Share market valuations: Nuanced view needs to be taken

On Thursday, May 23, some news channels were carrying screaming headlines — 3.8 lakh crore added to investors’ wealth. To be sure, there is an elegy too when the reverse happens — 7 lakh crore of investors’ wealth vapourises! Such manic-depressive or bi-polar headlines are not new to India. On the 23rd the Sensex soared on the expectations of Modi’s return to power through the ongoing hustings. Many scrips in the Sensex basket hit the roofs. And a few months earlier when the short-seller Hindenburg triggered a market crash, the dirge that shareholders lose wealth went on for weeks. The truth is the end of the day (EOD) market capitalisation is at best notional. Real gains or losses happen only when actual sale or purchase transactions take place.

Let us say a person and his associates own 47% of the shares of a listed company. If he were to go to the market on May 24 on the back of the rally a day earlier with a view to selling 20%, he would not get the fabulous price discovered a day earlier. Mass selling triggers a negative reaction. Thus, the fabulous notional values are at best illusory if not ephemeral. To be sure, small investors who book their profits do not cause any ripple thus being in a position to book profits when the prices hit the roof. But if they are avaricious and sit on their shares in the hope of the market permanently heading north, they would be disappointed.

It is only in the case of open-ended mutual funds scheme such notional value matters, as by their very nature, they offer a revolving window permitting free entry and exit on the basis of the net asset value (NAV) of the scheme which is the aggregate value of the portfolio of the scheme less liabilities. The NAV is divided by the number of units to arrive at the entry or exit price. When the market rises, the NAV also rises and there is likely to be a large-scale exit. In such a scenario, the fund manager will have to liquidate a part of the scheme’s portfolio so as to be in a position to pay off those seeking exit. Technically, this is called redemption pressure which is a fund manager’s nightmare when unit-holders queue up for redemption. Those staying put are the victims. In close-ended schemes, there is no redemption pressure on the fund managers as the unit-holders seeking exit have no option but to directly sell their units in the market.

One must remember the market reacts to both fundamentals and non-fundamentals. One has to sift the grain from the chaff. If the rally is triggered by micro or macro fundamentals, the appreciation is indeed nothing to scoff at but if it is a liquidity driven boom, one has to take the meteoric and stratospheric rise in valuations with bagful of salt. Experts have often wondered how the market performs much better than the economy when the truth is it is supposed to be the barometer of the economy. This conundrum is explained by the phenomenon of liquidity driven boom that has come to characterize India ever since Foreign Portfolio investors (FPI) were allowed unbridled entry and exit into the Indian bourses. Too much money chasing too few goods causes inflation. In the market when big investors chase select scrips, their prices soar to dizzying heights not warranted by its fundamentals.

Time was when FPI had a stranglehold on the market. Now domestic institutional investors led by Indian mutual fund houses dominate equally if not more. And if their combined investments mark a day, inevitably the prices soar to dizzying levels. Alas, if there was a scientific formula to sift the grain from the chaff — how much of the value is due to fundamentals and how much due to liquidity — it would help fair and dispassionate decisions. But that is not possible.

The media is also fond of tracking the relative riches of company promoters in pecking order once again on the basis of the ephemeral market valuations of the sliver of the pie they own in their companies. In addition to liquidity marring dispassionate valuations, the Indian market is also vulnerable to manipulations by insiders mainly promoters. It is well-known a sizeable share of the FPI is actually investments in the bourses by the Indian promoters through the FPI route. Black money accumulated in dubious foreign destinations return to India riding piggyback on FPI. Bulk of the black money thus returning to India vide the FPI route finds its way to propping up the shares of the promoters thus resulting in artificial valuations.

The truth therefore is too much should not be read into the notional appreciation or depreciation in market value. They are at best blips on the radar. At any rate, the plaintive and irrational elegy shareholders lose wealth is hysterical as no shareholder is promised a fixed capital gains. The elegy gives the impression that the shareholders’ vested right has been trampled with by the market. This is hardly true any more than the exultation when the reverse happens.

Analysts therefore take a more nuanced view of valuations say six-month average or moving average. As a rule of thumb in the shorter term, anything in excess of price-earning multiple of 25 is viewed with caution. More outrageous valuations however happen in the primary market with the merchant banker wangling exaggerated IPO price even for loss-making companies in cahoots with qualified institutional buyers who bid for the shares on offer, with the small investors willy-nilly having to follow them Pied-Piper-like. More on this at another time.

S Murlidharan is a freelance columnist and writes on economics, business, legal and taxation issues

Published on: Friday, June 07, 2024, 06:00 AM IST