Archive for the ‘Market analysis’ Category.


The following note is from upcoming annual letter to subscribers. I will be publishing the rest of the letter on the blog soon

When I look at companies which are priced a lofty multiples, I try to break it down to the first principle of investing – The value of an asset is the sum of its discounted cash flow over its lifetime.

A company with a high multiple, is not necessarily expensive if the company can grow its free cash flow for a long period of time. This means the market ‘assumes’ that such a company has a sustainable competitive advantage and a large opportunity space. Please note use of the word ‘assume’. The market is not some all knowing entity which can see the future. It is just the aggregation of the combined wisdom (or madness) of its participants.

The market on average and over time gets the valuations right, but not always.

As I look at several companies in the small cap and midcap space now, I am left wondering if investors really understand the implications behind the valuations. A company selling at a PE of 50 will need to deliver a growth of 25% for 10 years to justify the price. In order to make any returns for an investor buying at this price, the actual growth will have to be much higher and longer.

How many companies are able to deliver such growth rates for so long? Let’s look at some numbers from the past

In the last 10 years, we had around 233 companies in the sub 3000 cr market cap space, deliver a growth of 25% or higher. That’s around 6.2 % of the small/ mid cap universe. As the market cap/ size increases, the percentage of companies which can deliver this kind of performance only shrinks.

How many companies in the above space currently sport a PE of 50 higher ? around 22% or roughly 830. So 3 out of 4 companies in this group of ‘favored’ high PE companies are going to disappoint investors in the coming years in terms of growth

In other words, if you could buy all these ‘favored’ companies (greater than a PE of 50), you have a more than a 50% chance that you will lose money. Why would you take such a bet?

All investors in aggregate are taking this bet assuming individually, that their ‘chosen’ companies will not be the ones to disappoint. Ofcourse every individual thinks he or she is smarter, more handsome or <insert your criteria here> than the crowd (also called illusory superiority).

The odds are against everyone being right. So it makes sense to be cautious and do your homework well enough. Some of these companies could turn out to be the bitcoins of our market: assets with promise but without cash flow. In such cases, the end result is likely to be unpleasant.


I just couldn’t resist myself. I wrote in jan that the rebound would start on 22 april 2009 and then ‘predicted’ in feb that the bear market would end.

Wow! I got nailed it. I got two predictions right (ok, one is a little bit off, but give me a break). I am certified guru, soothsayer, the big kahuna and should be on CNBC !!. I should charge money for this 🙂

For those of you who reading this for the first time or are new to the blog – I am joking. I do not believe that anyone can predict the markets and it is a complete waste of time. If you guess enough times using all kinds of mumbo jumbo, you will get it right 50% of the times.

An investment strategy based on 50% success rate will get you nowhere.

A few more interesting points
I have noticed a few more interesting thought processes on other blogs and discussion boards.

– I like the company, but the next 3-6 months are likely to be bad and so I will wait till the performance turns
– I will wait till the election results are clear and then buy when the market crashes
– The export market is bad, US is doomed and I want to wait till everything recovers

So what is being said that one should buy when everything is bright and sunny (or at least everyone thinks so!). So the best time to buy was Late 2007 to Jan 2008. Everyone was optimistic about the world then. Now we all know how that turned out!

Maybe the above works if your investment horizon ranges from a few days to a few months.

However if you are investing for the long term, i personally think the smartest thing to do is to analyse companies in depth and buy them when there are selling at a good discount to instrinsic value.


I am not planning to make any forecast on where the forecast will be in the next few month. However I have done some analysis on the sensex and nifty index and uploaded it in the google groups. You can check here to download the file Quantitative calculation 2008.xls and check the first worksheet – market valuation.

The numbers for june 2008 are computed for both the sensex and the nifty. A few observations

  • The current PE for the sensex is around 16.8 and 17.7 for nifty. By historical standard ( history is few years back, not a few months) it is not too low. Just about towards the upper end of the PE band
  • The Return on equity (earnings/book) is still pretty high by historical standard. In the 90’s the numbers were generally low in 14-19% range. The last 3-4 years were actually an exception. We had a confluence of positive factors. Low interest rates, high demand growth and high capacity utilization all resulted in high returns. Companies had also re-structured and so net margins and ROE have been high in the past few years. The business cycle may be turning, with interest rates and inflation creeping up. We could revert to an average ROE of 18% (still higher by historical standards)
  • The Earnings growth has been 20%+ in the last few years. This has slowed down to around 10-12% in the current year.

Lets do some scenario analysis. For sake of assumption lets look at some probable scenarios on factors which are based on fundamentals

Book value is around 3540. An ROE of 18% which looks like a fair no. (look at the data for the entire 90s till 2003. I am still assuming a higher  number). So normalized earnings is around 640 Rs which is lower than the current number of 820. What this means the earnings growth could slow down over the next few years as ROE reverts to the historical numbers. It is important to remember that ROE, unlike PE is not driven by market pschology. So the historical numbers do count in case of ROE.

For PE looks at the years 96-98. Interest rates were high and market PE ranged between 14-17.

Now for a juicy forecast – lets say earnings grow to around 900 in 2 years (book value will have to grow by 20% per annum and returns will drop to around 18% for that, so it is not impossible) and the PE is around 16-18, we are looking at a range of 14500- 16500.

Keep in mind that the assumptions in arriving at these numbers are still optimistic. We are still assuming reasonable growth in book values, moderate drop in ROE and fairly decent multiples. If things turn out better then we could have another bull market. But if we revert to historical levels, even on some variables such as ROE or PE or growth, then even the current market level is not too low.

Ofcourse other than the data, everything else in this post is a hypothesis. So my guess is as good as yours.