What's the market saying

Market is uncertain. Gains will be slow and selective. Here is how to navigate successfully.

By Devangshu Datta        Print Edition: April 5, 2007

Here’s a little Rs 60,000-crore case study. According to the Society of Indian Automobile Manufacturers sales of automobiles are growing at double digits. In 2006-7, the industry with a capacity of 1.09 crore vehicles (four-, three- two-wheelers combined) will sell over 1.2 crore units—a growth of 15% over sales in 2005-6.

The industry has gone into overdrive to meet the demand created by a newly prosperous middle-class revelling in car loans. Somehow it squeezed more productivity out of the assembly line. In the next financial year (2007-8), demand will stay strong since salary hikes have comfortably beaten inflation.

No matter how hard the auto industry sweats its assets, it will have to expand. Collectively auto manufacturers will spend Rs 19,700 crore doing that in the next two years. By 2010, auto expansions worth Rs 60,000 crore will have created ample capacity.

But it takes time to build new facilities. In 2007-8 and perhaps in early 2008-9, there may be capacity shortfalls. What will happen? Prices may climb. That could cause inflation and put off some buyers. If that happens demand will ease down to fourth gear from overdrive, perhaps even slip to third gear.

This story is likely to be repeated across many other sectors. Cement, telecom, construction— demand is outrunning supply in each case.

Massive capacity expansions are on (in services, expansions consist of more hires and ITenabling to improve productivity). About 36% of India’s GDP will be ploughed into capacity-creating investment in 2007-8 and Rs 60,000 crore is indeed a little number in that broader context.

The capacity crunch is visible even in financial services. The ratio of bank loans to bank deposits is well above 70% at the moment. Given that banks must maintain cash reserves and commit loans to “priority” sector (aka agriculture), it won’t be easy to fund all the EMI deals that Indians love. Interest rates are rising—as every mortgaged householder and bank depositor knows.

This means 2007-8 is unlikely to be a great year for the Indian stock market. Growth will ease down a couple of notches. Consensus estimates suggests that the earnings growth of the 50 large companies that comprise the Nifty index will slow down from 28% in 2006-7 to between 15% and 20% in 2007-8. And, higher interest rates will also lead to money being pulled out of stocks and parked in fixed income investment options.

But if you look beyond 2007-8 to 2008-9 or even further ahead in time, prospects are very bright. “The long-term fundamentals of the Indian economy remains robust. The demographic dividend, the consumption boom, the infrastructure thrust are secular trends which are likely to support 7-8% GDP growth for many years. This will obviously manifest into steady equity returns over the long term,” says Ajay Argal, senior manager of Birla Mutual Fund.

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R. Rajagopal, head, equities, DBS Chola Mutual Fund, is even more optimistic, “The Indian economy is slated to grow at 8 to 10% over the next few years and inflation is expected to be in the range of 5-6%. The nominal GDP is expected to grow at about 14-16%. We believe India Inc’s earnings will grow at about 18-20% CAGR (compounded annual rate of growth).”

In a nutshell, the economic cycle will go through a mild slowdwn in 2007-8 followed by another period of booming growth. Stock prices could be relatively low in 2007-8 and future returns will be bright for anybody who’s committed to invest for two or three years. That is the argument for investing steadily through the next 12-15 months.

Our polled group (and opinions from financial majors such as HSBC and Lehman Brothers) suggest that the Sensex has a downside of about 10000. On the upside, it could reach 17000 but the downturn is more likely. In terms of the Nifty that is somewhere between 3000 and 4900.

The only contrarian is Sandip Sabharwal, CIO, JM Financial, who says, “The downside is only 3-4% while the upside is 30% from current levels (the Sensex was 12430 on 16 March) over the next year.”

Apart from lower earnings growth, higher interest rates are likely. This usually leads to lower price-earnings (PE) ratios.

Let’s compare the earnings per share to returns from debt. Right now, interest rates are close to 9.5%. So the PE ratio of debt is 10.5 since we pay a price of Rs 100 to earn Rs 9.50 (100 divided by 9.5). If we take into account only the earnings, the current PE of debt is way below the current Nifty PE of 17.5. A value investor would want at least the same rate of return from stocks as from debt. Hence he will be unwilling to buy stocks at PEs in excess of 10.5. If interest rates rise, the PE of debt would drop further, making it more attractive. If interest rates rise to 12%, the PE of debt will drop to 8.3 (100 divided by 12). Most experts believe that interest rates will peak somewhere in the next 12 months.
 

This is classic behaviour at the peak of an economic cycle. Demand outstrips supply; inflation rises; stock prices drop; the recovery comes along when capacity catches up with demand.

There is a fair consensus in terms of earnings growth. Most fund managers and analysts seem to believe that companies that comprise the Sensex and (some of the country’s biggest companies) will see earnings (profit) growth at between 15% and 20%.

Apart from key variables such as earnings growth rates and interest rates, stock prices depend on many other factors that affect both the operating environment as well as investor sentiment.

Foreign institutional investors (FIIs) will compare Indian equity with other emerging markets such as Russia, China and South Korea and head where they think the grass is greenest. Indian growth rates are slated to remain among the highest in the world. According to an HSBC research earnings growth in 2007-8 will be 13% in China, 15% in Brazil, 21% in South Africa and 5% in Russia. The projection for India in the report is 16%.

In 2007, FIIs have been net buyers to the tune of Rs 4,963.7 crore, although they have sold stocks worth Rs 2,768 crore since the Budget.

There’s also politics—both local and global. In 2008, there will be some global uncertainty due to the US presidential elections and its impact on Iraq, Iran, Afghanistan and the spin-off effects on oil prices. Indian investors must also account for the added prospect of a string of assembly elections and a general election in 2009. Policy will be impacted by populist measures.

All this could create a window of opportunity for patient investors who stay focused through the turmoil. Historically, Nifty and Sensex have achieved PE ratios of 20-plus every couple of years. On the downside, bottoms tend to come between PE 9 and 12.

If you invest at a 2007-8 PE of say, 12, that translates into a Sensex level of roughly 10500- 11000. If earnings growth recovers to the five-year CAGR of 23% by 2008-9 and 2009-10, and PE ratios climb back to over 20, we are looking at a 26000 Sensex by 2010.

Coming to sector specifics, earnings growth in 2007-8 will be concentrated in a few sectors. A study from HSBC divides the Nifty- 50 basket into 16 sectors (including “others”). Just five, namely telecom, finance and banking, information technology, oil exploration, and engineering and capital goods will collectively deliver over 82% of the Nifty’s 2007-8 earnings growth.

Our fund managers’ favourite sectors come from within this ambit with automobiles and power thrown in. But this doesn’t mean specific stocks in other sectors will do badly. It is safe to assume that other sectors will pick up. We are looking at several years, remember?

In the following pages, we examine 48 high-quality businesses spread across sectors. If you wish to be a winner in the great bull market of 2008-12, select some out of this group and invest systematically in the next financial year.

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