‘If the market is so overpriced, why isn't it declining?’

“If the market is so overpriced, why isn't it declining? In my view, the market could become even more expensive from here in the next few years," he said.

His suggestion for investors is that any correction is best lived through remaining invested. The prevailing negativity and concerns about market valuations, while partly valid, don’t outweigh the benefits of a long-term investment strategy, Khemani said.

Edited excerpts:

Is there any common misconception about the markets that you'd like to debunk?

Markets aren't as expensive as everyone claims. While many believe they are, I’m offering a different perspective.

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When everyone pushes a single narrative that the market is expensive, people get more fearful and scared. If the market is so overpriced, why isn't it declining? In my view, the market could become even more expensive from here in the next few years. Historically, when interest rates rise, markets tend to dip, but they rebound when rates are cut. With the Fed beginning to cut rates, foreign institutional investor (FII) money is likely to come significantly, so we'll likely see more buying, which could drive prices even higher.

 

Markets are climbing higher steadily. With that in mind, are you finding opportunities in this market as well?

Yes, opportunities still exist. Investing is about finding the right companies and management at reasonable valuations. While the market has evolved from two years ago, there's still plenty of money seeking investment. We’re fully invested, keeping only 1-2% in cash, and we're not concerned about short-term fluctuations.

Valuations have risen, but understanding them requires looking deeper. When valuing any asset—whether real estate, fixed income, or equities—you focus on three factors: yield, growth in yield, and discounting rate. For equities, yield is return on equity (ROE), and growth in yield is earnings growth. India’s ROE is 16%, among the highest globally, with earnings growth projected between 15% and 20%. The discounting rate, influenced by the risk-free rate and risk premium, has dropped, boosting valuations.

Labeling the market as expensive by comparing it to historical averages ignores the structural changes in key factors. Just as property prices rise with development, equity valuations should reflect the evolving economic landscape.

Today, corporate India's earnings stand at $150 billion, up from $8 billion in 2001. By 2035, this figure could reach $1 trillion, implying India market cap could go to $20-25 trillion in the next 10-12 years. For long-term investors, short-term market corrections are less concerning than identifying companies poised for substantial growth. The focus should be on finding opportunities that can multiply several times in the coming years.

So, are you saying that if you focus on historical valuations, the market may seem expensive, but if you consider the forward-looking growth opportunities, the outlook might be different?

Correct.

Those who argue based on historical comparisons are relying on a reversion-to-the-mean approach. However, reversion to the mean typically occurs in economies without significant transformation. India, on the other hand, is in the midst of an unprecedented transformative phase. Given this, it's unlikely that we'll see a simple reversion to the mean. This approach is, therefore, quite flawed in the current context.

What gives you this confidence?

India's systemic risks have historically come from five key areas: the current account deficit (CAD), fiscal deficit, banking sector health, inflation, and debt-to-GDP ratio.

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In the past, issues like a high CAD (e.g. 1991 and 2012) led to economic instability. Today, CAD is down to around 1%, and we might even see a surplus in the next five years. Our fiscal deficit is well-managed, the banking sector is stronger than ever, inflation is low and stable, and the debt-to-GDP ratio is among the lowest globally.

These structural risks have been largely addressed, making our economy more resilient and less likely to face the severe crises of the past.

Are you suggesting that a sell-off is not a probable outcome?

Even if a sell-off occurs, it would likely be triggered by a sudden event, which is unpredictable. The current situation is seen by many as an opportunity to invest. The potential for significant gains is substantial right now.

Does that mean you're comfortable with the current valuations?

We are very comfortable. That doesn’t mean there is no euphoria in pockets. We don’t invest in them and advise everyone to avoid FOMO (fear of missing out).

Then what about capital goods and industrials?

While we are comfortable with the overall market, it doesn't mean every stock or sector is attractive. There are promising areas like capital goods, defence, and railways, but evaluating these individually doesn't reflect the broader market. We're holding our positions in these sectors without making new purchases.

The common mistake is focusing on these euphoric sectors/stocks and then judging the entire market based on them. The key is not to get fixated on these pockets.

So, you don't have any exposure to these sectors?

We’re maintaining our current positions in capital goods and not taking fresh positions. We're not buying new stocks in this sector unless we see a compelling opportunity.

We’re selective and patient, waiting for the right opportunities. Recently, we bought a stock after a 30-40% correction.

What kind of sentiment are you sensing from your clients? Are you anticipating redemption pressure or a desire for people to exit?

Currently, there’s a sentiment split: some feel they’ve missed out on gains by not investing, while others who are already invested are anxious about potential corrections and are contemplating selling.

For instance, a large family office recently inquired whether they should sell their investments now and buy back later, hoping for a 20% correction. I advised them to consider their long-term objectives rather than optimising for tactical moves which anyway one cannot be right all the time.

The prevailing negativity and concerns about market valuations, while partly valid, don’t outweigh the benefits of a long-term investment strategy. For those with a 10-year horizon, the most effective approach is to remain invested and not be swayed by temporary market conditions.

What advice do you give investors concerned about whether they should exit the market given current valuations?

We say—All Is Well. Often, fears arise from limited information and negative media coverage. While some criticize market highs, this can lead to missed opportunities.

Overall, we’re optimistic. However, we should lower expectations in the short term and avoid euphoric investments. Our approach is to invest with a long-term perspective, finding value without chasing fads. India is the most promising market around the globe and likely to remain so during AmritKaal.

As Morgan Housel notes, “Optimists sound like salespeople, pessimists like well-wishers." My optimist pitch might sound like sales pitch, but staying invested in this kind of transformative phase is the best approach. Any correction is best lived through remaining invested.

What is your investment strategy?

We seek high-quality companies at a fair price, where "fair" means considering the growth potential, not just historical P/E ratios. People often compare today's P/E ratios with past ones, but we focus on the growth rate. Expecting a high-growth company to have a low P/E is unrealistic—it’s like expecting a luxury home at a bargain price.

Do you see equal opportunities across different pockets—large-, mid-, and small-cap?

India offers an abundance of investment opportunities across various sectors, from manufacturing and infrastructure to financials and IT services. We're often overwhelmed by choices, rejecting more ideas than we accept. The market's diversity, especially with emerging IPOs, is vast.

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Also, one needs to think differently from the crowd. For instance, when we invested in Senco Gold at ₹300, few showed interest. Today, it's valued at ₹1,100.

Are there any sectors you prefer or plan to avoid going forward?

We favour sectors like manufacturing, financials, consumption, IT, and infrastructure. Currently, we are bullish on manufacturing and new to making investments in the consumption space. We're cautious on financials but may increase exposure later.

What about defense companies?

Defence is a big opportunity but we’re not investing in defence companies, in general, at the moment due to euphoric valuations but we keep looking for ideas and will invest when risk-reward is favourable. For example, we recently bought into a pre-IPO company at a reasonable valuation, expecting significant growth.

What’s your take on the SME IPO space?

The SME (small and medium enterprises) IPO space is crowded, and we approach it cautiously. We only invest when we find exceptional entrepreneurs and business models, which is rare. Liquidity and the risk-reward balance make it less appealing. The effort to find quality opportunities doesn’t align well with the impact on our portfolio.

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