'This is still a market with legs'

It couldn't have been a better day to have a panel discussion on the prospects for the Indian stock markets. The benchmark Sensex on the Bombay Stock Exchange has just shattered all records by recording its highest ever single-day gain of 789 points to hurtle past 18,000. Are we moving too fast?

October 9: It couldn't have been a better day to have a panel discussion on the prospects for the Indian stock markets. The benchmark Sensex on the Bombay Stock Exchange has just shattered all records by recording its highest ever single-day gain of 789 points to hurtle past 18,000. Are we moving too fast?

That's just one of the questions Business Today posed to five of the brightest minds on Dalal Street. Rashesh Shah, CEO& MD, Edelweiss Capital; Manish Chokhani, Director, Enam Financial Consultants; Ratnesh Kumar, Managing Director & Head, India Research & Asia Pacific Equity Research, Citi Investment Research; Gagan Banga, CEO, Indiabulls Credit Services; and Nilesh Shah, Chief Investment Officer & Deputy MD, ICICI Prudential AMC, attempt to make sense of the euphoric rise in the indices.

The panel: (1st row L-R) Banga, Kumar; (2nd row L-R) R. Shah, N. Shah and Chokhani 
The panel’s conclusion: The rally has a long way to go, but the days of 30-35 per cent annual returns may well be history. Excerpts from the discussion, moderated by BT’s Executive Editor, Brian Carvalho.

BT: We’re now in the fifth year of a pretty spectacular rally, which began somewhere around 3,000 levels (on the Sensex). Today, we’ve topped 18,000. Is this a fair representation of the India growth story, or are we running ahead of fundamentals?

Ganga Banga: We deserve to be here. Even if we look at valuation we aren’t the most expensive market in the world today. Also, it’s not as if India hasn’t been expensive earlier. What’s more, the story today, unlike in the past, is more international and in that sense we aren’t that compartmentalised as we used to be earlier. We are getting more and more integrated with global risk, and it’s a pure liquidity-based rally. That is the only worrisome factor. I don’t think valuations are a big concern.

Manish Chokhani: Like what is a normal feature of most market cycles, we started in the depth of pessimism. We first discussed research and fundamentals and later went on to discuss momentum, technicals and liquidity. We are towards that end of the game rather than the beginning of the game. When you have rises that are perpendicular you will have corrections that are perpendicular. A feature of this bull market has been the levels of skepticism (amongst retail investors), which is why a lot of smart money has not been in the market this time.

Even during the last correction (when the Sensex dipped 13 per cent) a lot of people got out. But if you look at where we are in the entire cycle, which could go on for 40-50 years, I can say that what we are seeing today is not wholly unexpected. Markets don’t top out on 18 to 19 times forward earnings. This is still a market with legs, but it’s clearly not a cheap value investors’ market.

Ratnesh Kumar: In the fifth year of this bull market, if you’re asking me: Are we justified to be here, my answer is: Absolutely yes. We have had a five-year (cumulative average) corporate profit growth of 25-30 per cent and that is almost unprecedented in the recent history of corporate India. So to a great extent profits have kept pace; the market’s rise has been justified by the huge growth in profitability. Profit growth is a function of a lot of things, many of which came together well.

Basically we had decent demand growth going and operating leverage was on the side of the corporate sector. So first and foremost it is important to remember that the rally or the fifth year of the bull market is very well backed by pretty strong growth in corporate profits. The second thing that has also worked in our favour, over the last five years since 9/11, is that there has been a persistent increase in global risk appetite.

This has basically resulted in a substantial amount of capital going into a lot of riskier assets. India has been a big beneficiary of this and because our story has been strong we have been able to capture a larger share of foreign flows coming into Asia in the last fourfive years than we were able to do in the previous 10-15 years. So these are the two aspects that are underpinning the market rally.

Rashesh Shah: When I started my career around 1988, the market (Sensex) was around 400. In the six years between 1988 and 1994, the market went up from 400 to 4,600, almost 11x in six years in spite of Harshad Mehta scam, the Babri Masjid demolition and the Indian forex crisis (in the early 90s) and everything else you could have. So ultimately it is all about growth and I think that was also the era where there was a global growth.

 Our Panelists

Rashesh Shah
CEO & MD, Edelweiss Capital

Manish Chokhani
Director, Enam Financial Consultants

Ratnesh Kumar
Managing Director & Head India
Research & Asia Pacific Equity Research, Citi Investment Research

Gagan Banga
CEO, Indiabulls Credit Services

Nilesh Shah
CIO & Deputy MD, ICICI
Prudential AMC 

It was the first phase of inflows into emerging markets. Compare that scenario with today’s, when the market is at 18 times fiscal 2009 earnings, and we aren’t seeing the euphoria or the madness that one was used to associate with investing in equity markets; people aren’t overstretched or overleveraged, and price-earnings ratios of 100 aren’t getting acceptable.

We aren’t seeing the usual signs of a euphoric market. When markets rise, it sometimes does seem that they’re going up too fast.

But fact is that growth in corporate earnings has been a lot faster than what most people expected.

Fact also is that in the absence of earnings even an 8 P/E is expensive; and in the presence of earnings an 18 P/E can be cheap.

Meantime, global liquidity has taken off, and I think the situation today (post the subprime crisis) is pretty similar to what happened in the US after the collapse of LTCM (Long Term Capital Management, a hedge fund that went under in the late ’90s, triggering fears of a liquidity crisis).

Liquidity came back with a bang and found its way into the high-growth area of IT at that time.

This time around, all the liquidity is coming straight into emerging markets where all growth is here. So with liquidity and earnings being positive and neither showing signs of going away, we are fairly ok.

Manish Chokhani
Director, Enam Financial
“Indians are underinvested in equities. Public holding is not even $100 billion. We are saving $350 billion every year and in three years those savings will touch $1 trillion” 

BT: Okay, granted that there’s a lot of money coming into emerging markets, and India. But a fear is that this money could drive stocks up to unrealistic levels, and create a bubble-like scenario, similar to what happened on the Nasdaq at the turn of the century when valuations were totally out of whack. Are we anywhere close to such a scenario?

Manish Chokhani: It’s important that everyone has this model in their head and that this becomes their investment thesis. It really began when they broke the gold standard (the dollar replaced gold as the international currency in the early ’70s) and the dollar became the currency measure of the world. And ever since then they have printed dollars and it was free money. Effectively each bull market in every decade has been caused by excess money supply. And it ends in a bubble in every decade. In the 1970s, the boom was in commodities like oil, gold or silver.

We saw fantastic tops. But after those excesses,prices corrected for the next 20 years. It was effectively a bear market for oil and gold, with the top being reached in the 1980s. That money then looked for a place to go in the next decade and eventually caused a top in Japan. It was completely crazy, 100 P/Es were acceptable. At one point, Japan was 50 per cent of the world’s market cap. Property prices peaked too. The value of the Imperial Palace (the residence of the Emperor of Japan) was said to be equivalent to the value of all the real estate in the state of California. It was that kind of excess.

The tail-end of that bull market came at the beginning of 1990, and touched India and other emerging markets. But it never sustained. In the 1990s people looked for the next area of growth, which was TMT (technology, media and telecom) and the Nasdaq. And that culminated in a complete blowout as well.

This decade, if you are looking out for growth where do you go? Back to real assets. Real estate all over the world is going crazy. Oil is at $80, heading towards $100. Gold has gone from $250 (per ounce) to $750 and is heading towards $1,000. And then there are the emerging markets like India, Brazil, Russia and China with their domestic stories, and which form the centrepiece of the bull market this time. If we just look beyond our border, China is trading at 44-45 times and no one is worried about that market.

They’re doing $20 billion IPOs for relatively poorly-run companies (the stateowned Industrial & Commercial Bank of China is offering $20 billion worth of shares; this will be the world’s largest IPO ever). We still have a lot of room before the bull market culminates. That will happen when crazy things start taking place, like India companies buying trophy bad assets overseas, and people like us will have explanations for why they did it and will justify it.

Only something like this will disrupt the current bull market.

Rashesh Shah: In a bull market, capital gets cheaper, and in a bear market capital gets expensive (be it bonds or equity). In the last five years, capital has got cheaper; and along with that the India growth story has emerged. So when you combine the two, a P/E of 8 at the bottom of the cycle has now become a P/E of 18. I think we are fortunate; in the last Asia boom, it was everything except India and China that benefitted; this time it’s only India and China benefitting. Every boom has its own story. The current rise may look steep, but adjust it against past earnings, growth and future potential, and the cost of capital is still not expensive.

BT: Let’s take a closer look at the crisis in the US—the subprime mess and the possibility of that economy slowing down. There are two very different views on how that will impact foreign flows into India. One is that a weak US market will result in increased flows into emerging markets, including India. Another is that global liquidity will dry up, and consequently foreign flows into Indian markets. Which is a more likely scenario?

Ratnesh Kumar: I am looking at two scenarios: A slowdown or a recession. If you have a slowdown of the US economy, it won’t affect the risk appetite of investors, and assets will look to find other regions for higher growth. If that happens emerging markets, including India, will be the beneficiaries. However, if the US gets into recession, it’s a different ball game. After all, at the end of day the US is still a source of a lot of capital, directly or indirectly in terms of other central bank putting money there. And even though our relative growth—or that of China—is much better than that of the US, a recession in the US will result in risk appetite going for a complete toss. However, as a house we don’t believe this will happen.

Manish Chokhani: The US has a $10 trillion GDP. If there’s a slowdown, you are talking maybe of (an erosion) of about 1 per cent growth in GDP, or $100 billion in incremental GDP. Recession is when you are saying a $300-400 billion of GDP will get wiped out. That, given the ability of the central bank to print notes, is a scenario nobody in the market is seeing. Also, when you’re talking about flows, remember that the US has not been the source of capital in this bull market.

Rather, the US has been a consumer of capital, because everyone including India has been buying US treasuries to bridge the US current account. The source of capital has been the Asian block and the oil exporting countries. And that capital has clearly by now realised it is pointless getting deployed over there (in the US) and it’s probably safer in a new place. Again, in a historical context, when Japan died it didn’t mean that you didn’t have a bull market on Nasdaq.

Similarly, just because the US is a blue chip that is falling, it doesn’t mean you can’t have a bull market elsewhere. Consider an Indian example. In the 1990s IT services was the place to be. These companies are currently not participating in the bull market. That doesn’t mean you can’t have a bull run without its presence.

We should also clear this misconception about our dependence on foreign flows. We are a $1 trillion GDP economy and our domestic savings are to the tune of $350 billion. People like us are going around and tapping those savings and bringing those investors into the market. And this is a half-glass empty market. Indians are fundamentally underinvested in equities. Local public holding is just 10 per cent of the market, and is not even $100 billion. We are saving $350 billion every year and in three years those savings will touch $1 trillion.

Continued on the next page...

BT: But you need to be a brave man to tell the retail guy: “Come, invest when the markets are at 18-19K; they will go much higher from here.”

Nilesh Shah: If you ask a barber whether you need a hair cut, he would certainly say, yes you need a hair cut. But when I was coming here I was talking to people with the market touching 18K, they were sad about it rather than being happy about it. It could be a bit of exaggeration, but it’s not far away from reality. We didn’t see any celebration on the street when the market touched 18K—certainly not the kind of celebrations we saw when the market touched 4,500 in 1991-92. Successive quarters of shareholder patterns reveal that retail investors are out of the stock market and the FIIs are getting into the market. Our feedback is you have to be in the Indian equity market based on longer term growth. If you are not there then at least make a beginning by making regular investment. Use corrections as an opportunity to build up your position, but don’t wait for the correction to get an entry into the market. A lot of people are waiting on the sidelines and with the market rising they have lost the opportunity.

Manish Chokhani: Retail investors are coming through ULIPs today. Insurance companies are the larger source of retail capital than mutual funds today, and that trend is not going anywhere in a hurry. Two, everyone and his uncle, be they domestic or foreign houses, are saying they want to get into wealth management in India. They’re also talking about taking financial products to the masses. Why should anyone be sitting with fixed deposits? I don’t know what is going to happen in the next three or six months, or a year—and that really doesn’t matter—but in five years, are you telling me that the index can’t hit 36,000?

Rashesh Shah: You will not ask the retail guy to come in and buy at 18K because the index is going to become 18,500 in a month. What’s important is holding equity assets in your long-term portfolio. A large part of retail equity buying has been short-term in nature, because it is still seen as a speculative, volatile asset class. At the other extreme, you don’t have the large institutional investor present in the market. You have insurance and mutual funds, but you don’t have EPF (Employees’ Provident Fund) and pension fund investing in India.

Though they are allowed by the government, EPF has made a statement that equity is a speculative asset class. So ironically, what you have is the EPF, which is supposed to take a 30-year view, viewing equities as speculative. And the retail investor, who should also have a long-term view, is coming into the market because he expects the index to move from 18,000 to 18,500 overnight. Equity is still the best asset class available.

Ratnesh Kumar
MD & Head, India Research & Asia Pacific Equity Research, Citi Investment Research
“Unlike in the US, Europe or even Japan, retail savings coming into our market will take a longer time”
There will be periodic sell-offs and corrections, that’s part and parcel of every asset market. It’s a lot more visible in equities because it gets reported every day, unlike say real estate. Indian equity is a great asset class that Indians have not discovered themselves. The FIIs have. Two years ago Indian institutions were 20 per cent of what FIIs were putting into India; they have become 40 per cent with insurance players coming into the fray. We are confident that in the next three to four years, Indian local institutions will be at par with FIIs.

Nilesh Shah: People are viewing the market as a 35mm screen. Their canvas is 1992 to 2002, a decade in which the indices were rangebound. No one is willing to see the market from 1979 to 2007— the 70 mm view. From 100, the index has touched 18,300, 183 times in 28 years. It’s just that people have to adjust their vision from 35 mm to 70 mm.

Rashesh Shah: In 1994 the index was at 4,600. In 2003 the index was at 3,000. If you take a 8-9 year view and adjust for inflation, people lost 70 per cent. In between we have had scams, the UTI meltdown and that has taken away confidence among investors in India. Ironically we have only 8-10 million investors investing directly or indirectly in India; we used to have 8-10 million people investing 15 years ago.

So the base has not increased. India needs 40-50 million people investing in the market. But this can’t happen with a short-term mentality. Intra-day traders and short-term investors will always be there, but a large part of the Indian middle class should be long-term invested with a mentality of buying a slice of corporate earnings. This would come only through education. None of us has invested heavily in educating investors as what equity means as an asset class.

BT: So what should the retail guy be doing? Assume that he has 25-30 years to go before retirement, what should be his ideal asset allocation?

Gagan Banga: In the current scheme of things he should be very overweight on equities. I think 30 per cent of an individual’s money should be going into equities.

Manish Chokhani (laughing): We would be the 100 per cent kind of guys.

Gagan Banga: I am speaking conservatively, keeping in mind a guy who is earning 30K-40K a month. As for the remaining 70 per cent, we have to expose ourselves to various type of commodities. We can’t really change the very nature of the Indian thinking and there will be gold, real estate, FDs and cash. So all of that will be a part of the 70, but surely 30 per cent should be in equities.

Rashesh Shah: I would like to add one thing to this. We have been advising clients that before you get into equities, buy your own house as that will keep getting expensive as the India growth story moves along. A lot of people have not yet bought a house and it keeps getting expensive by the day. Look beyond metros like Mumbai, to second-tier and third-tier cities, and housing is a big need there.

Ratnesh Kumar: Let’s look at two kinds of household savings—financial and physical (house and gold). As a percentage of GDP, financial savings are 55 per cent, and 45 per cent is physical. Even if the equity part of the financial saving goes from 5-6 per cent to 10-20 per cent over the next 5-10 years, that will give the markets a massive boost. Foreign ownership of the market is 21-22 per cent when we include ADRs and GDRs. Insurance and mutual funds put together is only 8-10 per cent. Domestic savings going into various equity assets will take a longish period of time, especially given that things are not all that cheap anymore. We are also more vulnerable to external developments, like say a US recession or any other global risk event, than we were five years back when the Sensex was at 5,000 or 8,000 or 10,000. Unlike in the US, Europe or even Japan, retail saving coming into our market will take longer time.

BT: Nobody talks about political uncertainity these days, although it’s very much on the horizon. This in turn may be leading to lethargy on the reforms front, and a reluctance to make tough decisions. Doesn’t this worry investors any more? Or is it that there is a confidence amongst investors that whatever happens, reforms cannot be reversed, and that politics can do little to derail the India growth story?

Manish Chokhani: In 2003 we had zero confidence in India and its future and therefore the market wasn’t given a P/E multiple for the future. The current context is that demographics will win over politics, and force the politicians to do what is right. Unless you have a complete different composition (at the Centre)that turns up and says whatever is done in the last 10 years is wrong, we aren’t going to go in a reverse direction. For example, when the last government came to power, the market promptly collapsed, only to quickly come back because investors realised that the basic direction hadn’t changed.

I suspect it will be something like that. You will get bouts of volatility. When someone sneezes in Delhi, markets will catch a cold. But eventually one will figure out that nothing is changing. It’s extremely difficult today to make a bear case based on politics. That’s because the macroeconomic situation has never been so good. Corporate earnings and balance sheets have never been as robust as they are today. The Reserve Bank is sitting on $250 billion…you require a really lousy government to mess this up.

BT: Interest rates are proving to be a double-edged sword. Whilst lower rates will doubtless increase liquidity flows, there’s also the worry of a strengthening rupee and the havoc it is wreaking on exports.

Rashesh Shah: We have the highest real interest rate in the world. We need a 100-200 BPS fall in interest rates. With rampant consumerism and people taking credit cards and personal loans we have seen people discovering the joys of credit—but not the joys of cheap credit. Interest rates in real term are artificially high, but we as Indians are so happy that at least credit is available. Till the financial service sector is closed, it will be difficult to bring down interest rates, but the pressure is mounting.

There is a classical economic theory that you can either manage monetary policy or manage exchange rates. You can’t manage both. You have to choose one over the other. You can fight it out for a couple of years, but eventually you have to yield on one. I think the moment the RBI stops fighting the exchange rate and begins focussing on monetary policy, a lot of opening up will happen.

Gagan Banga: But in the short term this will not happen. You have the prospect of an impending election and the big fear is going to be where prices go and in that context I don’t see it coming. In the next 3-6 months we can expect a maximum 25 BPS cut in interest rates.

Ratnesh Kumar: One point on interest rates: For the first time in three years, deposit growth has caught up with credit growth and the most important macro development in the past 12 months in India has been the slowing down of excess credit growth. I would call it excess credit growth because 35-40 per cent was not sustainable. Credit has moderated to a more manageable level at 20-25 per cent; on the inflation side things are okay and will peak at 5 per cent, but it would be still sufficient to call for an early next year reduction in repo rates. In the market place we are already beginning to see the easing of rates before the RBI really cuts rates.

BT: So would that mean that exports will continue to take a hit, and exporters will have to learn to live with this phenomenon?

Nilesh Shah: There’s no other option. Textile mills are in trouble, they can’t survive with this exchange rate. Certain sectors operate at margins of 2-3 per cent and the rupee appreciation of 10 per cent in a month will certainly see exports taking a hit in the short term. Eventually Indian corporates will have to learn to manage to handle the rising rupee.

BT: And where does that leave the IT services sector? Is it no more the flavour?

Manish Chokhani: It’s a structural change. In the 1990s you exported, and you got in foreign exchange, which is what the country desperately needed. In this decade the last thing you require is foreign exchange, with the RBI having a battle on its hand (managing the rupee). The story today is about infrastructure creation. A corollary to this is consumption. Companies in sectors like retail, or media or fastmoving consumer goods (FMCG) are those that will be able to grow at 30-40 per cent. Financial services is another beneficiary (of the consumption-led story). These are the predominant themes.

Ratnesh Kumar: In the last five years we’ve had extraordinary earnings growth. That will normalise in the next five years. We don’t have the benefit of operating leverage with us any more. Financial leverage will start to build now as companies start to put up assets and make capital expenditure. Going forward earnings growth expectation should be 15-20 per cent rather than 25-30 per cent.