Should investors stop their SIPs? What works better – value or growth style of investing in delivering better returns? How do market cycles work? At Cafemutual Confluence 2018, Vetri talked about these issues and more.
Vetri began his presentation with an oft-repeated comment, “In the long run, equity markets are slave to earnings.” He shared that it is embedded deep in everyone’s mind that economic growth will entail corporate earnings growth and markets returns will follow. He adds that another equally powerful parameter that plays an important role in determining the outcomes - valuation cycle.
To understand the role played by valuation cycles on outcomes better, Vetri analysed historical market data. Studying the PE multiples during periods reporting substantial growth in Sensex, he notes that there is significant PE expansion happening during every upcycle of the market. To summarise, along with earnings, PE changes also forms a significant component of market rally.
He delves deeper into data to analyse the contribution of earnings in a rally v/s the contribution of PE expansion. Historically, there have been seven major rallies during 1984 to 2018. Of these rallies, five rallies viz. 1984 to 1986, 1990 to 1992, 1998 to 2000, 2009 to 2010 and 2013 to ongoing had significant component coming from PE expansion. The exception to these were 1993 to 1994 and 2003 to 2008 which had Earnings per share (EPS) contributing a higher proportion towards market returns (59% and 54% respectively). He also shares the example of the 1998 to 2000 IT led rally, which may also be called bubble as the EPS growth stood at -2% while the market returns were driven by 100% PE expansion.
In other words, while we call markets as being slaves to earnings, a significant proportion of market returns during bull markets come from PE expansion, he observes. He further adds that there is no scientific way to calculate the amount of expansion as it is linked to the collective confidence of millions of domestic and global investors.
Next, he briefly analysed the change in PE multiples during some corrections which occurred in between these bull rallies. Even in this case, he observed that contraction in PE multiples was a key contributor of the correction. In a nutshell, Vetri mentions that PE expansion and contraction is a key driver of both bull and bear markets. Though, in the very long term, earnings play an important role in market growth, the greed, the bottoms, the panic and fears are driven by change in PE multiple.
He then delves into different PE levels and mentions that simplistically, many people may say that when PE multiple is low, returns will be high and vice versa. However, he adds that in reality it is not so straightforward. Moreover, you cannot just look at averages to form conclusions. To prove the point, he says that data analysis reveals that if the PE ratio of the market is between 9 to 13 then the average 1 year return would be 47%; however, this average hides the vast variance in returns from +104% to -22%. Similarly, one may say that PE in the range of 23 to 50 seems expensive as average returns are 6%. However, the maximum return during the period is 89%. Thus, we can see that the outcomes are all over the place. However, when we analyse returns over the long term (10 year +) the range starts to contract and the asset class returns come closer to the expected value. Concluding his analysis on valuations, Vetri said that while earnings contribute to market returns over long periods in the short term, valuations play a crucial role in determining outcomes.
As investors, Vetri believes that while you cannot predict the valuations, you can prepare for them through asset allocation so that when equities correct, the other asset class shores up the portfolio returns.
In the second part of the presentation, Vetri analysed whether investors should stop his SIP. First, he calculates returns of investors who never stopped their SIP as 12.5%. He observes that if an investor stops the SIP when market corrects then restarts it again after a gap of a year then his returns drop. Essentially, Vetri highlights two points that if investors back away from SIP when markets correct then it eats into their overall return.
However, the bigger challenge is that you end up investing a lot less in the market. This would mean your final amount is lower and the amount not invested needs to be channelized in such a way that it earns returns higher than equities to reach the overall 12.5% earnings level; in other words, the cost of trying to intervene or back away from SIP can be very high. He also analysed what would be the outcome if an investor stops the SIP when markets run up a lot and re-enters it after a year. This leads to a marginal increase in returns to 13.88%. However, similar to the earlier case, it leaves you with some free money and this free money needs to earn returns higher than equities for you to reach the desired corpus. Thus, he feels that stopping the SIP does not make sense; rather investors should continue investing systematically as it earns them average valuations over extended periods of time.
Finally, he talks about the performance of growth v/s value. Analysing MSCI growth and value index he observes that though there is some differentiation in performance over short periods (5 years) as we increase the time horizon (15 year +) the difference turns miniscule. Thus, rather than worrying about growth and value, he believes that sticking to one investment style over long term results in robust performance. Typically, one style may do better than the other in shorter periods; however, over a long-term period the difference in investing styles has marginal impact on returns.
He concluded by saying that valuations matter, as they eat into or add to returns. Thus, to add a margin of safety to client’s portfolio, asset allocation plays an important role. Also, he advised investors to stay the course with SIP. Finally over the long term, it’s not value v/s growth but good investing and good stock-picking which gets investors to their destination though the journey may look a bit different.
