The Other Reason To Hold Equities For The Long Term

(Click here for the previous piece in this series about why you should hold equities for the long term)

It is most commonly believed that earnings drive the stock market. As companies’ earnings grow, so do the stock prices of companies and the indices that are constituted by these companies.

Nevertheless, if we look at the history of earnings growth and performance of the indices, there is no apparent one-to-one relation between these two factors, at least in the short term (i.e. a one year period). In FY95, for example, the earnings per share (EPS) representing the earnings growth was up by 29%. In the same period, the Sensex was down by 12%. Similarly, in FY09, while the Sensex EPS was down by a mere 2%, the Sensex fell by 37% in the same time.

So what is it that really steers the Sensex? In real terms, it seems to be the sentiment, quantified by the Price-to-Earnings (PE) ratio, which plays a larger role in the returns generated by the indices over shorter periods.

To understand this, we studied the past 20 years’ (ending FY13) data of the BSE Sensex. Our research shows that on a median basis, almost 90 per cent of the yearly returns are due to a change in sentiment – effectively, a change in the PE ratio – rather than a shift in earnings or EPS.

For example, in FY96, the Sensex EPS increased by Rs 69 on a yearly basis to Rs 250. On the other hand, the PE dropped to 13.5x from 18.02x as at the end of FY95. Despite the higher earnings, there was a decline in the Sensex corresponding with the lower PE. If the PE ratio had remained at the value of 18.02x, the value of the Sensex would have been 4504 against the actual of 3409. Thus, it is clear that short-term returns in equity are mostly determined by the change in PE level.

Nonetheless, over a longer period (say 5-10 years), most of volatility in sentiment is evened out and the equity returns follow the earnings. For example, for the 10-year period ending FY05, the earnings growth was 10% while the Sensex returns were 7%.

This shows that in the short term, factors other than earnings determine the returns generated. It cannot be overemphasised that equity investment decisions must be made on a long-term basis rather than short-term.