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August 11, 2000
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Why equity valuations should drop

In theory, equity valuation and by extension, stock-picking is simple. Just take the return from a safe debt instrument, add on a risk premium and look for stocks, which promise to beat that through whatever combination of capital gains and dividend. In practice of course, the process is complicated by innumerable factors, not least of which is the unpredictability of equity returns.

In the long-term, equity returns must however be inextricably linked to earnings and interest rates. Interest rate fluctuations, in fact, tend to have an immediate effect even if earnings don't always show a strong short-term linkage. And, the recent rise in rupee interest rates coupled with not so robust first quarter results make it almost a certainty that the market will hit a new low fairly soon.

Many equity valuation models effectively start by inverting the price-earnings ratio to judge the "earnings yield" and then comparing that with the risk-free discount rate. Some investors build expected earnings into such models to get a forward projection.

Other sophisticated models use discounted cash flows as a variation of earnings and/or variations of enterprise value as a substitute for price. Enterprise value is calculated by adding debt to market value and then subtracting free cash and short-term investments. Thus it is often a better indicator of "true" price than simple market value, since it adjusts both for debt and free assets.

But the one immutable variable involved in all valuation models is the risk-free return. If equity returns don't maintain a sufficient spread over risk-free returns, then equity investments cannot be worthwhile. If interest rates rise, the risk-free return also rises. And, stock prices must drop before the valuation model signals "buy" to an investor.

Which is why any interest rate hike normally leads to a sell-off in equities. Sell-offs don't happen only when special circumstances are in force. One of those occurred in early 1992 when the official interest rate became irrelevant because funny money from the Scam was flooding the market.

Another special circumstance is during an economic boom when earnings growth, and future earnings expectation outpaces interest rate hikes. This is what occurred in the US during calendar 1999 and early 2000. Rates rose, but earnings growth remained strong and the market kept moving up because the spread between earnings yield and discount rates was maintained. Note that this usually occurs only in the latter stages of a boom. In the early stages, interest rates have to stay low in order to fuel the expansion.

Well, there has been a tectonic upheaval in short-term rates over the past month. This has been provoked by the slide of the rupee and the protective measures taken by the Reserve Bank of India (RBI). It will inevitably result in a rise in longer rates. ICICI and State Bank of India have already raised prime lending rates and most lenders will follow suit. The chance of rates coming down once the currency stabilises is unfortunately, not good. This is because of the government's massive borrowing programme to fund the fiscal deficit. That will ensure a crowding out that keeps rates high and liquidity low.

So there must logically be a downward realignment of equity valuations. Neither of the special circumstances outlined above seems to apply here. There isn't a great deal of funny money in the market. The only real route for that would be hawala funds returning to India via the medium of foreign institutional investments.

To discuss the nature of FII funding is outside the scope of this piece, but FII investments have been net negative for the last two months. What's more, the foreigners will remain cautious until the rupee stops gyrating.

India is also not midway through an economic boom. At best, it's in the early stages and the jury's out on that. First quarter results were nothing to write home and CII's (Confederation of Indian Industry) sectoral review definitely indicates that there is no broad growth pattern. Balancing that is good exports, good infotech earnings, a dot-com boom, and an exponential jump of bank credit in Q1. Business Confidence has just dropped from all-time highs but it remains good according to the NCAER latest survey. So we may be in an economic revival, but this is definitely not a situation where earnings are expected to outpace rising interest yields.

Earnings expectations for Q2 haven't improved for the vast majority of stocks. Most stocks especially working capital-intensive companies and those with net forex outgo are likely to be hard-hit by changes in the monetary environment. Expectations have got worse for these companies in particular. I would expect the market to re-align at a lower P/E ratio than the current trailing discount of around 25 for the Sensex basket. That computes to an "earnings yield" of roughly 4 per cent.

Any valuation model would however adjust upwards for forex earners who may get windfalls in the form of rupee depreciation. Hotel and tourism may just gain the most in share-price terms because that sector is the most depressed in terms of growth. The usual suspects in IT and pharma also look attractive, pharma more than IT because the stock prices are relatively lower.

Among the favourite defensive sector of fast moving consumer goods (FMCG), any company that can leverage a dominant market position to create negative working capital requirements will do well. To put this more bluntly, any FMCG company that can simultaneously arm-twist suppliers into waiting, and distributors into paying upfront will do well.

In pharma, the big barrier to making the right company-specific calls would be a correct assessment of business prospects once the patents regime changes to product from process. Maybe biotech will be a great new area, maybe not. Some Indian research and development (R&D) efforts will undoubtedly pay off commercially, but it will take an informed insider to pick the right projects and companies.

Outside the ambit of forex earners, valuations must definitely drop. The moot point is by how much. But a 100 basis points annualised rise in debt-yield expectations would translate into at least that much in the way of extra risk premium. To deliver the extra earnings yield, the market would have to re-align at a trailing P/E of roughly 20. That would be an average drop of around 15-20 per cent in prices.

If this logically likely sell-out occurred, it would bring the Sensex down to somewhere between 3350-3600 levels. Even the upper end of that range would mean a new low breaching the May 2000 bottom of 3831 points. But consider the environment in May and the environment now with special regard to expectations.

The interest rate has gone up since May, the Q1 results haven't lived up to the projections of optimists. There has been no government action leading to either genuine divestment or to improved infrastructure especially in telecom. Surely aren't expectations worse now than they were in May? So why shouldn't the market hit a new low and do it fairly quickly?

In the circumstances, an interesting speculative foray may exist. In the break-up of outstanding positions, shorts seem to have a rising trend with mid-settlement minus positions often rising above Rs 7 billion. This is far higher than average short positions of around Rs 3 billion. But stock-specific shorting carries the unpredictability of picking the wrong position or even more likely in the current situation, being crucified by a sudden spike in undha badla rates caused by the RBI sucking out liquidity.

Since we are talking about a macro-trend here, the situation looks ideal for derivatives. As the spot equity market has dipped lower, so has the newly established futures market. But the current Sensex/Nifty futures for August and September show mildly positive carry, since the rates are higher than the spot. If the market hits a new bottom in August-September or even later, the futures are overvalued at current levels. An intelligent speculator might like to sell the future. At standard derivative leverages, this could mean a fortune.

Devangshu Datta


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