Why valuations are important when investing

By Morningstar |  27-10-20 | 
 

Dhaval Kapadia, Director – Portfolio Specialist, Morningstar Investment Advisers India, shares his views on the importance of valuation driven investing with Rishiraj Maheshwari, founder, RISCH Wealth & Family Office.  

What are the key drivers of equity returns over the short and long term?

Over the short run, markets are driven by multiple factors such as fund flows, headline-grabbing news, trading activity, and sentiments. Some of these factors can change very quickly some on a day-to-day basis hence markets can be very volatile over the short run and returns can be quite unpredictable.

This can cause a fair bit of distress if markets are not doing well or euphoria if markets are soaring. It’s like watching a T20 game, where there is excitement in every over if not each ball due to the short duration of the game. On the other hand, you may not get the same excitement or over to over euphoria while watching a test match. The skills, patience and technique required for a test match player is different from that of a T20 game.

Long-term investing is like a test match requiring different skills and patience. Over the long run, equity returns are driven largely by fundamentals and valuations.

What are the fundamental factors?

Morningstar’s research analysts have studied long-term equity returns across various markets to identify their key drivers. We found that the key drivers included – expectations around inflation, dividends and earnings growth and valuations. These are considered the fundamental growth drivers of equity returns over 5 to 10-year periods. In other words, if dividends and earnings growth were high during certain periods so were equity market returns and vice versa. Factors such as sentiment, fund flows, and trading activity did not play any major role in determining long-term equity market returns.

How important are valuations in impacting equity market returns?

Valuation is nothing but the price that investors are willing to pay for the fundamental growth expected in the long run. The price tends to change more frequently in fact for highly liquid stocks on a minute-to-minute basis whereas the underlying value of a stock less frequently. When prices of stocks or market indices are trading significantly above fair valuation the potential for returns is lower whereas the potential for losses is greater. And when they’re trading below their fair value the potential for returns is greater whereas the potential for losses is lower.

Say when markets move up sharply without significant changes to the fair value, it reflects rising optimism about the stock or market index. When this optimism becomes excessive, it would tend to correct or there would be some trigger that would bring down this optimism or unreasonable growth expectations to normal or realistic levels. In other words, valuations would come down to more reasonable or sustainable levels.

We see this phenomenon occur time and again in markets. For instance, investors would recall the 2014 to 2017 period when markets moved up sharply, particularly small and mid caps which were up 2.5 to 3x within a span of 3 to 4 years, i.e. Rs 100 invested in 2013 was worth Rs 250-300 by the end of 2017. The expectation was that small and mid caps would outperform with the new government coming to power, etc. And many optimistic investors continued to invest in such stocks even in 2017 and early 2018 at peak valuations. What came next was a rude shock to many of those investors. From their peak in January 2018 mid and small caps corrected by 55% to 60% over the next couple of years.

Simply put, investing at high valuations tends to reduce long term returns, whereas investing at low valuations tends to improve long term returns. For instance, investments made in late 2008-09 or during 2011-13 have been amongst the best ones. These were periods when valuations were low and pessimism was strongly reflected by investor selling.

Change across various scenarios and can reflect extreme pessimism or optimism particularly over the short term. For instance, when equity markets fell sharply in March-April 2020 on fears around COVID, widespread lockdowns and its potential impact on the global economy including India, it reflected uncertainty and pessimism, particularly about the near term. Since then markets have witnessed a sharp recovery.

What about risk, do valuations also impact risk or losses in an asset class?

Not only does investing at high valuations tend to reduce long-term returns but it also increases the probability of making losses and their extent. This happens when excessive optimism reflected by high valuations undergoes a correction. And we’ve seen from history that when markets undergo sharp corrections of over 35 to 40%, investments made at these levels tend to fall lesser from their original investment levels. The concept can be viewed simply as buy low and sell high.  

As a lay investor who may not be tracking valuations very closely, what indicators can they watch out for?

If an asset class has done very well over the past two to three years and has generated superlative performance, be wary of investing in it. For instance, small and mid caps did very well during 2014-17.

Look at fund flows or retail trading activity, if that seems to be rising along with strong market performance it would clearly indicate an overheated market with optimism riding high. Or is there too much pessimism with investors exiting investments when markets have underperformed.

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