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Equity Mutual Funds - Should You Stay Invested, Or Book Profit?

As the economy improves, investors can expect equity market returns to be led by a combination of valuation improvement and a stronger earnings growth

As equity markets hit new highs, one question that seems to be on top of all investors' minds is whether one should stay invested, or book profit. Given the roller coaster ride of the past 6 years, this is an important question.

In this article, we analyse the factors contributing to market movements and provide a historical context so you can take an informed decision.

What drives markets?

At a very basic level, the return that investors make from equity markets is driven by 2 factors.

  • Growth in profits (earnings) of companies. This is reflected in the Earning Per Share (EPS) of the company.
  • The value which investors assign to these earnings. This valuation is reflected in the Price to Earnings multiple (P/E) of the stock.

For the purpose of the analysis that follows, we've used the annual Sensex EPS and P/E data starting 1991 published by the Bombay Stock Exchange. Sensex EPS represents the collective earnings of the 30 companies that make up the Sensex. Similarly Sensex P/E represents the collective valuation of the same 30 companies.

Is the market over valued?

To understand this, let's see how valuations have varied historically.

Historically, the Sensex P/E has a median value of 18.1. Since the Sensex does not stay flat during the year, we should also look at the highs and lows. The Median P/E at high is 21.5 and Median P/E at low is 13.6x. In some years it can be higher than the P/E of 21.5 and in some year lower than 13.6x, whereas the median observation normalises the same.

In other words, historical P/E valuation has a median value of 18.1 with a low of 13.6 and high of 21.5. To understand this better, here's the valuation of the Sensex at similar levels.

January 2008: Sensex was 21,200 and a P/E of 28x

November 2010: Sensex once again reached 21,005 with a P/E of 22x Now: Sensex is close to 22400, P/E is 18.3x

You would notice that although the 3 observations over 6 years are at almost the same Sensex level, the valuation has come down from a peak of 28x to 18x. While the Sensex may be at a high, the valuations are about average. If one considers 2015 earnings, the Sensex P/E of 16x is actually lower than average.

Are company profits growing?

Over the past 5 years, the average revenue of the companies in the Sensex, have been growing at 17.8% per annum and earnings at close to 11.6%. The lower growth in earnings is a result of margin pressure faced by companies due to general economic weakness. This usually follows economic cycles. As and when the economy improves, margins tend to catch up and profits grow faster than revenue.

The current EPS of the Sensex is 1222, which is expected to grow by approx. 15% to 1400 by FY2015 (March 2015).

What could an equity investor conclude from above?

1. Though revenue growth has been strong, earnings growth has not kept pace. As and when economic growth improves, earnings growth for companies should be strong. 2. Equity markets valuation is at 16x FY2015, which is near the lower end of the historical P/E range of 13.6x – 21.5x. 3. As the economy improves, investors can expect equity market returns to be led by a combination of valuation improvement and a stronger earnings growth. 4. Even if the economy takes time to improve, since valuations are low, down side risk to equity market returns is limited.

What's our recommendation?

Given this above context, we recommend that you stay invested in equities, and enjoy the ride as and when the economy picks up – conditions for which are falling into place.

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