Investing on Mt. Everest

Recently, there has been much discussion about how the Indian equities market might be going through an overvalued phase. What follows is a perspective on this question that’s grounded in what global markets have taught us over the past several decades.

Historically, corporate profit growth has tended to lag nominal GDP growth. It’s true that once in a while, profit growth can exceed nominal GDP growth. However, if profits were to consistently beat nominal GDP (which is possible only in an economy dominated solely by exporters), then corporate profits would eventually exceed the GDP, and such a scenario is quite unlikely. Thus, typically, Indian corporate profits do not grow at the same rate as the country's nominal GDP.

Now, over time, stock market returns tend to trail corporate profit growth due to a lack of high-quality business managers, as many firms have to contend with mediocre management that detracts from their growth potential. Going further down the chain, investor returns often lag stock performance due to transaction costs and the difficulty of generating alpha, as the market largely behaves as a passive, no-alpha aggregation.

The upshot is that if nominal GDP grows at 10% then, over time, corporate profits will lag nominal GDP, stock price total returns will lag corporate profits, and investors returns will lag stock price total returns.

How well does this typical historical picture match up with what we’re currently seeing? Well, current returns in the Indian market, as indicated by the Nifty Total Return Index (TRI), reflect a significant increase in price multiples, thus posing a key risk for investors. In the last 12 years, the PE (price-to-earnings) multiple for the Nifty Index has increased by approximately 680 basis points (from 17x to 23.8x).

As you can see in the graph above, far from lagging behind profit growth (as measured by the change in EPS, or earnings per share), the market’s returns have greatly exceeded the latter. This seems to suggest that the Indian market is indeed overvalued at this point, and that new investors could easily end up overpaying for equities if they’re not circumspect.

For more actionable insights backed by data and analyses, we invite you to read the latest edition of Netra in its entirety.