Dispersion galore: The most common grumble from
portfolio managers is that the street and the market is
pushing them to buy the same set of stocks – the
winners of the past five years – stocks which continue to
command rising and premium valuations. Ordinarily,
there is no issue with buying past winners. Indeed, our
factor work shows momentum is a winning style in the
long term. However, the opposite spectrum of the
market is very attractively valued and the risk of
concentrated portfolios is not lost on fund managers.
The point goes beyond portfolio risk. The fact is that the
stocks, which have delivered the best performance over
the past five years and now trade at significant premium
valuations (Exhibit 1), have not really delivered outsized
relative fundamental performance versus the past
(Exhibit 2 and 3). The gap in trailing earnings growth
and ROE of India’s best companies with the worst is in
line with history and, yet, the P/E and P/B gap of their
stocks is the highest ever (ex-the tech bubble). What
explains this?
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portfolio managers is that the street and the market is
pushing them to buy the same set of stocks – the
winners of the past five years – stocks which continue to
command rising and premium valuations. Ordinarily,
there is no issue with buying past winners. Indeed, our
factor work shows momentum is a winning style in the
long term. However, the opposite spectrum of the
market is very attractively valued and the risk of
concentrated portfolios is not lost on fund managers.
The point goes beyond portfolio risk. The fact is that the
stocks, which have delivered the best performance over
the past five years and now trade at significant premium
valuations (Exhibit 1), have not really delivered outsized
relative fundamental performance versus the past
(Exhibit 2 and 3). The gap in trailing earnings growth
and ROE of India’s best companies with the worst is in
line with history and, yet, the P/E and P/B gap of their
stocks is the highest ever (ex-the tech bubble). What
explains this?
Scarcity value: The valuation reward is not driven by
better fundamental performance but by the dwindling
opportunity set of superior fundamentals. Exhibits 4 and
5 show that the percentage of companies generating
20%+ earnings growth or 20%+ ROE is at decade lows.
Money pools have been concentrated in this shrinking
universe of stocks driving up their valuation multiples.
The prime reason is that the market is taking a rather
dim view of what the underperformers of the past five
years can achieve in the next two or three years and
hence, does not see any basis for higher multiples for
this set (Exhibit 6). The issue is the growth cycle. Until
the growth cycle broadens, weaker companies will likely
struggle to generate earnings and ROE. At some point,
when growth improves and broadens, the premiums will
contract. However, the recent QT by the RBI creates
growth uncertainty and put paid to our call for a
contraction in valuation dispersion. Our view now is that
the market may continue to add P/E points to this small
universe of fundamentally superior stocks.
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