The biggest debate in the market, however, is the earnings cycle. In recent quarters, earnings were weak with revenue growth dipping to a seven-year low. Our macro models suggest that the earnings cycle is likely to turn in 2015. Over the coming two years, we see earnings compounding at 18 per cent for the broad market led by improving margins. In the past five years, margins have dropped by 500 bps to near all-time lows with two-thirds of the decline due to rising interest costs and rest due to compression in gross margins. With likely fall in interest rates and improving growth, both factors will be addressed. Corporate balance sheets are healing, albeit slowly, as evident in improving credit ratings.
Another issue with Indian equities is the elevated ownership of the Indian market by foreign investors and their near-universal optimism about it. This lends itself to volatility in equities linked to global market conditions. However, what we see over the coming months and quarters is a big shift in the attitude of domestic households towards equities. Consequent to better trailing returns, real interest rates and demographics, there is a structural case for domestic savings in equities.
Equity supply is likely to be materially higher in the second half of 2015, and, if such supply is bunched up, it will produce greater volatility. Thus, even as we stay constructive on equities with a three- to five-year horizon, we see higher variability in returns. The other aspect of the market that causes greater volatility is middling valuations. Valuations lie at a level which do not provide much insight into forward returns. Even as the market looks fair or better than fair relative to long bonds and emerging markets, an upturn in the earnings cycle and falling rates will likely support valuations. If we are right about earnings, then the market looks very attractive on a two-year basis. In part, the market is pricing in some of the recovery in earnings, but not all of it.
The market prefers quality (high ROE and free cash flow generators) and growth stocks (high revenue and EPS growth) over value (low PE, low PB, high dividend yield) and junk (high beta, high financial leverage), underscoring a nascent bull market. Full- blown bull markets usually disregard fundamentals, but the current bull market is acutely focused on fundamentals. These preferences make a lot of sense to long-term investors buying good businesses at reasonable valuations. However, later this year, stocks of companies with financial and operating leverage may be back in vogue as growth data starts turning around.
No good story, however, comes without risks. A delay in recap of SOE banks, which are impaired by high levels of stressed assets and are unlikely to generate credit growth in the early stages of the next cycle, could be a risk. The possible negative feedback from global factors, including deflation risks, higher US rates and poor Chinese growth, will be the other. There could also be a delay in RBI cutting interest rates and the rupee's overvaluation. This could hurt growth and derail prospects of an earnings recovery.
From a portfolio perspective, choices depend on an investors risk appetite and time frame. Those with a 12-18-month time horizon should prefer rate-sensitive sectors such as private banks, industrials and consumer discretionary, and technology stocks, as a hedge to the domestic story. While investors with a longer time horizon could also use the same sectors, their strategy could be fine-tuned to look at owning good businesses with heavy moats around them at reasonable valuations. We endure an allergy to high beta, which performs only in short cycles but underperforms over long-term horizons. Retail investors, who do not have expertise in equity investments, are best placed to systematically invest in diversified equity funds without paying too much attention to the market levels.
In summary, we continue to like Indian equities with a three- to five-year view, and believe the equity market will likely to be more volatile in the months ahead. However, now that the fundamentals of the market are in good shape, equities could well be the best-performing asset class in India in 2015/16.
HIGH POINT: Government's Role
The Central government is helping India's cause after inheriting major cyclical issues -high infl ation and a plethora of stalled infrastructure projects. Both issues are being addressed by the Centre. Infl ation is now nearly half its recent highs and the completion rate of projects has registered a V-shaped recovery in recent times. Several other reform initiatives have also been launched by the government, including those in taxation, infrastructure, fi scal consolidation and ease of doing business in India. Despite widespread scepticism, the government has also made some progress in making new laws and implementing them.
(The author is Managing Director, Morgan Stanley India)