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Why the Sensex could touch 8000

Shobhana Subramanian | July 18, 2005

Neither soaring oil prices nor a faltering monsoon has been able to stop the Sensex in its run. India was the best performer in the region in the April-June quarter, outperforming the MSCI Asia-Pac index by 9 per cent. Having raced past the 7000 mark, the Sensex seems to be looking for its next milestone.

There could be some stumbling blocks along the way, but given the yen that foreigners have for Indian equities, India's market capitalisation -- currently nudging $430 billion - could soon catch up with that of its regional peers - Korea at $505 billion and Taiwan at $507 billion.

Better than the rest The economy's in fine fettle even if GDP growth at 6.9 per cent for FY05 and estimated at 6.5-7 per cent -- is a trifle lower than what we might want.

True, economic momentum may have slowed; export growth has slowed to a three-month moving average of 16 per cent -- still strong but somewhat slower than the 19 per cent in the second half of 2004. But the potent combination of capex and consumption should drive growth.

Within Asia, Indonesia and India are the only two countries expected to grow faster this year than last year while Korea and Taiwan are expected to post less than 3 per cent growth in 2005. Moreover, India is less exposed to a slowdown in either China or the US.

Says S Naganath, president and chief investment officer, DSP Merrill Lynch, "In a world where growth is slowing down; capex, consumption and the outsourcing opportunity should see India post an average GDP growth of 7 per cent over the next five years and that's a handsome growth rate."

The premium's justified Indices by themselves really don't have a meaning. It's the price that one is paying that needs to be looked at. The forward price/earnings (P/E) multiple for the Sensex for estimated FY06 earnings is well past 14.

The average since 2001 would be around 12; for FY07 earnings, the multiple would be lower at around 13 times. Is this expensive?

Says Sanjiv Duggal, director and chief investment officer, HSBC AMC, "The long-term historical average of 18 times is not really relevant, but even if one were to look at the last four years, we're at the top end of the band. Moreover, the return on equity, though good for a lot of firms, is trending down. So the market is not really cheap."

That's true. Because though the Sensex might be trading at a multiple of around 15, stocks are quoting at much higher valuations. One foreign brokerage feels the Indian market is overvalued by about 25 per cent. Besides, India and Indonesia are the only two countries trading at above post-2001 averages. But that doesn't seem to be worrying investors.

As Naganath says, "Investors are willing to pay a premium for sustainable growth and India stands out as an above-average performer both with reference to the GDP and corporate earnings."

Adds Kannan Venkatramani, portfolio manager, Prudential Corporation, "Indian companies offer an above-average RoE compared to regional markets, signaling better quality. Therefore, given better quality, Indian valuations, which are at par with the region, are reasonable."

Has the Indian story been re-rated? Duggal believes that some amount of re-rating has already happened but that a true re-rating of the market will happen after there is confidence about the reforms being implemented. Kotak Securities managing director, S Narayan, however, believes that there has been a re-rating of the India story.

"The increasing number of India-dedicated funds being launched by big players, is testimony to this," he says.

Sedate but sustainable It's now clear that corporate India cannot grow its earnings at 25-30 per cent forever, and a more sedate 15-20 per cent is a realistic number.

The growth in Sensex earnings in Q1FY05 is estimated to fall for the first time in 20 quarters while Sensex free-float earnings are likely to fall for the first time in 18 quarters.

Analysts believe EBITDA margins could contract by about 200 basis points y-o-y in Q1. And that would make it the fourth consecutive quarter when margins are falling y-o-y.

Observes Venkatramani, "The FY05 results did not signal margin pressures, at an overall level. In fact, they were up, primarily driven by better operating leverage. Going forward, a potential downturn in commodity prices would put pressure on margins in that sector and hence margins overall. To a small extent, wages could also pressure margins in sectors such as software. Moreover, capacity expansion would put pressure on return on capital employed."

There is conviction though, that coming off a higher base companies can turn in a sustainable 12-15 per cent earnings growth, in the next few years.

Foreign flows:
Devoted to India Foreigners are buying Indian stocks like its going out of style they now own about 20 per cent of the Sensex and 17 per cent of the broader market.

In 2005 alone, FII inflows have been close to $5 billion, the Japanese having been big buyers with their investments in the last six months placed at anywhere between $1.5 and 2 billion. A good part of this has come in through other fund houses such as Fidelity, Prudential and Jardine Fleming.

Says Devesh Kumar, head (equities) at ICICI Securities, "Apart from the increasing number of India-dedicated funds, India's weightage in allocation of money has gone up by between 3 and 5 per cent. India is no longer the residual part of a portfolio." But, is the money here for good?

Quips Narayan, "An India-dedicated fund has no option but to stay invested in India. The flows are sustainable in the long term though the intensity may not be the same at all times."

However, Narayan cautions that if the flow dries up even for a month, it could have an impact on the market. Says he, "The reason why there was not too much of an impact when FIIs pulled out some money earlier this year is that local mutual funds supported the market. That may not happen all the time."

Interestingly, the carry-trade element of the fund flows -- estimated to be in the region of 15-20 per cent of inflows this year -- was expected to move out with interest rates rising in the USA. However, that has not happened.

Explains Narayan, "These funds make a return of around 8-9 per cent in India which is substantially more than they can make overseas. So funds are happy to allocate carry-trade money to India. " Adds Kumar, "The carry trade will, if at all, flow out of the less attractive markets first."

What could go wrong Soaring oil prices apart, the main concern is that the reform process will slowdown, in turn slowing down corporate earnings.

Says Duggal, "If policies are not implemented and progress on infrastructure is tardy, manufacturing growth could slow down". He adds that, "Corporate India has to deliver to meet expectations which are very high, and new investors who have come in should not be disappointed". With valuations running high, there is little room for disappointment.

In particular, valuations of mid-caps have outpaced those of the large-caps. Cautions Venkatramani, "Mid-caps are expensive relative to large-caps. At the same time, their earnings growth profile is converging towards that of large-cap stocks. However, given this, we do believe we can find some specific stocks on a bottom-up basis."

The near term:
A bit uncertain A foreign brokerage has predicted a 9 per cent fall for the MSCI Asia Pac by year-end since it believes that falling long-term interest rates indicate that growth is slowing and likely to continue to disappoint.

Though a lower interest rate might make equities look cheaper because of a lower discount rate, a slowdown would mean lower earnings growth too. Even if this conclusion is incorrect and lower interest rates are the result of structural and not cyclical factors, they believe that the markets would take a while to digest this.

However, they believe that India could buck the trend, though valuations, are high. Market watchers believe that India might well provide a short-term parking opportunity for global funds. It's difficult to predict though how the markets will pan out in the short term already stocks have come off on disappointing numbers for quarter one of FY06.

Some more poor numbers could bring down prices further. A not-so-good monsoon could do some more damage. But then there will always be cycles. In the long run, the India story continues to look good and might just get better.

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