Don't overpay for a stock on growth hopes

Investors should diversify into value funds, where managers look for margin of safety

In its annual report, the Reserve Bank of India (RBI) cautioned investors about the sharp rise in stock prices at a time when the economy was contracting. The Nifty50 rose 70.9 per cent, the Nifty Midcap 150 by 100 per cent, and the Nifty Smallcap 250 by 117.2 per cent during financial year 2020-21 (FY21). The gross domestic product (GDP) contracted by 7.3 per cent during this period.

Should you worry?

Valuations are above long-term averages at present (see table). “It’s the result of years of quantitative easing and easy monetary policies that have led to the injection of a lot of liquidity in the market,” says Gautam Kalia, head–investment solutions, Sharekhan by BNP Paribas.

Some experts, however, contend that investors should not worry about valuations. “Earnings growth has been on a higher trajectory between Q2 and Q4,” says George Heber Joseph, chief executive officer and chief investment officer, ITI Mutual Fund.

As reported by Business Standard, corporate profit as a percentage of GDP rose to a 10-year high of 2.63 per cent in FY21.

Restarting of private sector capital expenditure is expected to provide a fillip to corporate earnings. “While the country’s GDP continued to grow, very little capacity addition happened over the past 10 years. Shortages are bound to emerge,” says Joseph.

While the second wave of Covid-19 may dent earnings growth for a while, companies are better prepared now, having pared costs. The pace of vaccination is expected to pick up as availability improves.

Avoid overpaying

Direct investors should avoid overpaying on growth expectations. “Adopt a stock-specific approach and judge for yourself whether a stock’s current valuation is worth paying for,” says Ankur Kapur, managing partner, Plutus Capital, a Sebi-registered investment advisory and wealth management firm.

One option, according to him, is to stick to quality companies. “High quality means the return on capital employed should have averaged 15 per cent and sales should have grown 8-10 per cent annually over the past 10 years, and net debt should be zero,” says Kapur. He suggests having a longer holding period to counter the high valuations such quality stocks command. Kapur warns against investing in sectors that are capital guzzlers or where the return on investment is low.

Go for a value fund

Mutual fund investors should diversify their portfolios and opt for value funds. “Value investing means buying quality companies when they are trading at a low price, and then waiting for compounding to happen,” says Joseph. He says that in his value fund, whose new fund offer is on until June 8, he will follow the SQL philosophy, where S refers to margin of safety, Q to quality of business, and L to low leverage. “The chances of making an investment error are lower when you maintain a margin of safety,” adds Joseph.

Another option is to invest in balanced advantage/dynamic asset allocation funds. These have lowered their average equity allocation from 69 per cent in April 2020 to 45.7 per cent in April 2021, in keeping with their mandate to reduce equity exposure as markets turn expensive. “These funds are suitable for investors who are unable to manage a diversified portfolio on their own,” says Kalia.

Alternatively, investors may build a portfolio on their own that is diversified across equities (domestic and international), debt, and gold with a fixed asset allocation, which they should stick to through periodic rebalancing. Have a seven-year investment horizon in equity funds to avoid the risk of loss, and opt for systematic investment plans so that the purchase cost of units gets averaged out.