Investment realignment: Don’t look at stock valuations in isolation, consider risk-reward ratio

The equity markets have been quite volatile in recent times with the NSE Nifty 50 yo-yoing between 18,300 – 15,300 since the start of the year.

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Image: Pixabay

By Manish Jain

The equity markets have been quite volatile in recent times with the NSE Nifty 50 yo-yoing between 18,300 – 15,300 since the start of the year. On the face of it, the overall correction may have been just ~11% from the peak, incidentally pegging India as one of the best-performing markets in the world. However, averages always hide more than they reveal. The correction in the equity markets has been far deeper than what the indices are telling you. The top five stocks (Reliance Industries Ltd (RIL), HDFC Bank, Infosys, ICICI Bank and Housing Development Financial Corporation (HDFC Ltd) together account for a little more than 42% weight of the index. So, in effect, if these stocks are not corrected, it will not show up in the index. 

Digest this, the bottom ten stocks (account for a measly 5.36% weight of the index) have all corrected more than 20% so far this year. So, in effect what we are telling you is that: a) don’t go by averages, they hide more than they reveal, b) markets have been far more volatile than you realize, and c) these are the best times to realign portfolios.

Now that this has been established, the moot question is: what should be the realignment strategy in these tough times? The first rule is not to panic. As investors, we usually over-analyse and over-exaggerate the eventual impact of headwinds. Time and again we have seen this, whenever a macro catastrophe comes, everyone (including the experts) believes that the world as we know it will end, however, sooner than expected normalcy returns and as investors we most often miss what was a great money-making opportunity. If you believe that long-term industry fundamentals are strong, the management quality is intact and corporate governance has not been compromised, then a correction is a good time to add the stock to the portfolio. Swim against the tide, be greedy when the world is fearful and vice versa.

The second rule is not to look at valuations in isolation. Just because a stock trades at 50x multiple, it does not mean it’s expensive. Look at the risk in conjecture with the reward. Multiples don’t fall from the sky but they are a derivation from the discounted cash flow. So, look at the long-term DCF objectively and see if it all adds up or not.

Third, not always do the price reflect the business fundamentals, there are often times when mispricing happens and that’s an opportunity. So, when a stock undergoes a significant correction, you will hear a lot of noise often with a changing narrative. Use your own judgment and analyse the situation.

In conclusion, the world may be going through a tough time with hyperinflation and geopolitical tension. However, remember there is always light at the end of the tunnel. Our economy is on a strong footing, inflation has peaked and domestic demand looks strong. So, invest in equities now to create exponential wealth over the next few years. Portfolio construction takes time, energy and effort. Do not panic nor despair.

However, remember to always invest in quality stocks, the “Good & Clean” businesses.

(By Manish Jain, Fund Manager, Ambit Asset Management. Views expressed are the author’s own.)

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