Conventional wisdom

Time to shed the historic view that low P/E, soft inflation and weak rupee create investment opportunities

By Mohan Sule

The financial markets are divided into two camps: optimists and pessimists. Those with confidence in the economy note a silver lining to every dark cloud. On the other side are those who forecast bubbles ready to burst. The markets need both types of participants to discover value in neglected assets and effect correction when prices run ahead of the underlying strength of the asset. Yet the increasing volatility in global markets reflects the confusion of investors on what constitutes the threshold of opportunity and pain. The decision of the British that the UK will be better off without carrying on the burden of weak EU members despite many heavyweights weighing in favour of continuance as the path to prosperity is another illustration of the increasing doubts about traditional wisdom. The historic view that the boom in IPO issuance co-exists with resurgent equities is also being challenged: bubbly stock prices are contagious and the virus can lead to the collapse of both markets, leaving investors with pricey duds and putting them off investing. Retail investors seeking quick and massive returns through new offerings contributed to the near 20% plunge of China’s secondary market a year ago, requiring the authorities to suspend IPOs to control the fall. Conventionally, a low P/E indicates value buy. On the other side, the miserable valuations might be due to the scepticism about the stock’s revenue visibility or corporate governance. Conversely, a high P/E suggests earnings not keeping pace with the price. A contrarian might see the figure as the market’s validation of a stock’s growth potential. The smart investor gets out of the stock when earnings hit or miss estimates, resulting in a correction. If investors were to latch on to these stocks on moderation of P/E, they might have to be satisfied with a slow trot.

Also, there is no consensus on what should be the P/E to consider a stock a value ‘buy’. Many monopolies and MNCs are quoting at many times the ideal range of 15-20 and still sought after by investors for their business model, steady pace of growth, payout policies and corporate governance. Ultimately, the choice boils down between stocks with a consistent track record of corporate actions and those that compensate for the absence of dividends with rapid capital appreciation. The investment strategy cannot be uniform across the listed universe. Investors have to pick stocks as per their ability to absorb risk or objective: seasonal or all-weather, large caps versus mid and small caps, mid caps with and without transparent operations. There cannot be one-size-fits-all sort of an approach. Another contentious issue is inflation. It has been embedded in the collective conscious of investors that prices should remain static to attract low interest rates and encourage companies and consumers to borrow money to climb up. Capping inflation, however, comes at the cost of growth. Even mature economies are finding virtues in triggering inflation: the European Central Bank and Bank of Japan are following the US Federal Reserve in making available plenty of cheap credit in the hope of spurring consumption. A country is said to be emerging when its population with purchasing power expands. This sort of an economy does not have a ready-made infrastructure on standby, poised to meet the galloping demand. In the interim, the spurt in usage can strain existing supplies, causing prices to jump.

The third issue for tempers to flare up is the foreign exchange rate. Weakness benefits exporters but hurts importers. The currency of open countries moves as per demand and supply stemming from the cost of money and policies on deficit. In India, the rupee is convertible only on capital account. As a result, the finance ministry and the commerce ministry are constantly at odds on the currency’s value. India imports more, particularly crude oil, than it exports due to its inward-looking economy. To finance imports, the country needs foreign fund inflows. If the emergence of the IT and pharmaceuticals sectors as major exporters offered solace to policy makers, it also put them in a fix. Though the dollar remains strong due to its safe-haven status as well as the recovery of the US economy, the Indian currency has appreciated in relation to its competitors in overseas markets, largely because of the gush of foreign direct investment on the back of the Make-in-India initiative. Foreign investors prefer countries with weak currency but want better returns from their investment when it is time for repatriation. Recognizing the limits of depreciation as a tool to boost growth, the market seems to be marking down valuations of export-oriented stocks.