What returns will I get from equities going forward? – Part 3

In the first part of this series (Part 1) we had explored the impact of valuations and in the second part (Part 2) the impact of earnings growth on estimating future equity returns.

We still have some missing pieces and in today’s post let us take a deeper dive into valuations.

While doing my first post on valuations, I had accidentally chanced upon an interesting insight..

PE Ratio.png

Sensex valuations mean revert!

Grr..That’s too obvious right..

True, I was just kidding. Now look at this chart below

Sensex Min PE 2Y data.png

Take a few minutes to analyse this chart.

In this chart I have plotted the minimum PE valuations of the Sensex recorded in all possible 2 year periods in the last 17 years.

Now that I have given you the required data, its time for the detective in you to decipher the insight..

And just in case it helps, let us take the guidance of the great detective Mr Sherlock!


Are you able to OBSERVE…

Not got it, yet. Here is a clue

  1. The maximum of the minimum PE recorded in every possible 2 year period of the last 17 years is 17.4 times
  2. Current PE valuation is 23.5 times

There you go. Now you can connect the dots..

The insight is simple:

If you take any two year period in the last 17 years,
The Sensex valuation has always ended up falling to a PE valuation of at least 17.4 times during some point in the 2 year period.

For convenience and being a little conservative, let us round it off to 18 times.

So this means, if history repeats, in the next 2 years, Sensex valuation at some point during the next 2 years should at least fall to 18 times from the current 23.5 times.

This works out to a bare minimum valuation decline of 23% sometime during the next 2 years!

Wow! This is getting interesting.

This also means if you have a large sum of money today and want to invest in equity, we have some tough decisions to make.

This 23% valuation decline will have to be offset by earnings growth for us to make actual returns.

Let us take the best case where we assume this decline happens only at the end of 2 years, thereby giving earnings growth 2 years time to offset the decline.

Assuming if earnings growth clocks an above average 20% growth for the next two years, we end up with around 44% absolute earnings growth (if you are wondering why it is not 40%, remember the compounding effect).

Knocking off 23% decline from this, we end up with an absolute returns of around 11% for 2 years.

That translates to a compound annualised returns of around 5.3% !!

Oops. Isn’t this what we get from FD or debt fund returns.

Let us check the equity returns at various earnings growth expectations due to this valuation decline:

earnings growth vs returns

Even at 25% earnings growth, the equity returns over the next 2 years will just work out to be around 10%.

One thing is pretty clear, the earnings expectations being built in today’s valuations are pretty high (around 25-30% earnings growth).

So this means, given the requirement of a staggering earnings growth even historically it must have been extremely tough to notch up good returns if the starting valuations were this high.

As always, let us put our conclusion to test.

Any guesses what the future 2 year returns looked like historically, whenever the Sensex valuations traded above a valuation of 22 times ..

fwd 2Y Returns vs Starting PE

I have plotted the month end valuations (only for periods where PE>22) from 2000 till date and compared it with future 2 year returns.

Good. As expected, except for one occasion (Apr 06 to Apr 08 where it gave 20% CAGR) every other time the Sensex valuation has crossed 22 times the 2 year annualized forward returns has been less than 10%.

Even in the case of Apr-06, the starting valuation of 22.8 at the end of Apr-08 had declined to 18.4 – which implies an annualised valuation loss of 10%. However the earnings growth was extremely strong at around 34% annualised. So the overall returns adjusting for valuation loss still stood at 20%!

Thus our framework holds good and hence for the next two year returns even to be 10% and above we need earnings growth over & above 25%. That’s definitely a tough ask.

All this is fine boss. I have money now. How should I invest?

Now if you are someone who has just started investing in equities and is in the wealth building stage (i.e your total assets are still less than 5 times your salary), please ignore all the above ramblings. Simply continue with your SIP. In 10 years the outcome will be

Image result for all is well

For the others, whose overall equity investments are more than 5x your annual salary (this is just a random no to imply that the value is reasonably large for you), you need to seriously consider an asset allocation framework. (runs beyond the scope of this post)

How to invest currently into equities if you have a large one time amount to be deployed

As in life, there are millions of possible solutions. This is mine and you are free to improve upon it.

You want to invest a large amount in equities with a >7 year time frame

  • 25% of the money – Deploy Rs 25 in Equity Funds
    • Humble approach
    • “I don’t have a freaking clue where the markets are headed. And no one can predict or precisely time the market. So I will have a long time frame to mitigate the valuation risk. Time in the market is more important than timing the market”
    • Prefer value oriented fund managers like Sankaran Naren while selecting equity funds
  • 25% of money – Dynamic equity allocation funds
    • Funds which auto adjust equity allocation
    • I don’t trust myself. I might panic when market falls and fail to reallocate back to equities. So let me automate my asset allocation.
    • Eg: Motilal Oswal MOSt Focused Dynamic Equity Fund, ICICI Prudential Balanced Advantage Fund etc
  • 50% of money – Stay in liquid funds and deploy only when PE valuations come below 18 times over the next 2 years
    • Valuation based approach based on our findings above
    • I hope to start with a reasonable framework and keep evolving & improving it based on the feedback

The idea is to strike a balance between our insights (which can go wrong, thanks to the greatest humbler – the markets) and a “Time in the market is all that matters” approach.

Where can we go wrong?

While historically PE ratio has always gone below 18 times in a 2 year period, what if it doesn’t repeat.

What if it goes to 35 or say 50 times and stays there. Who decides where the PE value must be? Why should it mean revert?

Are we missing something..


This means we need to introduce a 3rd lens to evaluate future returns
(1st being valuations, 2nd being earnings growth).

And what would that be?

Hang on till the next post…

Till then happy Diwali and happy investing 🙂


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Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments


What returns will I get from equities going forward? – Part 2

10 minute read

In the first part of this series here, we discussed on how to evaluate valuations and plug it into our future returns estimates.

Today, we shall solve the next part of the future returns puzzle – Earnings.

Let me be honest upfront. I don’t think I know an exact method to predict earnings growth. In fact I don’t think I ever will 😦

So acknowledging this inability of mine, the idea here will be to work around with a simple framework which is not intended to be precise, but rather can be a good starting point in our conversations about equity return expectations.

Now that we are done with all caveats, let’s dive in..

How do we estimate future earnings growth?

Carl Jacobi to our rescue

Jacobi, a German 19th-century star mathematician, believed that the solution for many difficult problems could be found if the problems were expressed in the inverse – by working backward.

Image result for invert always invert

He was fond of saying, “Invert, always invert”

So instead of asking what will be the future earnings growth, what if we invert our problem and ask –
“For my expected returns from equities, what is the earnings growth required?

Let me explain..

Assume you need at least 15% from equities in the next 5-7 years.

In our earlier post, we found that

Returns from equity = Change in earnings + Change in PE valuations + Dividend Yield

The current trailing PE for Sensex is 23.5. As we had seen in our earlier post here historically we have always got the opportunity to exit above a PE valuation of 17x in the last 2 years of our investment time horizon.

Assuming we get to exit at 17 times PE, this implies a 28% absolute decline due to PE value coming down from the current 23.5 times.

This negative 28% spread across 5-7 years implies a compounded annual loss of ~5-6%.

The dividend yield of Sensex has historically hovered around the 1% to 1.5% range.

I intend to make around 15% from equities. (You are free to have a different return requirement)

Thus putting all this together,

Returns from equity required = 15%

= Earnings growth + Change in PE valuations (- 5 to 6%) + Dividend Yield (1%)

= Earnings Growth – (4 to 5%)

So for getting 15% returns from equities, the Sensex earnings growth should grow by around 20% for the next 5-7 years!

Phew, that gives us a fair idea of the expectations being built in. But how easy or difficult is this 20% number to achieve.

Let us take a look at history..

  • FY 93-96 : 45% CAGR
  • FY 96-03 : 1% CAGR
  • FY 03-08 : 25% CAGR
  • FY 08-16 : 6% CAGR
  • FY 16-21 : ????

You can clearly see that Sensex earnings growth has remained cyclical and alternates between low and high growth periods.

So going by the historical trend, it seems reasonable to expect better growth over the next 5-7 years.

But let us dig further..

Earnings Growth details.png

Source: MOSL

As seen above the Sensex earnings growth over a 5-7 year period has crossed 20% only in the FY93-96 period and FY 03-08 period.

  • FY 93-96 is when Indian economy was opened up for foreign investments and its a one off event.
  • FY 03-08 was primarily led by a strong global growth, domestic investment cycle and commodity bull run.

Now that means, there has only been 2 instances in the past where 20% expectations have been met. Out of which, one of them was led by a one off event, so technically it’s just one instance in the entire 23 years!

So while earnings growth, given their cyclical nature is expected to improve going forward, 20% growth is definitely not an easy ask.

What should happen for this 20% earnings growth to materialize?

A simple way to evaluate where we are in the earnings growth cycle is by using the corporate profits as a % of GDP equation.

corp pat as a % of GDP.png

Source: MOSL, Livemint

In order to arrive at our approximate estimates for the next 5 year earnings growth, we need to project these two parameters

  1. Nominal GDP Growth (i.e Inflation + Real Growth)
  2. Corporate Profits as a % of GDP


  • For nominal GDP growth, let us go by RBI estimates which is around 6-7% real growth + 4-5% inflation = 10 to 12% Nominal Growth
  • We will assume that the corporate profit as a % of GDP moves closer to the long term average (5% of GDP) over the next 5 years. (to around 3.5% to 4.5% as a % of GDP)
  Final 3.0.png

Going by this, our reasonable estimates of earnings growth for the next 5 years can be around 15% to 21%.

But do corporate profit as a % of GDP mean revert?
Let us see what happened in the US where we have the data spread across a large period

Screenshot-2017-10-1 Corporate Profits After Tax (without IVA and CCAdj) Gross Domestic Product

Great. The long term data clearly shows that Corporate Profits as a % of GDP is cyclical in nature. Thus our assumptions for mean reversion of Corporate Profits as a % of GDP in India is reasonable.

Ok, so where that does leave us with

  1. Earnings growth can be around 15% to 21% over the next 5 years
  2. Valuations will lead to a negative impact of 4-5% over the next 5 years
  3. Dividends will add around 1 to 1.5%

Thus overall return expectations for the Sensex over the next 5 years can be approximately around 11% to 17%

Mutual funds historically have done slightly better (by capturing higher earnings growth due to stock selection) and can be expected to provide ~1-2% out performance over the Sensex.

Now that we have a reasonable framework, depending on how reality evolves and we can improve or adapt our existing process.

All this is fine. But how in the world, do we convert all this mumbo jumbo into an executable framework?

Hang on till the next week..

Till then, happy investing as always 🙂

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Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments