Equity Investors in India Poised for Disappointment

 |  Includes: IFN, IIF
by: Vivek Kundnani

On midnight of August 15, 2007, India will bring in its 61st year as an independent nation. With a population of over 1.1 billion, the world’s largest democracy has witnessed rapid economic growth in recent years. Armed with rising disposable incomes, the Indian middle-class has led the resurgence of the Indian economy and catapulted it in to the global arena to wrestle with the big daddies of the developed world. In fact, a recent Goldman Sachs report estimates that India will be one of the top three economies of the world by 2050. Only time will tell whether that scenario materializes or not. However, one thing is for certain in the not so distant future. Indian investors, as a group, will not earn nearly as much return on investment in the next few years as they have in the previous few. Here’s why…….

Since 1997, the Indian economy has grown 146% at a compound annual growth rate [CAGR] of 9.41%. Over the same time period, earnings of the 30 companies that make up India’s BSE Sensex have grown around 150%. No surprises there. However, over that same 10 year period, India’s BSE Sensex has risen 345% at a CAGR of 16.11%.

In comparisons such as the one above, an abnormal base period can distort the figures. And January 1997 was an abnormal month for the Sensex, characterized by a depressed price/earning [P/E] multiple of 13.5. However, had the Sensex been trading at a P/E multiple of 17, which is the average multiple over the 10 year period, the Sensex would’ve still risen 260%; way above underlying companies’ earnings.

An investor would define “stocks” as securities that enable her to obtain ownership interests (no matter how small) in companies. In that respect, stocks do or at least they should reflect the performance of the underlying businesses they represent. It’s just plain and simple common sense. And history reminds us time and again that corporate performance and stock prices converge over longer periods of time. A disparity in the performance of one over the other can not continue in perpetuity.

Some pundits would like to explain this disparity by the phenomenon called “multiple expansion” or an increasing price/earning ratio. After all, the Indian economy is healthier than it ever was, corporations are better managed and consumers are richer than ever. No doubt investors are willing to pay a premium for Indian equities given the above factors. But how much higher can that premium go?

BSE Sensex

In simple terms, the price/earning multiple is the amount investors are paying for each rupee of earnings. For instance, if the P/E multiple is 15, investors are paying Rs.15 for each rupee of earnings. That amounts to a yield of 6.7%. If the P/E multiple shoots up to 25, that reduces the yield to 4%. And these yields will be significantly lower, if frictional costs (costs that investors incur to buy or sell stocks, broker commissions, fees etc) are taken in to consideration.

This begets the questions that what is the current P/E multiple telling us about the BSE Sensex? The answer follows….

The average P/E multiple of the BSE Sensex from 1997 to 2006 is 17. This covers a period of 120 months and roughly two business cycles. The table below gives a break-up of forward 1 month, 3month, 6 month and 12 month returns of the BSE Sensex at different average monthly P/E levels over the 120 month period from January 1997 to December 2006. Here’s an example to simplify the above sentence. The average P/E of the BSE Sensex in August 2003 was 15 and BSE Sensex was 22% higher by August 2004 which is also the forward 12 month return. These forward returns have been averaged and presented in the following table.

BSE Sensex average forward returns

The results are not surprising. The lower the P/E ratio, the higher the returns investors earned. It should also be noted that from 1997 to 2006, the BSE Sensex has always been lower 12 months from when it was trading at a P/E above 20. The current P/E multiple is flirting with 23.

Obviously, the next step is to find out what level should the BSE Sensex be trading at to warrant investment consideration? Using the current EPS of Rs. 656 and the average P/E multiple over the past 10 years of 17, the BSE Sensex should be at, and brace yourselves for this, 11,150; 25% below current levels. Even if the BSE Sensex can sustain a higher than average multiple of 19 (because “it’s different this time”), we get a value of 12,460, 15% below current levels. These valuations are definitely not attractive to rational investors.
Now let’s look at Indian equities from a different angle. Hypothesize with me for a moment. Let’s assume that the earnings of the 30 companies that make up the BSE Sensex increase 18% annually for the next 3 years without hiccups. Let’s also assume that at year end 2009, the BSE Sensex will be trading at a higher than average trailing P/E of 19. This puts the BSE Sensex around 19,000 at the end of 2009, 30% higher than current levels of 14,500. Even based on this optimistic hypothesis, equity investors will, at best, earn an average return of 9% annually over the next three years. That pales in comparison to the over 30% average annual returns investors have realized over the past three years. Now, compare that “at best 9% return” to the current yield of 7.5%-8% on Indian Government bonds and suddenly, Indian equities go from looking bad to downright ugly.

In conclusion, although I believe that the BSE Sensex is currently over-valued, the Indian economy remains stronger than it ever was. And on midnight of August 15, 2007, India will definitely bring in its 61st year as an independent nation. I would love to stay and partake in the enormous growth India has to offer; but as far as Indian equities are concerned, I’m ready to pack my bags and leave.