Investors are uncomfortable using earnings-based valuation tools as there are worries on what is the real earnings power of companies. I am not talking about fraud here but simply the fact that earnings have risen as a percentage of GDP, and as is typical in strong economic cycles, companies have potentially over-earned compared to the sustainable profitability of their underlying business model. If companies have over-earned in the past few years how does one adjust for this? Over the last few years, we had a virtuous cycle of rising capacity utilization, falling rates, significant pricing power, easy access to capital and surging growth rates. All this combined to supercharge earnings and capital efficiency ratios. Unfortunately most of these factors are now in reverse, with the inevitable consequence on earnings. Investors are beginning to realize that in many companies earnings are far more cyclical than they had realized. Strong economic growth can disguise inherent cyclicality, and once exposed, cyclical earnings attract lower multiples. Many supposedly secular growth stories will be exposed as cyclicals which benefited from the huge tailwind that India had over the last five years.
...We are coming off a huge bull cycle in 2003-2007. Given the quantum of stock price appreciation, it is logical that the markets will only bottom out with time and when they appear very-very cheap. India has probably not yet reached that stage of extreme price attractiveness — the markets are cheap, yes, but not yet distressed.
With the passage of time as we get more comfortable with the economic outlook, one may need less margin of safety on earnings and have a greater willingness to pay up for growth. Investors have to be willing to extend their time horizons again and not become obsessed with the next quarter. For that we need the elections out of the way, and some semblance of normality globally.
Arun Natarajan is the Founder & CEO of Venture Intelligence, the leading provider of information and networking services to the private equity and venture capital ecosystem in India. View free samples of Venture Intelligence newsletters and reports. Email the author at email@example.com