, but it is also important to note that fundamentals are improving.  Growth is coming back and corporate profits are rebounding smartly with the Top 200 companies reporting a 107 percent YoY increase in net profits in Q4 FY21.

The second wave of the pandemic has inflicted huge costs in terms of lives lost and suffering. But we have succeeded in bending the curve: Fresh cases have steadily declined from above 4 lakhs to around one lakh now and are set to decline further. Progressive unlocking is happening.

An important factor driving the market now is retail investor participation. This so-called ‘Robin Hood phenomenon’ is a global trend. The new breed of young investors is trading, often recklessly, in the market. And, in this ferocious bull market, they are making money, which encourages more trading and speculating.  Mid and small-caps are witnessing huge volumes and the indices are outperforming. Froth is building up in this segment. Investors have to be cautious.

It is important to understand that 80 percent of the profits of India Inc comes from the top 20 companies. Most of this Top 20 are high-quality companies with good earnings visibility. Remain invested in the top quality names in financials, IT, pharma, cement, and metals. Also, consider a rotation trade in favour of industrials. Capital goods majors have started performing and have the potential to appreciate further. Better returns may come from mid and small-caps, but there is a big risk in directly investing in them. So continue to invest in this segment through mutual fund SIPs.

The biggest known risk to the market now is from potential inflation in the US, which can lead to a spike in bond yields and sell-off in equity markets. But we don’t know when this will happen and how intense the sell-off would be.