Exit even hyper-growth cos if valuations are exorbitant: Raamdeo Agrawal, Motilal Oswal Financial Services

There might be a 3-4% downside still left, but we are done with the broader market correction though deeper correction in mid and small companies may continue, said Raamdeo Agrawal, joint managing director, Motilal Oswal Financial Services. FIIs will come back only if they find valuations reasonable, he told Rajesh Mascarenhas in an interview.

Edited excerpts:

Are we in the grip of a bear market? Will the impending elections have any impact on the market?

There might be a 3-4% more downside, but I think we are done with the broader market correction. However, deeper correction in mid and small companies may continue as oil prices, rupee and interest rates are all aligned. There is a crisis of earnings too. Corporate profits are not growing in pace with inflation. Broader market may remain range-bound until there is a big trigger for a U-turn. If you have a view that oil is headed for $100, there will be more pain left. Election results are already being discounted as they are not going to impact the corporate sector or its earnings. It’s a one-day event. Right now, the market is very kind. After correction, some stocks look reasonable, but it’s not a healthy market for an innocent investor.


Do you think Indian stock markets are affected by the global economy? Will FIIs come back?

We are heading for a tough time in terms of global liquidity and money flow to emerging markets. US, Europe, Japan, everyone has started withdrawing stimulus. World liquidity is tightening and in India there is no earnings growth. At the same time, valuations are too high. In the current valuation, FIIs are unlikely to invest in the Indian market as the US yield is nearly 3.2%. FIIs will come back only if they find valuations reasonable. Something has to change drastically to boost earnings growth. Hope our exports go up sharply because the World economy is doing well.

NBFCs are facing a huge liquidity crisis. What is the way out now?

This crisis will decide which is a good or a bad NBFC. But I think and hope all NBFCs survive the current crisis. You can see some bounceback in the beaten-down stocks. But the whole issue is about liquidity. If NBFCs trade below book, they will not be able to raise equity and hence growth will be impacted. Also, they are not going to make significantly more profits in the next 5-6 years. So they will not command high PE multiples.

Where is the opportunity right now?

Except oil & gas, some of the private banks and NBFCs, I don’t think valuations are good enough to invest. Even if you are going to buy the best company with over 50 PE, you are not going to make more than 15% return in the long term. Currently, so many companies are overvalued. So valuations will have to come down to make them more investors-friendly.

What are your new themes?

In the short- and medium term, all companies showing earnings growth tend to get rewarded by investors by way of rising stock prices and market value. However, our model suggests that all growth is not good. If a company’s RoE remains below the cost of equity for long, then high growth actually detracts from value, as the company has to raise significant levels of capital from its equity holders to fund growth. If a company’s RoE is exactly equal to its cost of equity, then no amount of growth adds any value whatsoever. The PE in such cases works out to 7.7. Growth adds positive value only when RoE is higher than the cost of equity.

What is your advice for the retail investors?

Stock markets tend to extrapolate recent earnings performance into the future. If a company is currently in a hyper growth mode, the market is likely to end up extrapolating this too far into the future, ramping up valuations. Hyper growth rarely lasts beyond 5-6 years and will prevent smart investors from buying into such stocks based on unrealistic growth expectations. Further, investors already holding stocks of companies in the hyper-growth mode must seriously consider exiting if valuations hit exorbitant levels.

What are your conclusions from the 23rd Annual Wealth Creation Study?

Our study has thrown out some important observations in terms of two key drivers of value — RoE and earnings growth. The higher both these numbers, the greater the value and vice versa, shows our study. Mere growth without healthy RoE creates no value. Beyond healthy levels of RoE (40-50%) driving earnings growth adds more value than raising RoE further. PEG (price/earnings to growth) less than 1x is a near-infallible formula for healthy outperformance. Valuations above 50 PE have a very low probability of generating market outperformance. So, my advice to investors is to buy stocks with high quality business run by high quality management, with healthy earnings growth for long periods, say 5-6 years at a reasonable price, preferably PEG of less than 1x.