A bit more pain could mean serious gains

Investors in the Indian stocks markets may still have some reason to cheer. The Bombay Stock Exchange Sensitive Index, or Sensex, has fallen sharply in recent months, down almost seven per cent since April. However, according to Morgan Stanley, if the price-to-book value (P/B) of the Sensex goes below three, the index gives 30 per cent returns in the next 12 months. On Monay, the Sensex closed at a P/B multiple of 2.98.

In three of the past four occasions, when the Sensex P/B has gone below three, the average returns in the following 12 months have been 30 per cent. But there is a caveat in the report, too. With a little more pain, that is if the P/B ratio comes down another 15 per cent from current levels, the chances of the market giving positive returns will be higher, said the Wall Street-based firm.

P/B is the ratio of the company’s or index’s market capitalisation to its book value, which is the total assets excluding intangible assets and liabilities. For example, a P/B of two indicates investors are valuing the company at twice the value of its hard assets. A lower P/B indicates the stock is undervalued. In other words, P/B reflects investor sentiment on the value of the stock to its actual accounted value.

Vikas Khemani, president and head of wholesale capital markets at Edelweiss, said price-to-book is a good indicator for taking contrarian bets in a bear market. “It’s ideal to invest in the market if you believe the earning power of the book is going to improve. Otherwise, the market can continue to trade at a low P/B multiple for a long time,” he said.

At the peak of the bull market in January 2008, the P/B multiple of the Sensex was nearly seven. The global financial meltdown that followed saw the 30-share index crash 60 per cent from the 20,873 on January 14, 2008, to 8,509 in October 2008. After the crash, the P/B multiple for the Sensex had declined to under three for the first time on October 10, 2008. In the following 12 months, the index had delivered a whopping 58 per cent return.

Similarly, on two such earlier occasions, in June 1999 and May 2004, after the Sensex P/B multiple went below the three mark, the market had given good returns.

“Buying equities is proving to be painful but we believe that, unless the world spins into another crisis, it is difficult to imagine Indian equities will go substantially lower on a relative basis,” said Ridham Desai, managing director & head of India equity research, Morgan Stanley.

The report notes India’s relative valuation to the Asia-Pacific (ex-Japan) market, in dollar terms, is currently lower than what it was during the 2008 crisis. And, though the market is 85 per cent above its March 2009 levels on an absolute basis, when adjusted for the growth in book value, the market is up just 15 per cent.

The brokerage, however, warns that given the macro situation, corporate earnings could fall by eight to 10 per cent in the ongoing financial year. It also observes that market participants in the valuations could be pricing things wrongly on the macro front.