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What to expect in 2010

Will the bull run continue or will the bears return to spoil the party in 2010? We look at how the growth in corporate earnings is likely to affect the market direction this year.

R. Sree Ram and twitter-logoTanvi Varma         Print Edition: January, 2010

It was the best of times, it was the worst of times. After a flip-flop 2009, investors, analysts, brokers and market watchers are all likely to agree with this famous line by Charles Dickens. A columnist who covers the financial markets recently said that 2009 was the year that managed to confound and confuse the wisest and coolest of market hands; just when you thought things couldn't get any worse, the markets rebounded, and when you thought all was finally well, indices slipped.

Surprisingly, the toughest times for the market can be the best times to take investment decisions. This, according to experts, is the right time to go cherrypicking— look for good stocks that have been beaten down by a bad economy. In 2008, the Indian economy was going through one of its worst phases. Industrial production growth fell by 0.2 per cent, manufacturing, automobiles, steel and other core industries showed a de-growth of 0.6-17.2 per cent, and the Sensex fell to a 40-month low of 8,747. As experts aired their concerns about the contracting economy,investors had a clear choice: to invest or leave the market.

The iron-hearted went on a bargain hunt, while the less brave took refuge in equity funds. Risk-averse investors, meanwhile, looked for safer options like debt funds and fixed deposits. The sharp recovery in economic activity brought back confidence and inflows to the markets. The BSE 500 rose by 81 per cent in 2009 (till 11 December 2009). Equity diversified funds, on an average, generated a return of 76 per cent. Debt funds were not far behind and turned in a decent return of 5 per cent. "We saw our markets getting re-rated sharply after the decisive verdict in the national elections and growth revival," says Mahesh Patil, co–head, equity, Birla Sun Life Mutual Fund. What does this mean for 2010? Will the bear go into hiding? Over the next several pages, we try to find an answer to this question with help from investors and analysts. We are probably staring at cautious optimism—not the best option, not the worst either.

With key indices moving up, the cause for optimism is obvious. The caution is because 2010 might not be such an easy year to take an investment call or make money. This is because of the sharp rise in stock prices. Tracking the stark rebound of economic indicators, stock markets have seen an across-the-board rise in valuations. "Valuations of Indian markets are at a premium to global peers," says Anish Jhaveri, CEO, Antique Stock Broking. From 12.2 times in January, the trailing PE multiples of the Sensex rose to 21.2 by the end of 2009. If the index rose 72 per cent in less than a year (till 11 December 2009), the last time it traded at 21-plus PE multiples was at the height of the stock market boom in January 2008, when it hit the 21,000 levels. Even the worst performing sectoral index, the BSE FMCG, returned 43 per cent, while the best performing, the BSE Metal Index, returned 196 per cent. "At current valuations, there are very few sectors that are undervalued," says Huzaifa Husain, head of equities, AIG Investments.

The good news is that the resurgence in the economy makes investing in Indian equities a great idea. From a flat growth in January 2009, industrial production registered a growth of 10.9 per cent in August, which perked up the GDP. The July-September GDP growth of 7.9 per cent came as a pleasant surprise, as markets expected a rise of 6.5 per cent. This led to an upward revision of the 2009-10 GDP forecast to 7.2 per cent from the earlier 6.6 per cent. In the next financial year (2010-11), analysts expect the economy to enter the 8 per cent growth trajectory.

India, being the second fastest growing economy after China, will make any rational investor happy to participate and benefit from the economy's over 8 per cent growth. The trouble for retail investors is that most of the positives of 2010 are already priced in. At 16,700 levels, the Sensex is trading at 21.2 times its trailing 12-month EPS, way ahead of its long-term (11-year) average multiple of 18.3 times.

Even if we consider consensus EPS estimates of Rs 850-880 for 2009-10 and Rs 1,032 for 2010-11, the 30-share index is close to its long-term average multiple of 18 times. The benchmark index is effectively discounting the possible upsides of the current and the next financial year. "Most of the large-caps are partially discounting this possibility," says D.D. Sharma, senior vice-president, research, Anand Rathi Financial Services. This leaves little room for price appreciation or expansion of PE multiples, as beyond this, valuations enter the bubble territory. "Valuations fuelled by FII liquidity are already at the higher end of the ratings spectrum," says Ashok Jainani, vice-president, research & market strategy, Khandwala Securities.

The good news, according to Raamdeo Agrawal, director, Motilal Oswal Securities, is that, "As long as investors don’t buy into bubble valuations, the initial handicap of slightly premium valuations gets neutralised over two-three years."

At the same time, investors cannot avoid equities completely due to the non-availability of better options. Bank deposit rates are around 7 per cent a year. Considering the projected inflation of around 5 per cent in 2010, the post-tax real return could be in the negative.

Earnings to the rescue
Not all is written off. Even if valuations are moving closer to the bubble phase, no one is pressing the panic button. "Current market valuations are based on the fact that economic recovery is on and will sustain both domestically and globally," says Husain. Most analysts feel that corporate India will report robust earnings from 2010 onwards. "It is highly unlikely that earnings growth will not pick up from the current juncture as all the ingredients necessary for a robust economic and corporate performance are in place," says Hitesh Agrawal, head of research, Angel Broking.

This optimism stems from the improved corporate performance and restructuring. India Inc raised around Rs 44,000 crore in the first half of 2009-10 and companies used the money mostly to retire costly debt and clean up balance sheets.

In fact, substantial savings on interest costs has helped corporates clock better earnings in the past two quarters. Consider this: 1,257 companies listed on the BSE reported a 20 per cent growth in profits in the first quarter and 42 per cent growth in the second quarter. The last time such high growth rates were witnessed was in the second half of 2007-8. "All sectors, except telecom, cement and construction, have surprised positively and have beaten the street estimates by 5-6 per cent. Earnings growth in the past two quarters have come from margin expansion, which was led by savings in raw materials, operational cost-cutting and lower forex loss," says Mahesh Patil, co–head, equity, Birla Sun Life Mutual Fund.

"We believe the earnings of the Indian companies bottomed out in the quarter ending December 2008. Thereafter, we have seen a significant improvement in the profitability, which has not only surprised us but also the market," says Jhaveri.

With economists pencilling a robust growth, analysts expect higher sales and volumes for corporate India from 2010 onwards. Even if profits have picked up in the first half of 2009-10, low or flat sales have been the biggest worry for the stock markets. The same set of 1,257 companies has seen their sales fall by around 6 per cent in the first half of 2009-10. At the peak of the economic cycle in 2008, this set of companies saw sales grow by around 38 per cent. When we look at the 30 Sensex companies, the sales growth is pretty flat, largely because of the pass-through of lower raw material prices which led to price cuts. However, the bottom line has improved due to savings on interest and raw material costs.

"We have noticed a reasonably strong volume growth in many sectors, but it is not being reflected in revenue growth due to the sharp decline in commodity prices, which is passed on to customers. The situation will change significantly from the third quarter as commodity prices plunged in the October-December period," says Gaurav Dua, head of research, Sharekhan.

Higher sales will obviously push up earnings further. The Sensex companies are expected to report an EPS of Rs 850-880 in the current financial year. Not much to cheer because this translates to a flattish 3-5 per cent growth over the 2008-9 earnings. Analysts expect growth to pick up and estimate that the Sensex companies will grow 20-27 per cent in 2010-11 and report an EPS of Rs 1,032-1,080.

Sustaining growth
Higher sales and rising profits are glad tidings for investors. But there is also the niggling doubt whether this improvement in corporate performance is sustainable. As mentioned earlier, the market has already factored in the revival in corporate earnings in 2010. For the markets to enter the next phase of structural uptrend, sustenance of robust earnings beyond 2010 is important and will determine the future market direction.

To know if it is possible to sustain the robust earnings beyond this year, investors will have to closely track the quarterly corporate results, GDP growth and industrial production numbers from April 2010 onwards.

"A better visibility on 2010-11 earnings is of prime importance if the markets have to trade above the 17,500 levels and, more importantly, sustain at those levels," says Dipen Shah, senior vice-president, private client group (research), Kotak Securities. This is because it would confirm that business activity has indeed revived and will also provide visibility for the earnings beyond 2010.

When the financial crisis broke out in 2008, the government supported he Indian industry by cutting taxes and spending more money. This helped increase the sales and order books for some companies. However, the threat of runaway inflation and burgeoning fiscal deficit is likely to force the government to start withdrawing the stimulus measures in 2010.

Acid test for economy
How the economy responds to the withdrawal of the stimulus package is the acid test. If it continues to grow even after the government rolls back the tax sops, the uptrend will be confirmed and stock markets could witness another re-rating. "Markets are looking for confirmation that the recovery has stronger roots in volumes growth, which was lacking in the previous two quarters. With high level of real inflation, margins could be squeezed unless volume growth picks up," says Jainani.

If corporates turn in the much anticipated over 20 per cent EPS growth rates, then the chances of the stock markets surpassing their previous peaks become higher. "For 2010-11 and beyond, if the earnings growth for the Sensex stocks picks up to more than 20 per cent, then definitely in the second half of 2010-11 we would see the indices entering an all-time new territory. This will mark a new bull trend," says Sharma. Other analysts agree that the earnings growth should surpass market expectations. "For the next leg of the rally, it is important that the earnings upgrade cycle continues and corporate India beats street expectations in their forthcoming quarterly results," says Dua. Also, any policy reforms by the government during 2010 are likely to create positive momentum in the stock markets. PSU disinvestment, introduction of the goods and services tax, pension and insurance reforms are some of the key measures that could have a positive impact on the markets.

The budget is likely to be the starting point for such measures. "We expect the budget to be very proactive, which should promote fiscal discipline and also boost growth," says Patil.

What should investors do?
In 2009, investors' concerns focused largely on macro issues such as the revival in industrial production and the GDP. But in 2010, the issues will be stock-specific. Even if there is a revival in corporate earnings, company-specific issues are going to play a vital role in shareholder wealth creation. The companies that have the potential to register higher earnings growth are expected to attract maximum investor attention. "Investors would do well to adopt a stock-specific approach," says Shah.

As the economy revives, industries associated with domestic consumption and investment cycle, such as banks, capital goods, construction and engineering firms, are expected to witness a spurt in sales. On the policy side, hiking of the foreign direct investment limit in insurance, pension and financial sector reforms will help re-rate the financial services sector.

As India enters the next phase of economic growth, it might not be the right investment decision to avoid equity markets altogether. "We believe that the Indian economy will be much bigger 10-20 years from now. This would translate into stock markets giving good returns over these periods," says Husain.

If investors cannot spare the time or the effort to identify the right stocks to buy, equity mutual funds would be the right way for them to participate in the India growth story.

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