Have the markets already played out their dynamics before the economy has even properly taken off?
Are we now destined for a period of mediocre returns despite a strong economy? asks Akash Prakash.
There is a clear sense among most analysts that India's time has come.
A confluence of the lagged impact of past reforms, geopolitics, shifting supply chains, and the sheer size and momentum of the Indian economy has created a buzz around India.
Most expect the country to grow between 6 and 7 per cent for the coming years, with nominal GDP growth between 11 and 12 per cent.
We will be the third largest economy in the world before 2030 and already, on an incremental basis, deliver the third-highest contribution to global growth. In a world starved for growth, India is a clear outlier.
However, will this forecast of robust economic performance necessarily deliver strong market returns?
A well-known fact among allocators is that there is no correlation between a country's GDP growth and market performance, with China being the poster child for this.
Despite its world-beating economic performance over the last 30 years, China has experienced mediocre market returns of about 5 per cent annually in dollar terms.
Most investors currently seem to assume an automatic linkage between strong GDP and robust equity markets in India over the coming decade; however, this is by no means a certainty.
It is also a fact that while we may be about to enter India's decade economically, we have already experienced a golden period in the stock markets.
Over the past 30 years, compared to the 10 per cent total shareholder return delivered by the best performer, the US, India has delivered approximately 8.5 per cent to 9 per cent in USD (depending on the index used), ranking as the third-best in the world.
Over the last 20 years, India has delivered nearly 12 per cent, making it the best-performing market globally.
In the last 10 years, Indian markets have maintained a remarkable performance, delivering nearly 11 per cent, ranking second only to the US.
We've experienced eight consecutive years of positive returns and positive performance in 19 out of the last 22 years.
The only two years in the last two decades when markets declined by more than 5 per cent were 2008 (during the global financial crisis) and 2011 (during the taper tantrum). This level of consistency is amazing.
Have the markets already played out their dynamics before the economy has even properly taken off? Are we now destined for a period of mediocre returns despite a strong economy?
When looking at long-term prospective returns, starting valuation is critical. The reality is Indian markets are currently trading at over 20 times forward earnings. This is in the top decile of their valuation history.
While most would argue that we will have multiples contracting in the coming years as valuations normalise, at the minimum, the case for a further expansion looks unlikely from a 5-10-year perspective.
At best multiples can hold near current levels, an argument based largely on the structural surge in domestic equity flows.
We are already witnessing approximately $35 billion entering Indian equities from retail savers through systematic investment plans (SIPs), insurance, Employees Provident Fund Organisation (EPFO), and the new pension scheme.
This number can rise to over $60 billion in the coming years just based on income growth and the increasing tendency to allocate savings to financial assets.
If we include a normalised $20 billion in annual foreign portfolio investment (FPI) inflows, we will soon have an annual demand for $80 billion in equities.
There has never been issuance/disinvestment of anything close to this magnitude.
India will be an extraordinarily favourable market for companies to list, and sponsors like private equity to disinvest. They will provide the quality supply to meet this demand.
There have been other markets like Australia or the Nordics, where large and committed domestic flows have kept multiples high.
India is, however, unique in that capital controls ensure our equity flows are effectively locked into the home market.
Such a wall of equity demand, if it persists and remains structural, may create an environment of sustained high trading multiples.
The best-case outlook can be that the multiples mildly compress over the coming years.
Therefore, the market's prospective performance will be entirely driven by earnings.
The best predictor for market earnings is nominal GDP growth.
In the case of India, given that we are not at peak corporate profit share/GDP, and the formalisation of the economy is continuing, the listed equity universe may grow earnings in line with or slightly faster than nominal GDP.
Thus, an earnings stream for the market of 12 to 15 per cent per annum is possible.
The fact that we are on the cusp of a private sector capex revival only strengthens the case, as profits get front-loaded in a capex cycle.
The issue will be ensuring that we do not dilute the earnings with incessant capital issuance.
There should not be a large gap between market earnings growth and the earnings per share (EPS) growth.
This is what happened in China and many other emerging market countries.
The strong economic growth never translated into EPS growth, largely due to excess dilution.
Given the wall of domestic money, there will be serious temptation for corporate India to issue equity.
Corporate India and the markets must not lose their focus on return on equity.
Even from here, on reasonable assumptions, Indian equity markets can deliver 8-9 per cent USD returns for an extended period (12 to 15 per cent earnings growth, with some multiple contraction, add 1 per cent for dividends, subtract 1 per cent for dilution and 2 per cent for rupee depreciation).
This return stream, if delivered, should be enough to continue to place India as one of the more attractive markets globally in the coming years.
It will be a lower number than what the markets have delivered in the recent past, but still strong enough to outpace other asset classes.
For this number to be delivered, economic growth has to hit the 7 per cent level and profit margins need to be sustained.
However, margins can be threatened by regulation or new entrants.
The downside of India's decade is that we must expect significant new competition from both global players and domestic startups.
Our extensive use of the digital public infrastructure also enables disruptive new entrants and drives down incumbent profitability.
The flip side is that following the balance sheet recession of the last few years, concentration has increased across Indian industry.
Greater concentration leads to higher profitability. Formalisation is also driving up margins for incumbents.
India has had a patchy track record on EPS growth. After compounding at over 20 per cent in 2003-08, we experienced a decade of sub-5 per cent EPS growth as the profit share of GDP collapsed.
In the last two years, this profit share has once again risen, driving an EPS recovery.
For the Indian markets to deliver, corporate profit share/GDP has to sustain and even rise further, similar to what happened in the US over the last 15 years.
While looking at the longer-term trajectory, there are clear signs of excess in mid/small cap equities where we will see reversion to the mean. Large caps will make up lost ground.
There is also a clear shift in risk appetite underway. Public sector undertaking stocks, asset-heavy companies in power and energy, capital goods, and manufacturing companies are the rage today.
We are witnessing a slow and steady relative derating of the highest quality universe, which had reached valuation extremes.
With earnings breadth broadening and the fastest earnings growth no longer in consumer and capital-light businesses, investors are diversifying their portfolios and putting money wherever they see the strongest relative earnings growth.
This style shift will continue, and to outperform in the coming days, investors who have grown up worshipping quality and earnings predictability will have to either reassess their risk appetite or be willing to endure a period of underperformance.
While there is no guarantee of economic growth delivering robust markets, Indian equities can still deliver acceptable returns over the coming years as long as EPS growth remains in double-digits and multiples contract only mildly.
This is probable, but not certain.
Akash Prakash is with Amansa Capital.
Feature Presentation: Aslam Hunani/Rediff.com
