The market is unlikely to become “cheaper” without the level of confidence in future growth or the future growth estimate going down.
India’s most popular stocks are drawing sighs from value investors, given their headline valuations, but equity markets still have a lot of value stocks to offer, in our view. We attempt to identify some in this report. We disagree with the norm of looking at factor value metrics to judge value, although we appreciate the ease of doing so. Ultimately, the value of a stock is the future dividends discounted by the expected returns. Valuation, on the other hand, is just the price of a security expressed as a ratio. Keeping the theory aside, the practice of value investing itself is a subjective process. In this note, we identify value stocks from our coverage universe, but expect to hear disagreement. We are adding Vedanta to our Focus List at the expense of Cummins India.
The theory of value
The value of a bond is the stream of future coupons discounted by the expected rate of return. Likewise, the value of an equity security, a junior claim on a firm, is the stream of future dividends discounted by the expected rate of return. There are four things that drive the value – the starting point of dividends, the growth rate of dividends, the terminal value of dividends and the expected return – a.k.a. the cost of equity. This is basic knowledge that all equity investors have and is also the tenet of value investing. If the price of the equity share is less than this estimated value or even equal to this value, we call it
a “value” stock.
Factor value metrics: What to do with them?
With ambiguity in estimating “value”, it is no surprise that most investors gravitate towards valuations as a proxy for value. Valuation is the point number of what a security trades at – in effect it is nothing but the price of the security not expressed in a currency but as a ratio. So if the P/E is 6x for one security vs. 20x for another one, we can say that the one trading at 6x is cheap (in price terms) relative to the other one. It does not shed much insight on the value of either security. Indeed, the only thing a valuation ratio reveals about value is the starting point of cash flow (i.e., dividends) relative to the price – which is one of the four things that an investor needs to estimate value.
Thus, we disagree with the norm of looking at factor value metrics to judge value, although we appreciate the ease of doing so. Also, the work that we have done shows that factor value has underperformed factor growth over the long term. Why this happens we think is straightforward. Most “cheap” stocks are cheap for valid reasons ranging from corporate governance to poor fundamentals and growth prospects, and while sometimes growth does become overvalued, it still appears to come out well in the long run. Pertinently, valuation ratios have limited ability to forecast share price performance especially with one- or two-year horizons.
Does the Sensex offer value?
The BSE Sensex index trades at 18.1x one-year forward earnings vs. a historical average of 14.3x, but then profit share in GDP is at cycle lows (just around 2.3% vs. the historical average of 3.5%). Thus, the index is trading at 12x normalised earnings. Put another way, it trades at its historical average P/B of 3x with the forward ROE approaching historical average. However, from the perspective of assessing the value of the MSCI India, all these ratios are largely irrelevant. So what is the value quotient of Indian equities? It all depends on how the index dividends grow in the coming years. The most current dividend is commanding a high price, but that tells us very little about the value of the index (or market). Our residual income model is projecting a 12% rupee return over the coming decade. If the return expectations are lower, the BSE Sensex is “value”.
Of course, confidence around these estimates can vary. For example, our model assumes 12% revenue growth to FY2028 (in line with our long-term GDP growth forecast), 14% net profit growth (higher than revenue growth because of the low starting point on margins) and a 6% terminal growth rate. Investors may demand a higher margin of safety by arguing for a lower price on current dividends (i.e., lower valuations). However, such margin of safety is illusionary – it comes only with a lower or more variable future growth. Indeed, the reason for richer valuations for India is greater investor confidence in future cash flows and its growth relative to other parts of the world. India brings to the table better demographics, domestic demand and strong entrepreneurial record – three of the four ingredients for superior growth with the only debatable factor being technology/innovation. We believe the debate on India should revolve around whether this greater confidence about the future is justified rather than the price at which the latest or the next two years’ earnings trade. In the meanwhile, the market is unlikely to become “cheaper” without either the level of confidence in future growth or the future growth estimate itself going down.