expectations = pain

Expectations = The Root of All Heartache (and Portfolio Pain)!

"It's hard to make predictions - especially about the future" - Robert Storm Petersen

Even a cursory look at SENSEX valuations should tell you that markets seem “richly valued”. But how does that help an average investor? Should she raise cash or brace for mediocre returns? Is there a rational way to gauge the expected returns from this point?

In his insightful book Expectations investing – Mr. Michael Mauboussin argues that “the ability to properly read market expectations and anticipate revisions of these expectations is the springboard for superior returns”. Mr Mauboussin advocated the approach for judging market-implied expectations for individual stocks. However, can the same template be extended for markets as a whole?

Global valuation expert Professor Aswath Damodaran, in an annual ritual, uses market implied cost of equity as a discounting rate (which is scaled according to relative riskiness of the stock to the overall markets) in his intrinsic value (read discounted cash flows) calculations to value stocks. We find cost of equity to be an intuitive proxy for expected returns.

Without delving into the mechanics of the calculations Professor Damodaran simply “goal seeks” internal rate of return which equates expected consensus cash-flow for the market to the current market indices. When we use the same approach to value what returns are baked in SENSEX (appendix carries the calculation should it be of interest) it seems to be pricing in 9% annualized return.

This entails that an investor may expect ~9% equity return every year given - 1) consensus expectations are accurate (earnings downgrade over the years and lofty earnings expectations should dissuade investors from believing in the accuracy of forecasts, more on the same later) 2) interest rate regime and risk averseness of the investors remain unchanged over the investment horizon (predictability of both can be tenuous at best – see the sharp increase in risk premiums demanded by investors in Mar-20).

Implied expectation - how does it stack up vs history and relative to the opportunity cost

How does the expectation compare with markets historical returns and how does one judge whether the same is enough compensation for the equity risk assumed? The first question can be answered by looking at 1yr rolling returns for SENSEX and second can be addressed by ratio of equity risk premium (ERP) to 10 year GSEC (higher the ratio more risk-averse are the investors thereby demanding higher risk compensation).

Howard Marks says the key to dealing with the future is in knowing where we are, even if we can’t know precisely where we are going.

Distribution of 1 Yr rolling returns for Sensex over the last 40+ years calculated monthly

Majority of the time one year rolling returns have been higher than current implied returns.


The ratio of equity premium to GSEC is at 37th percentile – ie ~60% of time, higher risk compensation was sought.

Achieving consensus expectation will be no mean feat…

We now look at base rate of earnings growth over the last 20 years and compare it to current market expectations. Sensex is pricing a 2 yrs. forward earnings growth of 26%, a feat, which has been achieved only twice in the past 20-year history and is ~20% higher than fastest two growth achieved in CY01-05. Even if one adjusts for the lower base year effect of COVID, the ask rate on the base of CY19 is still ~17% which is 3x of growth achieved in CY06-CY18. This is possible but the odds seem unfavourable.

It seems all muddled up..

Current implied stock returns seem lower vs returns historical average but the alternative does not seem enticing as well, risk premiums demanded are closer to the long term averages but the achieving consensus expectations seems like a stretch. How should the investor approach such markets?

Here’s what we think about it:

1. Temper your return expectations

In a low implied return set up, markets may be overextended and with many sectors where the valuations are expensive. Tempering the return expectation not only aligns the investors with possibility of lower returns but also helps in resisting the urge of participating in segments which appear alluring but eventually subjecting the investor to mediocre returns (if not permanent capital loss) as the valuation pendulum retraces. (Think Information Technology (2000) and Real Estate and Infrastructure (2007))

2. Seek asset diversification

Diversifying through debt/hyrbrid funds and global equity may help reduce volatility for similar returns or enhance returns for similar risks. Global equities also enhance investable universe, provide access to opportunities not available domestically and sometimes may offer cheaper proxies to favoured domestic themes.

3. Extend your investment horizon (allocate to equity what you can set aside for more than 5+ years)

Sensex rolling returns (excluding dividend) for 1/2/3/4 yrs calculated monthly for 40+ years seems to suggest that for a marginal reduction in the returns the variability of the returns comes down meaningfully as the investment horizon is extended. Howard Marks defines risk as “More things can happen than will happen” – as time horizon is extended “More (uncertainty of returns)” becomes “Less”.

  1-Year 2-Year 3-Year 4-Year
Median Returns 13.1 14 11.5 12.7
Std Deviation 35.2 21.6 16.7 14.4



Calculating the implied cost of equity

For calculating implied cost of equity we use the consensus forecast for earnings CY21-22 which is then forecasted to grow at nominal GDP growth. The terminal year cash-flow is expected to grow at GSEC yields which is good proxy for the long term GDP growth of the economy.

  Current Year TTM CY21 CY22 CY23 CY24 CY25 Term Year
Expected Earnings 1,412 1,612 1,758 2,250 2,565 2,924 3,334 3,541
YOY Growth (%)     24.5 28 14 14 14 6.2
Free Cashflow Conversion     77 82 60 60 60 60
Free Cash Flow     1,347 1,834 1,539 1,755 2,000 2,125


Key Assumptions

1. CY21 and CY22 is based on consensus expectations

2. CY23-25 earnings are expected to grow at nominal GDP (we assume 14%). Free cash flow conversion ratio is based on 20 -year average which is ~57%.

3. Terminal growth is assumed at G-SEC ( ~6.2% ) which is good proxy for long term GDP growth.

Total 2021 2022 2023 2024 2025 Term Yr
50,363=  1,347/(1+r) + 1,834/(1+r)² + 1,539/(1+r)³ + 1,755/(1+r)⁴ + 2,000/(1+r)⁵ + 2,125*1.062/(r-0.062)(1+r)⁶
r = Implied Expected Return on Stocks = 9.3%
Minus Risk Free Rate = 6.2%
Equals Equity Risk Premium of 3.1%


All Data as at Mar 22, 2021.

This note is for information purposes only. In this material DSP Investment Managers Pvt Ltd (the AMC) has used information that is publicly available and is believed to be from reliable sources. While utmost care has been exercised, the author or the AMC does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers, before acting on any information herein should make their own investigation & seek appropriate professional advice. Any sector(s)/ stock(s)/ issuer(s) mentioned do not constitute any recommendation and the AMC may or may not have any future position in these. All opinions/ figures/ charts/ graphs are as on date of publishing (or as at mentioned date) and are subject to change without notice. Any logos used may be trademarks™ or registered® trademarks of their respective holders, our usage does not imply any affiliation with or endorsement by them.

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