100+ PE stocks: Should you worry?

In a market that has witnessed anaemic growth in corporate earnings for quite a few quarters and is finding it difficult to sustain at higher levels, there are companies quoting at over 100 price-to-earnings (PE) multiples. These are not small companies whose share price and valuation can be pushed up easily. These have market capitalisation of more than Rs 5,000 crore, with some as high as Rs 42,000 crore. The list includes companies owned by multinationals like Blue Dart (PE of 350), Gillette, Alstom T&D India, ABB, 3M India and Thomas Cook. Info Edge, Crompton Greaves, EIH, Mahindra CIE and Shree Cement have Indian owners.

Companies with close to 100 PE include United Breweries (PE of 98), WABCO (92) and Jubilant FoodWorks (88). The data is based on trailing 12 months' earnings (ending June/September 2015) and the latest share price of these companies.

So as an investor what should you do?

Unlike small companies, the reasons for big companies trading at such high valuations are different. In the case of subsidiaries of multinationals, G Chokkalingam, founder of Equinomics Research & Advisory, says, "Some of these stocks are trading at very high PEs because the market has expectations of delisting." "History shows that multinational parents typically try and raise their stakes when valuations are attractive. But at these (high) valuations delisting will not happen," he adds.

While that indicates a potential downside for such stocks, the main reason why these companies, both Indian and foreign owned, are trading at astronomical valuations is because the market believes their earnings potential is significant. Bloomberg consensus estimates for the period FY15-18 shows that many of these companies are expected to report earnings growth of over 35 per cent.

Also in the majority of cases the floating stock is low as promoters and institutions have big holdings. Excluding EIH, Mahindra CIE and Thomas Cook, which also barely have retail holdings at about 10 per cent, retail holding in other cases is between 3 and 9.5 per cent. Simply put, there is a scarcity premium attached to some of these stocks.

"There is a pressure in the system for high earnings growth stories given the state of the economy and corporate earnings. The market is providing higher valuations where profit growth is strong," explains Chokkalingam.

100+ PE stocks: Should you worry? Gautam Sinha Roy, fund manager at Motilal Oswal AMC, shares this view. "Among reasons for some of these stocks trading at high PEs is they are perceived as very high quality companies with superlative business economics. Also globally, liquidity is cheap so there is money chasing such ideas," he says.

Experts, however, caution investors about jumping on to the bandwagon. "It would be risky to buy such stocks now. For those already holding such stocks, if they are able to see earnings growing at, say, over 50 per cent annually for two or three years they should hold on," says Roy.

The flip side is there could be a fall in the share price or a time correction if market expectations are belied.

Roy explains, "The downside risk is the time correction, that is, even as earnings grow the stock remains at current levels. That apart, a change in global liquidity conditions or a sharp slowdown could hurt valuations. Investors need to be aware of this."

Chokkalingam adds, "In 2010, when the market corrected, Siemens fell sharply. The perception that multinational stocks are safe is not true. In 2013, Clariant, BASF and ABB had also fallen by as much as 50 per cent."

Most experts believe that the risk is always there. Among the key criteria that investors should track is long-term earnings growth. Also if there is a broader revival in the economy then the valuation premium of some of these companies will contract.

"It is very difficult to say when this trend (of high PEs) will correct, but the risk is always there. Earnings growth is the key criteria to keep an eye on," says Roy.

The risk also stems from the fact that some of these companies' earnings track record is not inspiring, and valuations are largely driven by hope of strong earnings.

Chokkalingam says if earnings growth potential slows then PEs will shrink. Then the double impact on market capitalisation will be steep.

Experts have a piece of advice. There could be instances when PE valuations could be artificially inflated like in cases where a company's profit has fallen sharply but the business fundamentals remain largely intact. The market would still value them at a reasonable/fair value, thus PEs would tend to remain high. These are passing phases. Companies operating in the commodity space could also see high PEs when the cycle is at the bottom. Hence, investors should look at companies case by case.