The Sensex has risen 45% since January 2020, the pre-pandemic period and by 26% since January 2021. However, the BSE Smallcap index has jumped 114% and 62% in the same periods respectively. The overall BSE market cap has jumped by 160% from Rs.102 lakh crore in March 2020 to over Rs.266 lakh crore now. Despite such a massive rally, the domestic equity market may not crash at least for another 3 to 6 months.
New retail investors continue to pour into the markets – more than one lakh new investors register on the BSE every working day. Over 2.65 crore new investors have registered in the markets in the last year. This is much more than what India had 2.45 crore investors as the overall base till 2011! Since March 2020, around 3 crore new investors have entered the stock markets and this net addition in the last 18 months was equal to the overall investors base India had created over a period of 140 years since BSE was established in 1875!
This structural change in terms of entry of new equity investors, significant recovery in the GDP, over $23 trillion of global monetary and fiscal stimulus packages, effective control of the spread of coronavirus, and finally normal monsoon performance are likely to be major positive indicators to support the current rally in the markets at least for the next 3 to 6 months. Any possible steep correction or major crash in the markets may come only after 3 to 6 months. However, it is time to be cautious in making investments in the markets at current valuations.
There are many stocks, which trade at a P/S Ratio of 10 to 20 times now – P/S Ratio is Price to Sales i.e. market cap to annual sales of the companies. There are many companies, whose stocks trade at an exorbitant valuation of as high as 20 times their sales. Some of them are justified on the basis that they hold high operating margins as high as 45% to 50% – it could be true. Still, it is better to look at PE (price to earnings ratio) rather than the P/S ratio. High operating margins would ultimately reflect in net earnings and therefore, in PE ratios. If a company has 10% net profit margins and its stock trades at 10 times P/S, then its PE ratio would be around 100! Keep this P/S ratio as a key parameter to monitor and alert yourself.
If any stock trades at more than 10 x P/S, then see whether it has got a very high net profit margin and also evaluate whether it would be able to grow its net profits at least by 30% to 40% every year. High net profit margins and consistent high net profit growth would ultimately sink the PE ratio and thereby, would offer an opportunity for wealth creation from your equity investments. Otherwise, chances are very high that you may lose heavily in such stocks once the current massive rally in the markets fizzles out.
Similar events were experienced during the last dot com burst – many dot com companies failed to have a positive bottom line and those days their valuations were still justified by many analysts on the basis of a very high rate of eyeballs for their internet ventures. But, finally, most of them collapsed on the markets. Now a similar situation is seen in many stocks, which trade at over 15 times Price to Sales with a PE ratio of around 100. Alert yourself and check for their net profit margins and rate of net profit growth. If any of your stock trades in the range of 10 to 15x P/S ratio and PE ratio of around 100 at present, then check whether it has got enough growth momentum in its net profits which will sink its actual PE ratio (keeping current stock price constant) at least in the range of 15 to 20 in the next 5 years. Otherwise, once the rally fizzles out the chances are very high that you might destroy your wealth in such stocks.
It is worth remembering the fact that the journey of stock markets (broad indices) has never been constantly linear over 3 to 5 years especially after massive spikes in them. Further, it is relatively easy to build sales, but very difficult to accumulate profits. This country has already seen some businesses (like trading, airline, etc.) which built a solid sales base through discounts but failed to consolidate profits and eventually disappeared from the business. Thus, evaluate your equity investments for the prices you pay on the basis of net earnings they make, not solely on sales they build.