Prashant Jain, Chief Investment Officer, HDFC AMC
|Click here to see analysis of Sensex – 10000 or 20000 or 30000?|
Perceived risk and actual risk seldom go hand in hand. That is one of the behavioural disadvantages in timing the market. At 21000, the perceived risk was small and the actual risk much higher. There was evidence of higher risk: when markets start valuing businesses that make cash calls on shareholders every few quarters higher than businesses that return cash to shareholders a few times a year, the risk is obviously high.
Currently, with the markets at around 15000, stocks of companies with sound fundamentals are down 10-40%, others are down 50-70%. In the short run, even good stocks tend to fall with the not-so-good ones as both are part of the same market. Apart from the attractive valuations and the fact that markets tend to discount expected adverse future developments today, one pointer to the expectation that the bottom is somewhere near is that the perceived risk is very high. At these levels, there is no doubt some risk in the markets. But the risk reward equation is favourable, particularly over a 1-2 year period. A 30% fall in the markets has reduced the downside and has increased the upside potential.
In my opinion, investors with two years or longer view and even a moderate tolerance for volatility should consider investing in equities now. Great returns are invariably made on investments made in times of panic and pessimism. That appears to be the case today. Let us rewind to the bull run between 2006 and 2007 to understand the market behaviour better and how I saw the shape of the markets in January.
Averages hide more than what they reveal: This seems to aptly describe the state of the equity markets in India. The bar charts on the opposite page show the percentage change in the prices of 30 Sensex stocks between the levels of nearly 10000 (6 February 2006) and 20000 (14 December 2007). It is evident that when the aggregate index was at 20000, a segment of the market was still trading at an index equivalent of nearly 10000 while another segment was trading at an equivalent of 30000 or even higher.
The leaders, the laggards and the in-betweens of this rally were as follows:
• Leaders had delivered more than 150% returns going all the way up to 300%. This group includes the energy, capital goods and telecom sectors and select utilities and PSU banks.
• Laggards include automobiles, cement, pharmaceuticals, FMCG, non-ferrous metals and IT stocks. These are stocks that had delivered less than 100% returns all the way down to –20%.
• In-betweens are mainly private banks, steel and select cement and utility stocks. These are the ones that had delivered between 100% and 150% returns.
This means that the laggards were trading at index levels of 8000-20000, the in-betweens at 20000-25000 and the leaders at 25000-40000. The average of all was 20000. In view of this, what is the most appropriate way to describe the market? The index is at 20000? Or the index is at an average of 10000 and 30000? I leave that to your judgement. At the moment, let us assume that the market was simply at 20000 and move on. The average though expensive, was still bearable. The Sensex at 20000 was trading at close to 20 P/E multiples on a one-year forward basis. While this was not cheap, it was not frightfully expensive either (see table: The average though expensive is bearable).
Two-year forward Indian P/Es are no doubt 10-30% higher than those in both the developed and the developing world, but can be justified given the significantly higher growth rates here. It is only China whose long-term growth rate is slightly higher than India’s, but then so are the P/Es.
Many large constituents of the Sensex, such as Reliance Industries, ICICI Bank, HDFC and SBI, have a sizeable portion of their value coming from businesses that are not contributing to earnings (e.g. E&P and new refinery for Reliance, insurance business for ICICI Bank, HDFC and SBI). Hence, it is preferable to adjust for the ‘sum of the parts’ to make the comparison more meaningful.
The average though expensive, is bearable
|When Sensex was at 20,000 it was trading at about 20 P/E multiples on a one-year forward basis. That wasn’t cheap, but not frightfully expensive too|
|COUNTRY||INDEX||PRICE EARNING RATIO |
|*Adjusted for embedded values|
Source: Broker consensus estimates
India as a mainstream economy: Ten years is a short period in the evolution of a nation, especially for a civilization as old as ours, but it is a long enough period for perceptions to change, particularly around the tipping point.
The point to note is that at present growth rates, in five years, the Indian economy should be bigger than the Canadian economy. This was unthinkable seven years ago. The magic of compounding at a 5% higher rate and the 20% or so appreciation of the Indian rupee has made this possible.
The Indian economy is all set to emerge as one of the largest in the world in the foreseeable future while continuing to remain one of the fastest growing. Several other things stay the same—India’s huge local market, favourable demographics, skilled, smart and entrepreneurial, English speaking people, high savings rate and low household leverage, an appreciating currency, an abundance of natural resources and now a bit of gas thrown in as well.
Contrast this with the anaemic growth rates of the developed world, ageing populations, low savings rate, high leverage of households, depreciating currencies, salaries that make these geographies uncompetitive for anything that can be moved either by wire or by ship. All this has led to a huge change in perception about India as an investment destination. Investors are rapidly realising that India may still be classified by economists as an emerging country based on per capita income or the state of its infrastructure (which, incidentally, is set to change), but for investment purposes it offers greater opportunities and bears lower risk than developed countries.
When perceived risk falls, lending rates or cost of capital falls. As a corollary, the fair P/E multiples/valuations of businesses go up. Simply put, if one can buy US equities at nearly 17 P/E, or nil growth US treasuries at 4% yield (25 P/E), what is wrong with a 20 P/E for Indian markets that offers secular growth in profits of nearly 15% a year? At least, that is the case with the valuations of Indian markets in aggregate or on an average. That’s why I said that averages are fine.
I must admit, though, that the speed of this transition has surprised many, including me. I think this has been the result of a number of events, not linked to each other, but taking place at the same time:
• The rupee appreciates by 10% in April-June 2007 after rising by 10% over 2002-2007.
• The subprime crisis erupts in the US and the Fed cuts rates to stem a possible slowdown in the US.
• Dollar hits a new low against the euro and other currencies.
• India should be a trillion dollar economy this fiscal.
• US singles out India for special treatment for the nuclear deal.
• The finance minister of a West Asian country says his country is reducing allocation to dollar denominated assets
Catching up with Canada
|Higher growth and rupee appreciation will soon make Indian economy bigger|
|$/Rs exchange rate||48||44|
|Source :World Bank|
What averages reveal: As was discussed earlier, when the Sensex was at 20000, a part of the market was at nearly 10000 and the other was nearly 30000 and that’s how the market was roughly at 20,000 on an average.
The leaders or high fliers, the key constituents of this market, were the energy, capital goods and telecom sectors and select utilities and steel companies. Whereas nothing is really cheap in this space, given the nature of the businesses, in my opinion, the risk reward is particularly unfavourable in energy or refiners, utilities and telecom. These sectors appear either over-valued or priced to perfection. In the same space, capital goods companies appear to still hold potential, given the sustained growth outlook and valuations.
Laggards or low-altitude fliers were automobiles, cement, pharmaceuticals, FMCG, non-ferrous metals and IT stocks. These are defined as those that have delivered less than 100% returns all the way down to – 20% between 2006 and 2007. In my opinion, some of these sectors have been rightfully punished and some wrongfully.
The fundamentals of cement, non-ferrous metals, IT and select pharma stocks have either deteriorated or the market has belatedly realised the same. The fall from grace of IT stocks is particularly noteworthy. It highlights once again why seven years is long enough for perceptions to change, and on the need to focus on the long-term earnings potential and what we pay for the businesses. Markets may behave like a voting machine in the short run but in the long run, they behave like a weighing scale.
The in-betweens or cruisers are banks, select cement and utility stocks. These are the ones that had delivered 100-150% returns. A noteworthy point is banks vs. utilities. If one compares the largest bank in the country and the largest utility, it is observed that the RoE and growth prospects are nearly the same, but the price to book value of the utility is nearly 4X and that of the bank is nearly 2X. When the market values two businesses similar in profitability and growth prospects at 100% different multiples, it is hard to justify the difference.
Sceptics may argue that the returns in utilities are fixed whereas banks are linked to economic conditions. In theory, this argument is fine, but given the way the Indian economy is poised, in my opinion, banks carry limited earnings risks. Utilities run the risk of the government or regulator lowering permissible returns.
The rush has begun: According to estimates, ongoing fund-raising is $20-30 billion over the next few months. This scale of fund-raising is large, particularly given the relatively short timeframe over which it is targeted to be raised. A majority of this is by utilities and real estate companies. This is not surprising, given the valuations in these sectors. What is worrying is that the majority of this capital will not earn anything for the next 4-5 years, given the long gestation periods of these projects.
This has been a bullish and bearish market at the same time. There have been, and there still are excesses in these markets (which many like us could not foresee) and due to the excesses, there are some opportunities (due to excessive neglect). But in the end, equities are slaves of earnings, and therefore it is reasonable to expect the excesses and opportunities to both disappear (till new ones emerge).
Long-term wealth creation is the result of good process and discipline. It is not feasible to buy all stocks that go up. A sensible way to create long-term wealth is to buy businesses that are sustainable, that are managed by reasonable people, that earn more than cost of capital and that are available at a justifiable price. This approach invariably works in the long term, but in environments such as present it does test the faith of its followers.
Keeping the faith in such times can be very rewarding over time, as it is in markets such as these that opportunities are created.