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..

Sensex valuations mean revert!

Grr..That’s too obvious right..

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

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

- The
**maximum of the minimum PE recorded**in every possible 2 year period of the last 17 years is**17.4 times** **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,

TheSensex 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:

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 ..

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

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 manager**s 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..

Maybe..

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