Workers can help us evaluate Equity Markets

Workers can help us evaluate Equity Markets

Sensex PE Ratio (2000-2018)

Japanese rail workers and their strange ritual..

A sleek Japanese bullet train glides noiselessly into the station. Then the strange ritual begins.

During the brief stop, the train conductor in the last carriage suddenly jumps out and starts talking to himself. He points at different parts of the train, station and comments something loud.

See this for yourself..

What in the world is he doing?

The Japanese call this technique, Shisa Kanko, a Japanese phrase meaning‘point with finger and call’. This is an error-prevention drill that Japanese railway employees have been using for more than 100 years.

The basic problem which the Japanese railways faced was that most of the accidents were caused due to human lapse of concentration and negligence rather than lack of knowledge.

Now, when you ask the rail worker to physically point at things and then name them out loud, he is forced to engage different senses via the brain, the eye, the hand, the mouth and the ears.

This makes him more conscious, aware and alert, thereby significantly reducing the possibility of unintended errors.

Studies have shown that this technique reduces human error by as much as 85 percent.

But aren’t we a lot more smarter and attentive?

Where is the gorilla?

Answer the questions in this video before you move one (it will just take 2 minutes)

As seen in the video above, all of us have our blind spots depending on where we have our focus.

Inevitably in an information overload world, the media has a significant say on where they want us to focus our attention.

As investors, this is not great for us as we get carried away by the news, focus on the wrong things and lose the actual big picture, leading to flawed decision making.

Better decision making starts with frameworks

Now all of us are sure of one thing – this is a bull market.

And yet another thing we are sure of – it will inevitably end someday in the future.

Historically we usually get to see 1 or 2 bear markets every 10 years. This means another 3-6 bear markets in the next 30 years.

In other words, we don’t get too many opportunities to learn how to handle bull market peaks and the bear markets that follow.

While we may read a lot on how to identify bull market peaks and behave during a bear market, nothing beats actually experiencing it and learning from it.

The good part is, we will have this opportunity soon (how soon is anyone’s guess). So, the key for us is to not let go of this great learning opportunity!

Now I honestly haven’t seen a full fledged bear market before. So while theoretically I should be fine, I am really not sure how I will actually handle a bear market.

What do we do about this?

I have a suggestion. Let us develop a framework to evaluate the risk in markets. Something via which we would get a sense of when we need to go slow on equities and when we should go all in into equities.

Now this does two things for us:


If it works, great! We have a framework which we all can use and have a far better investing experience.

If it doesn’t work, first blame me and later we can can always go back and check as to what went wrong and improve our framework

Instead of going blind into the final phase of a bull market, let us be prepared with a framework which can be evolved based on feedback.

Now let me be clear on one thing – the idea of the framework is not about precision – it’s just a disciplined way to get an approximate sense of which part of the market cycle are we in.

I may be wrong. But the idea is to quickly learn, improve the framework, and share the learnings so that everyone can benefit.

So let us check out the framework

Equity market evaluation framework

To evaluate equity markets I use the below 7 factors


Earnings Growth

Cycle – Credit Growth, Capacity Utilisation


Interest Rates

Other Dynamic Asset Allocation Models


To ensure that we do not miss out on any of these factors, we shall use the “point and call” Japanese concept for each and every one of the above 7 factors.

The basic starting point will be to have a rough expectation of the long returns i.e 5-7 year returns.

Returns from equity = Change in earnings + Change in PE valuations + Dividend Yield

So basically predicting equity returns boils down to answering these two questions

What can be the earnings growth?

Will the valuations move up (increasing returns) or move down (reducing returns) or stay flat (not contributing to returns)


For valuation I will stick to 3 metrics –

Primary metric

PE Ratio

 Secondary metric (will be used as a support to the primary metric)

PB Ratio


PE Ratio:

To understand how valuations impact overall returns you can refer here.

Sensex PE Ratio
Sensex PE Ratio

As seen above, the Sensex is currently at a PE ratio of around 23.3 times which is well above (around 30% above) the long term average.

You can also clearly see that Sensex valuations have usually moved between high and low valuations and eventually revert back to the average.

So if we have a 5-7 year time frame and we are getting in now, our returns will improve over and above the earnings growth if the valuations at which we exit is above today’s valuation i.e above 23 times. If it is lower, then our returns will be lower than the earnings growth.

So how do we know the exit valuations? Back to data as always

Maximum PE Ratio
Maximum PE Ratio

This is an interesting chart and hence let us take some time to understand.

I have plotted the maximum PE ratio of Sensex for each and every 2 year period since 2000 till 2018.

In other words this was the best valuation multiple you got, to exit over a two year period.

The interesting part is historically, you always got a chance to exit at a PE multiple of above 17!

Now while there is nothing sacrosanct about this number and the future might be different, it gives us a good starting point to think of exit multiples based on history.

It simply means, if history holds true, I have a high possibility of exiting atleast at a PE multiple 17 times (and higher than that if I have luck by my side).

So we can have a rule that states,
Post the 5th year (assuming your goal is 7 years away), you exit the moment PE multiple is above 17 times.

This implies your exit valuation multiple in the worst case will be 17 times. In the current context, from our starting multiple of 23.3 it is a drag of 37% or 6.5% per year from earnings growth.

If you assume average of 18 times as your exit multiple then it implies a absolute drag of 30% or 5% per year from earnings growth.

Pointing and Calling on PE Valuation:PE ratio implies a possible drag of 5-6% from earnings growth

Let us also check what the other metrics indicate

Price to Book Value

Sensex PB Ratio
Sensex PB Ratio

When you look at it from a Price to Book point of view, then the valuations look reasonable as they are close to their long term average.

But why this deviation between PE and PB?

PB = PE * Return On Equity

As seen from the above equation, the culprit for this difference in signals from PE and PB valuations is because of ROE. The ROE for Indian equities is extremely low at this juncture.

Trend in Sensex ROE (%)
Trend in Sensex ROE (%)

ROE usually tends to mean revert over time. We need to keep this context in mind while evaluating PE valuations which look expensive

Pointing and Calling on PB Valuation: PB ratio is reasonable. Low ROE leading to expensive PE valuation.

Midcap to GDP ratio below 100
Midcap to GDP ratio below 100

Pointing and Calling on MCAP/GDP Valuation: MCAP/GDP indicates reasonable valuations

2.Earnings Growth

Anyone who has tracked analysts prediction for earnings growth in the last 5 years know one thing for sure – it is damn difficult to get it right.

So while I profess no superior powers to forecast, taking a longer time frame of say 5-7 years, provides us with a slightly better chance to project earnings growth. (Of course, this can be wrong. But hey, we need to start somewhere right!)

Just like we used mean reversion as our base case in valuations, we shall use mean reversion in Corporate Profits to GDP as our base case to project earnings growth for the next 5-7 years. A longer time frame means we are providing more time and hence a higher likelihood of mean reversion happening.

India Corporate profits as % of GDP
India Corporate profits as % of GDP

A lot of reports come up with corporate profits as a % of GDP. While different reports have different numbers, the overall number is very close to each other. I have taken CLSA’s data. (Source: Link)

The average corporate profits as a % of GDP since 2001 is 4.2%. Currently for FY19 it is expected to be 3.3%.

Now assuming mean reversion to around 3.5% to 4.5% and a nominal GDP growth of around 11% (6% real growth + 5% Inflation) we end up with a profit growth range of 12% to 18%.

Pointing and Calling on Earnings Growth: Profit Growth Expectation for the next 5 years: 12% to 18%

Current Corporate Profit as % of GDP = 3.3%
Current Corporate Profit as % of GDP = 3.3%

5 Year Equity Return Estimates

Applying these numbers to our original equation:

Returns from equity = Change in earnings + Change in PE valuations + Dividend Yield

Change in earnings = 12% to 18%

Change in PE valuations = -5%

Dividend Yield = 1% to 1.5%

Pointing and Calling on future equity return expectations: Approximate estimate of equity returns over the next 5 years: 8% to 14%.

Assuming an inflation of 5%, that is a real return of around 3% to 9% which is pretty decent!

3.Cycle – Credit Growth, Capacity Utilisation

Credit growth has started to pick up

Bank Credit Growth (YoY%)
Bank Credit Growth (YoY%)

Capacity Utilisation is increasing – early stages of a capex cycle

Pointing and Calling on Capacity Utilisation & Credit Growth: Earnings growth can receive support from: improving credit growth and capacity utilization (possibility of capex cycle picking up)

4. Sentiment

A good way to measure sentiment is use FII, DII and MF Flows into Indian equities.

FII Flows

Weak FII Flows
Weak FII Flows

Foreign investors have been structurally positive on India. So while there are short term instances where they took out money, they have always returned back. So whenever FII flows were negative, it was a great time to invest in Indian equities.

DII Flows

DII Flows in Equity
DII Flows in Equity

DII flows have been very strong in the past few years which is also supporting the higher valuations. But a large chunk of the money came during 2017, which means for those investors the returns would be dismal (more dismal if it went to mid and small cap segment). So we need to monitor the DII flows very carefully.

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