Bulls on shaky ground
Oct 07 2012 , New Delhi
There is a missing link between the rush of reforms and the rally in stocks: the government actions do not help much to improve earnings outlook and, thus, stock valuations. So what is it that investors are chasing?
At the long-term Sensex price-to-equity (PE) ratio of 15.2, these EPS estimates peg the 30-share BSE benchmark at 18,200 for FY13 and at 20,500 for FY14. Usually, the market starts building in the next financial year’s EPS estimates from the last quarter of a financial year.
But this time around, stock investors appear to have other ideas; Sensex is well past 18,200 and appears to head toward 20,500 already. Some bullish projections even put the heartbeat equity index above its all-time high of 21,000 by next March, an upshot of the over-enthusiasm created by the sudden outburst of policy measures from the UPA government. But before you go overboard with such bullish projections, it’s prudent to see whether or not these reform measures have the potential to add to the earnings growth of India Inc in the near term. And the answer is a clear no. Have we, then, moved too much too fast?
Sensex appreciated 10 per cent in September versus a 6 per cent rise in the MSCI emerging market index. India has been one of the best performing markets ever since July, outperforming its regional peers. But very little has changed on the ground; the rate of inflation continues to rule at 7.5 per cent, industrial production growth has fallen to a bare minimum of half-a-per cent, dragged mainly by negative growth in capital goods, India Inc’s capex cycle has come to a grinding halt, a reverse movement in the interest rate cycle doesn’t look very near yet, and corporate India continues to smart under cost pressures and high interest burden, while consumer demand is drying up for auto, realty, consumer goods and FMCG firms. The most bullish projection for India’s GDP growth in this financial year is 6.7 per cent (PMEAC chairman C Rangarajan), and the most bearish 5.5 per cent (S&P), compared with 7 per cent in 2011-12 and 8.5 per cent in 2010-11.
Brokerages have very muted earnings projections for India Inc in the September quarter. Top-line growth of Sensex companies is expected to moderate to 13.5 per cent year on year from 17 per cent in the previous quarter, while for the broader basket estimates are even lower at 8 per cent to 10 per cent.
According to Manishi Raychaudhuri, head of research at BNP Paribas India, while the recent reform measures are positive for sentiments, their impact on corporate fundamentals will be limited.
Sanjeev Prasad, head of research at Kotak Institutional Equities, says there is a long grind ahead for the real economy, but stocks have already started discounting a smooth recovery.
“In our view, the Indian economy faces significant challenges with high (and rising) inflation in the short term and high fiscal and current account deficits in the medium term.”
Too many good things
Investors have a tendency to build any visible changes in economic fundamentals into stock prices at their earliest, more so when counterchanges occur after a prolonged phase of bullishness or bearishness.
Fundamentally, the India story continues to have its inherent strength in spite of a temporary slump and the gloomy global conditions, and when the government decided to act on several fundamental issues, it only helped matters.
What put Dalal Street in a sweet spot was that the revival in FII sentiment on Indian equities, the recovery in the rupee (8.6 per cent rise against the US dollar in September), rise in liquidity in global markets, a drop in crude prices and easing of nagging worries over the US and the euro zone and lifting of the fear of a possible downgrade of India’s sovereign rating, all happened at the same time.
“This was reflected in net FII inflow of $7.5 billion in FY12, out of which about $4.0 billion was poured in September alone,” points out Pankaj Pandey, head of research at ICICIdirect. Pandey agrees the economic recovery will be a gradual process and it is be too early to call it a turnaround, especially when most economic indicators such as inflation, industrial production, current account deficit and auto sales remain weak.
“But things should now start moving in the positive direction, leading to an improvement in key economic indicators. The rise in the rupee would help arrest the ballooning current account deficit and contain imported inflation. The revival in investor confidence should help restart the capex cycle, which would help reverse the economic downtrend,” he says.
The question is, will the recent changes carried out by the government lead to any earnings upgrade, and if at all how fast?
Even the bulls have their doubts. Saurabh Mukherjea of Ambit Capital, who predicts Sensex to hit 23,000 by March 2014, has made his worries known: “India Inc’s balance sheets are in worse shape than they have been for over 10 years and the banking sector’s dysfunctional loans are almost as big as the networth of the sector. Both these factors will be major retardants to a strong economic recovery in FY14.”
Pandey of ICICIdirect is skittish too. “The improvement in earnings growth would be a gradual process. The reforms certainly have the potential to push up economic activity and help improve companies’ performance. While earnings upgrades have not been seen as yet, the pace of downgrades has certainly reduced. We believe the earnings downgrade cycle may be over and we may start witnessing upgrades in the near future.”
However, prospective pockets do exist. For instance, the increase in FDI limit in aviation, TV content distribution, retail and insurance would enable higher inflow of much-needed foreign capital in companies grappling for funds and ease debt pressures. This would directly help bottom lines of such companies.
The diesel and LPG subsidy cut will reduce under-recoveries for the upstream and downstream oil firm. The appreciation in rupee against the US dollar as a direct result of higher FII inflow would help reduce operational cost for companies dependent on imports.
Real market movers
“The need is to kickstart the investment cycle,” says Raychaudhuri of BNP Paribas. “Many projects in the power, metals and chemicals (refinery) sectors are stalled because of issues related to environment clearance, land acquisition or fuel supply.”
The proposed national investment board to fasttrack projects above a threshold, fixing fuel linkages for power projects, launching some of the large projects that are on the pipeline, a drop in interest rates to revive demand in consumer sectors such as auto and realty can quickly revive the investment environment, reduce bad loans in the banking system and trigger fresh credit flow into the system.
And considering that some of these are said to be in the works already, it’s only a matter of time before investor interest shifts from traditional defensive sectors such as FMCG, pharma and IT to others.
“Though ground realities will take longer to change in terms of demand revival, an interest rate cut seems imminent. Consequently, the very first sign of earnings upgrade would be seen in capital-intensive sectors such as capital goods and infrastructure. Also, the banking sector may be in for an earnings upgrade if the credit growth picks up,” says Pandey.
According to him, capital goods and infrastructure stocks may contribute to any future rally in the market if factors like capex cycle and demand revival start falling in place along with a drop in interest rates. zz