“Many shall be restored that now are fallen and many shall fall that now are in honor” – Horace
We have observed many times that stock and sector performance tends to revert to the average over time—a phenomenon known as mean-reversion. This means that if a sector or stock has performed very well, its returns are likely to eventually move back toward their long-term historical average. When a sector or stock starts to do well, it attracts more investor money, which drives up valuations—that is, the prices investors are willing to pay for a company relative to its earnings or assets. However, when prices rise much faster than the underlying earnings, a catch up typically occurs, where either earnings increase to justify the higher prices or prices decline to realign with earnings. We are already witnessing this at the index level, as returns over the past year have not been impressive. Given this pattern of mean-reversion, it is important to examine which sectors currently appear undervalued or overvalued. In the following analysis, we compare sector valuations and recent performance to identify areas of potential opportunity or risk.
FINANCIALS offer best value
The table below compares valuation using three metrics: PE ratio, PB ratio, and dividend yield. The PE ratio shows the stock’s price versus its earnings from the past year; a higher ratio means a more expensive stock. The PB ratio measures price against book value, with higher values indicating greater expense. Dividend yield reflects annual dividends relative to price; a higher yield signals more attractive valuations. Clearly it appears that Financials, IT and Pharma are available at below average valuations. On the other hand, commodities, real estate and CPSE (Central Public Sector Enterprises) appear more expensive relative to their own history.
How have various sectors performed?
In a recent interview, experienced fund manager Shankar Naren noted (6 frameworks that will make you a better investor) that asset classes with recent poor performance may do better in the future. The table below displays SIP performance and rolling annualized returns over 3, 5, and 10 years. The table shows financials, banks, IT, and Pharma have underperformed, while CPSEs, commodities, and realty sectors have excelled. This doesn’t mean investors should simply switch from top to bottom performers; rather, fresh SIP investments might be better directed toward sectors with attractive valuations and potential for mean reversion.
BANK NIFTY rolling 10-year SIP XIRR is almost 1-standard deviation below average
NIFTY IT 5-year SIP XIRR return currently was this low during covid
Disclaimer: The above content is just for information and should not be construed as an offer to buy or sell or recommendation. This has not been produced by an investment advisor. It is a market commentary meant to document the thoughts of the author at the time of publication. The analysis is based on publicly available data and provides no guarantee about its accuracy and correctness. Contact your financial advisor for guidance on any investment related query.
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