The flight of Icarus

Equity valuations are having an Icarus moment. For more than a decade, the cost of capital fell. The post GFC dis-inflation or the lack of inflation meant central banks kept bringing down rates, even to negative territories in certain markets. Central banks also pumped significant liquidity into markets, especially in the wake of the pandemic, which depressed yields even more (Chart 1).

Chart 1: Global M2 YoY growth and US Treasury yields (as a proxy for global bond yields)

Source: SBIFM Research

Cheap and abundant money became the ultimate stimulant for risky assets. Markets disregarded all concerns on inflation or yields. QE became the new normal as the beast of inflation had been tamed, or so it was believed.

The heady rise in inflation in the last 12-18 months is breaking the back of ever-rising p/e’s. Monetary policy moves to counter rising inflation have spiked bond yields, and thus, as a corollary the cost of equity. The Orcus of inflation is merrily slashing away the excesses of the last decade.

The average P/E of ~BSE200 companies (curated for outliers) has corrected from ~38x in the post pandemic rally to ~27.5x at end of March 2023. The correction, some would argue (especially value investors), has been long overdue.

Observed cost of equity (using the Damodaran formula and data) for a 1 beta firm in India fell from the 16-17% to the 10-11% mark over 2010/11 to 2020/21. And is now at the 14% mark.

Chart 2: Cost of Equity for a 1X beta firm in India

Source: SBIFM Research. Calculation is done using the principals laid out by Prof. A. Damodaran

The BSE200 constituent’s curation has been done for sharp outliers (those having ‘absurd P/Es’ such as 500-1000x, loss making periods, etc)

If falling yields were a driver of cheaper equity capital, the inverse should hold true as well. Yields have risen on higher rates and a reversal of QE to QT, consequently the cost of equity has risen. The chart below shows the degree to which the two are directionally correlated.

Chart 3: Calculated cost of equity v/s Indian 10-year G-Sec yield

Source: SBIFM Research

The chart below depicts the move in the avg p/e of ~BSE200 constituents (curated). Each dot represents the Avg p/e compared to the cost of equity (at 1 beta). The red dot represents March ‘23, The dot yellow is the peak of Sep ‘21. It is worth noting how much it has corrected in just a year (Purple to Red)

Chart 4: X Axis - Cost of Equity, Y Axis - Avg P/E of ~BSE200 constituents

Source: SBIFM Research

The average P/E of the curated BSE 200 constituents has corrected by 12.9% compared to the p/e 2 years back (Mar ‘23 v/s Mar ‘21). The most intriguing change has been the FMCG pack, which has seen the average p/e remaining flat. The Industrial Pack has seen a 5.5% increase, which is not surprising given the increased investor interest in the potential for a new industrial cycle.

Table 1: Delta in P/E at the end of Mar 23 sector wise compared to Mar 21.

Source: SBIFM Research

The delta in p/e changes is uniformly the highest for those which rose the most. The tables below depict the delta in avg p/e in various buckets. In table 2, there were 42 stocks part of the BSE200 which had a p/e above 50 in Sep 21, those stocks had an average p/e of 75x which has corrected by ~33%. In contrast in Mar of 2013 (table 3) there was only 1 stock which had a p/e above 50x.

To keep things in perspective, in the 50+ p/e bucket, for the stock price to remain flat, earnings would have had to grow 49% over this period. The average stock in this 50 p/e+ bucket returned ~-11%.

Table 2: Delta in P/E at the end of Feb 23 by various buckets from the peak of Sep 21.

Source: SBIFM Research. Arithmetic averages for price performance and P/E

For the universe the average stock return was -1.5% and the p/e correction was 26.8%, essentially all earnings growth was eaten away by the p/e compression. The chart below decomposes the 1 year return of the Nifty from earnings and from valuations. As can been seen, recent earnings growth has been eaten away by the fall in valuations. Price, one pays matters. Excessive valuations will eat into earnings growth.

Chart 5: Nifty 1 year return decomposed by earnings factor and valuation factor

Source: SBIFM Research

The ten-year data (Table 3) is in some sense not surprising. The highest average return has been from the lowest p/e bucket of companies. These would have seen a dual impact of rising earnings as well as rising p/e’s.

Table 3: Delta in P/E at the end of Mar 23 by various buckets from the peak of Mar 13

Source: SBIFM Research. Arithmetic averages for price performance and P/E

So what lies ahead? The normalized bell curve for p/e’s (chart 6) shows a narrowing of the std deviations and a fall in the mean p/e (from 37.1x in Sep 21 to 27.5x in Mar 23). Still, from a 10-year perspective, average p/e’s are up 2/3rd’s. The average multiple is at 26x for a cost of equity not so dis-similar, 13.8% in Mar 23 compared to 14.6% in Mar 13.

Chart 6: Normalized bell-curve of p/e’s across time periods.

Source: SBIFM Research

This probably implies that if earnings don’t accelerate fast enough, we run the risk of mediocre equity returns at best or a price correction. Earnings have been supportive so far, but the future could see turbulence with growth expected to slow. The wings of easy money over the last decade exalted many market participants and securities. There have been meaningful corrections, but pockets of exuberance and valuation excesses remain.

We may, of course, be blessed by central banks once again with a pivot as the rate rise cycle pauses but it is far more likely that rates will remain at a higher levels than move back to historic lows. This means that cost of capital will remain elevated shifting the conversation back to earnings growth. This transition is unlikely to be smooth. Odds are that it’ll likely be a stock pickers market and that much harder to generate returns you were used to.

This presentation is for information purposes only and is not an offer to sell or a solicitation to buy any mutual fund units/securities. The views expressed herein are based on the basis of internal data, publicly available information & other sources believed to be reliable. Any calculations made are approximations meant as guidelines only, which need to be confirmed before relying on them. These views alone are not sufficient and should not be used for the development or implementation of an investment strategy. It should not be construed as investment advice to any party. All opinions and estimates included here constitute our view as of this date and are subject to change without notice. Neither SBI Funds Management Limited, SBI Mutual Fund nor any person connected with it, accepts any liability arising from the use of this information. The recipient of this material should rely on their investigations and take their own professional advice.