India Remains an Attractive Market

India never had a recession this time round. There was a small cyclical de-gradation evident in the earnings cycle when Sensex earnings fell from Rs 775 to Rs 765 between the years ended 3/31/2008 and 3/31/2009. Estimates for the year end 3/31/2010 are at Rs 874, so earnings growth has resumed. There is scope for further upside revisions for 3/31/2010; in my view it is likely that the year will close with earnings closer to Rs 925. Consensus estimates for the year ended 3/31/2011 are just short of Rs 1,000; in my view these are overly pessimistic and will rise to Rs 1,100 before long. Earnings visibility is high and there is high confidence in long term growth.

The market looks expensive on traditional valuation measures and while multiple expansion might be done, there is still money (both short and long term) on the table from earnings upgrades. For foreign investors interested in India, in my view an over-weight on emerging markets makes sense; it adds to portfolio return potential. Within the emerging markets, an equal weight allocation to India makes sense. Investors from outside India stand to gain more; funds flow into India is high for both direct and portfolio investment and this raises the demand for the Rs. This strengthens the Rs.

Think of it this way, if you invest $2.08 now, you receive stocks worth Rs 100. Over the investment horizon, the market returns 10% makes your investment worth Rs 110. Suppose that because of funds flow into India the Rs has risen to Rs 43 from Rs 48; the $ value of your initial investment plus return is $2.56 - whereas an Indian investor has gained 10%, a foreign investor stands to gain nearer 23%. Keep in mind that during January 2008, the Rs traded as low as Rs 39.27. Risk aversion and the flight to $ cause the Rs to go to Rs 52.06 by March 2009. As risk aversion abates, the Rs can be expected to strengthen to Rs 43. If it falls below Rs 43, it is probably time to start booking profits as that is a signal that risk taking is tending towards unacceptable extremes.

Please visit "The Quant Report" and link through to the file "Sensex Fiscal Years Ended 31 March" for a decade’s worth of historic data and the various valuation metric applied in arriving at below referred indicative out values.

Between the year ended 31 March 2000 and 31 March 2009, the Sensex has delivered annualized earnings growth of just below 14% and a dividend growth of a similar amount. The six year median earnings growth has run at an astonishing 28.91%. Using 31 March 2010 estimates annualized growth rates have been solid at 14.77%, 13.19% and 26.35% for earnings, dividends and six year median earnings respectively.

If you had invested Rs 100,000 in the Sensex at average prices which prevailed during 2000, and re-invested dividends at average prices during the year of dividend receipt, today your portfolio would have been worth Rs 428,906; in addition you would have had a dividend income stream of Rs 4,666 per year. Rs 4,666 is more than you would earn of a fixed deposit of Rs 100,000 post tax today and your initial investment would have multiplied 4.29X; that is a rock solid performance.

Earnings expectations indicate that the year ended 31 March 2009 was a trough earnings year. During the year ended 31 March 2010 earnings are expected to rise to Rs 874 which is up from the prior year’s earnings of Rs 765. With long term GDP growth of 6% and inflation running at similar level, corporate earnings can be expected to grow at a long term rate of 12% per annum.

The financial crisis caused by the bursting housing and debt bubble in US led to massive risk aversion and drying up of liquidity. The risk aversion is now abating and liquidity is starting to return to markets. A crisis of the size and intensity will leave a nasty hangover; in all probability the multiples seen at bullish extremes during the past decade will not recur.

During the year ended 31 March 2000 and 31 March 2009, average P/Es ran at 17.5X earnings, while median PE's ran at 16.5X. During the year ended 31 March 2000 and 31 March 2010, P/E 6 (annual average price divided by 6 year median EPS) ran at median levels of 28.83X. So despite calls of over-valuation, there is considerable money on the table. Earnings estimates for 2010 are average in the context of the forward cycle expectation so the earnings risk on a cycle basis is at normal levels. Performance in line with the past decades is indicative of a normal valuation of 34,754 by 2014 with rises to 40,551 on bullish extremes.

More conservative valuation measures are indicative of targets of between 20,252 and 27,002. In my view a 2014 target of 27,000 to 34,500 is very likely. On a 12 month basis there is a strong case for significant upside from where we are; I would look for at least 19,354 by end March 2010 and for 22,212 sometime during the following 12 months. Of course none of this will occur if risk aversion returns; what must be watched are liquidity flows and the US economic recovery. Other risks include drought impact of rural India, which is in my view unlikely to cause huge downside risks as of now; the risk of early interest rate rises looms, in my view moderate (not aggressive) rising interest rates are a long term plus as it is indicative of a return to economic health.

The bad boy to watch out for is India losing competitiveness as a global market as a result of loss of investor post tax returns - there are good changes in the new tax code which seek to eliminate tax abuse; but coupled with bad tax policy of taxing foreign gains in India, may result in drying up of liquidity flows into India. I expect to see first signs of nervousness in Q1 2010 because it is likely that the budget will drop securities transaction tax, which will lead to long and short term capital gains coming within the tax net. In Q1 2011 (or earlier - depending on when the final version of the new tax code is enacted), the response could be more severe.

It is sheer foolishness to assess capital gains tax on passive foreign investment in India - no developed market does it - not the US, not the UK or other West European countries, not Australia, not anyone with an ounce of sense. Foreign pension funds & investors who enjoy tax exempt or tax deferred status in their home jurisdictions, are not going to be amused about losing money to taxation in India. Other emerging markets including China, Brazil, and Russia will gain in relative attractiveness versus India and the impact on funds flow will be high; this slowdown in liquidity can have an adverse impact on valuations. Keep in mind that valuation can have a significant impact on the real economy - strong valuations allow corporate access to cheap capital. What I find really disappointing is that the statement that India has grown not because but in spite of the government remains true. Why, why must we cut our legs at the knees just as we stand up?

Nonetheless, India remains an attractive market; reduced liquidity may cause low valuations short term - this would be a buying opportunity. Long term valuations might not rise to bullish extremes seen in the past; but is that a bad thing - even using normal value levels as bull targets for the next cycle allows for significant capital appreciation. Growth might slow due to lowered access to equity capital, but the impact is unlikely to be more than 0.5% of GDP; and it might even lead to better managed growth and less volatility. In consideration of this risk, I would reduce overweight positions back to equal weight at 18k levels, using significant pullbacks to increase overweight positions later; keep in mind that pullbacks caused by what is viewed as bad policy can be severe in the short term; but once the disinterested liquidity is gone, markets will return towards normalcy fairly rapidly.

In my view global economic risks to the downside remain; but these risks will likely be 15 months to 18 months away - so far the crisis has been managed well - we need to watch for the first crisis management error to start worrying. We also need to closely watch "Tax", the bad boy on the block closely.

Disclosure: Long and overweight positions in all Sensex listed companies, with intent to return to equal weight when the market trades at its next Fibonacci level near 18,000.

Comments

[Mad Hedge F...:]

mge India has been one of my stellar picks this year, the “I” in BRIC, rocketing 112% from the March lows (click here for my initial report ). Although it appears overheated for the short term, I believe it has much further to run over the long haul. You want to buy countries that have yet to build infrastructure and a middle class, and China has already done that. India’s per capita GDP came in at a sparse $1,016 last year, compared to $6,100 for the Middle Kingdom. China’s economy today is about on the same level that Japan experienced during the late fifties, while India is still in the late twenties, with large parts effectively mired in the 16th century. India’s recent election of a more pro-business government was the trigger for improved growth, which is expected to exceed 6% for the rest of the year. India’s economy is entirely domestic, and is so far outside the world economic system that the global financial crisis was barely felt there. While we were melting down with a minus 6% GDP rate, India continued to bask in a plus 5.8% growth rate. No subprime debt, toxic portfolios, foreclosure crisis, government bailouts, or AIG, GM, or Chrysler. With 1.2 billion consumers, some 70% of GDP there accounted for by consumer spending, so retail figures large in the country’s future. Even Harley Davidson (HOG) has big expansion plans in the world’s largest user of motorcycles. For those of the ETF persuasion, look at Wisdom tree’s earnings based offering (EPI) or the one from PowerShares (PIN). Better start checking your share prices in rupees.

Oct 07 08:16 AM

[jimp:]

Shiv,

Do you have a preferred ETF that you think
is most able to take advantage of India's
present & future investment potential?
Thanks for the great article.

Oct 07 10:48 AM

[Shiv Kapoor:]

EPI is good on quality with reasonable holdings in Bharti, Reliance Industries, Infosys.

PIN is great in quality, it has good holdings in Bharti, Reliance Industries, Infosys; all Dow Global Titans. Personally, I like quality, but short term I think its exposure to Infosys is too high. I am also not keen on their exposure to ONGC - that is a public sector entity and why it is a great holding, its profitability is very influenced by goverment policy.

IIF I do not like at all.

Overall I like IFN best. Their portfolio quality is excellent and while there is some exposure to public sector undertakings (I generally avoid PSU's), most are infrastructure plays which are positively influenced by policy. I am not keen on State Bank of India because its profits can be hurt by goverment dictates on how much to lend and to who, but that is only a small position.
1. Reliance Industries, Ltd.
2. Infosys Technologies, Ltd.
3. Bharti Airtel, Ltd.
4. Housing Development Finance Corp., Ltd.
5. Oil and Natural Gas Corp., Ltd.
6. Jindal Steel & Power, Ltd.
7. Bharat Heavy Electricals, Ltd.
8. HDFC Bank, Ltd.
9. ICICI Bank, Ltd.
10. State Bank of India
11. ITC, Ltd.
12. Reliance Infrastructure, Ltd.
13. Mahindra & Mahindra, Ltd.
14. Larsen & Toubro, Ltd.
15. Hindustan Unilever, Ltd.
16. Lupin, Ltd.
17. Tata Consultancy Services, Ltd.
18. Wipro, Ltd.
19. Hero Honda Motors, Ltd.
20. Sterlite Industries (India), Ltd.
21. Jaiprakash Associates, Ltd.
22. Power Finance Corp., Ltd.
23. Punjab National Bank, Ltd.
24. Axis Bank, Ltd.
25. NTPC, Ltd.


On Oct 07 10:48 AM jimp wrote:

> Shiv,
>
> Do you have a preferred ETF that you think
> is most able to take advantage of India's
> present & future investment potential?
> Thanks for the great article.

Oct 07 11:07 AM

[jimp:]

Shiv,
I appreciate your thorough and quick response.

Thanks again

Oct 07 05:10 PM

[dpk:]

I was checking options of ETSs viz,EPI ,PIN and IFN.Leaps are not there and all the three are thinly traded (so spread is too high ) More disadvantageous to those who hedge with multi-leg orders.
But a beautiful article.
Problem with Indian derivative market is that it is too new. e.g.For spreads each leg is taken to be a separate leg for margin purpose so you need to siphon out a lot in the margin money on the short side of debit spread (as it is not covered with your long side)Options are thinly traded even for the current month and almost zero for subsequent months except for index.
But an upcoming derivative mkt has advantages too.You can find some real good entries.
To cut the whole story short in Indian derivative mkt., tools to hedge are not available as in US.So risk reward ratio for me who does not get into stocks is more attractive here than in India.

Oct 07 11:28 PM

[TvC:]

Shiv,
What about the effect of the strengthening rupee in turn depressing revenue and earnings of the Export Driven portion of the Indian economy. This will in turn reduce the net returns to the Foreign investor. Could you elaborate on what portion of the Indian GDP is Export Driven and what portion is focused domestically.

Oct 09 11:37 AM

[Shiv Kapoor:]

India's primary driver is expanding domestic consumption (56% of GDP). The external stimulus which was required to create income to consume has been delivered through export; now momentum caused by external demand has created a virtous cycle of need coupled with ability to pay in the domestic economy. Export remains important (it is about 22% of GDP); but not critical - revenue will be depressed and margins squeeze on strength of Rs, but this is limited mainly to export sector - and there too some pressure relief will come from productivity gains (India is very behind on productivity & those gains can drive margin growth to offet currency strength). BTW - I think sectors to focus on in India are materials/energy/infra... - anything driven by domestic demand - investing in export (IT/textile etc) driven sectors might be relatively weak. See my post on INFY.
India is a long term story; and the risks are high - risks will only start reducing once prosperity permeates through society - need per capital GDP to rise - see maxkapital.blogspot.co.... Until per capita GDP rises, expect volatility over economic cycle + also degree of external wealth through exports will be required. Import dependency is also high - particularly on machine/fert/chemicals... the latter 3 worry me most because these are supply contrained + food and energy security are very, very important for stability.

Get more info on GDP breakdown at www.mospi.nic.in/PRESS...


On Oct 09 11:37 AM TvC wrote:

> Shiv,
> What about the effect of the strengthening rupee in turn depressing
> revenue and earnings of the Export Driven portion of the Indian economy.
> This will in turn reduce the net returns to the Foreign investor.
> Could you elaborate on what portion of the Indian GDP is Export Driven
> and what portion is focused domestically.

Oct 09 01:10 PM

[SJMDESIGN LTD:]

If some one wants pure play in India.
I suggest TTM(tata) going forward with global recovery in increasing demand for automobile this company will go much higher than current price of approx $12.(very well run company than most of it peers)
For infrastructure play in india consider IIF .
These shares should be traded if they pop 20% in short term.
For a longer horizion they are good buy if they pull back 5%.

Nov 10 12:52 PM