Silver Lining To The Dark Clouds

Nothing apparently seems to be good at the moment. Economic growth has hit a nine-quarter nadir. Corporate performance is following on the lines of that slowdown and markets have been in a state of flux. No matter how hard it tries, the RBI has not been able to rein in inflation through the relentless rate hikes in the last couple of years and the Rupee has depreciated to its worst ever low. The government’s inefficacy in handling its own finances is amply visible in the widening of the twin deficits and with the unearthing of various scams, governance itself is a bigger issue today. A coalition headed by a week-kneed leadership is being held responsible for a policy paralysis which is seen to be at the root of most of the problems afflicting the economy  and the markets today.

While collectively all of the above point toward a very gloomy tomorrow, there certainly is a silver lining to the dark clouds. Worried investors need to know more than what is today being bandied about by popular media. India has always been looked upon as a structurally strong growth story. The big consumption led growth riding on the back of its large and young population made India a very interesting proposition for investors. And therefore a basic question that needs to be answered before raising doubts about the future of our economy and its growth prospects is whether such a structurally strong story can go bad within just two years?

Have the factors that were supposed to propel India into the next growth orbit and push it away from being a mere third world nation to an economy which would be the world’s growth engine disappeared all of a sudden? Should investors really be so worried about what they should be doing to guard against wealth erosion? Is it really all that bad? Our answer to these questions is a collective and overwhelming NO! As we said earlier, there is a good silver lining to the dark clouds that are presently surrounding us. Here is a step by step build up of the various analogies which support our conviction in a brighter future that the Indian economy offers not only to domestic but also foreign investors.

Valuations: Poised For A Rerating

The MSCI India index has underperformed over the last seven months compared to all the major developed and emerging market indices, except for Europe and Brazil. This underperformance has more to do with the deteriorating condition of the Indian growth story, as reflected in various macroeconomic indicators. The major sectors that contributed to such underperformance are industrials, materials, telecom, etc. Nonetheless, we believe that all negativities are already discounted in the price and are reflecting in the valuations.

Currently the Sensex is trading at trailing PER of 16.16 times. This is lower than its ten year median PE of 18.35. Dipen Shah, Head of Fundamental Research, Kotak Securities seconds our opinion. According to Shah valuations are not demanding but are certainly not far away from the lows too. “We are not saying that it is very costly and we think that it is certainly a time when one should start accumulating stocks” says Shah.[PAGE BREAK]

Shah is not the only one to recommend accumulation at current levels. Anand Tandon, CEO, JRG Securities too conforms to what Shah says. “Yes, the market is relatively less expensive. And while there are no near term triggers for upward movement, there is also not much reason for a further downside. If the global macro environment changes for the worse, we may get a short sell-off. However, that should be bought into” says Tandon.

Even if we consider the forward PE, currently the Sensex is trading below its 15 year average of around 14 times. It is not that only the Sensex is trading lower than its historic average. Even broader indices like the BSE 200 are trading at 12 times their forward earnings; a hefty discount to the historic level of 16 times. Such low valuations have not been seen since 2005 except during a few months after the Lehman crisis in 2008. Such a fall has resulted in Indian equities losing their traditional premium over other emerging markets. This got reflected in the premium that the MSCI India Index’s PER enjoyed to the MSCI Emerging Markets Index. Currently MSCI India is trading at a 32 per cent premium to the MSCI EM Index. This is against its peak of a 90 per cent premium that it enjoyed during March 2010 and the long term average of around 50 per cent.

Such a fall can be attributed to the drop in the profitability of corporate India. It is estimated that after growing by 12 per cent in FY12, the Sensex EPS is slated to grow in a single digit for FY13 against its long term average of 15-18 per cent. This has clearly brought down the return on equity for India Inc from the historical average of 19 per cent to the current level of 15 per cent. However we see that now the downside is capped and we may not see a significant downside from here.

According to Saurabh Mukherjea, Head of Equities, Ambit Capital, “There is never a guarantee in the stock market but what 20 years of history shows is that if you buy at these sort of valuations and even if the valuation falls from this point, your downside is highly limited. In fact in next 6-12 months one is likely to earn positive and in fact double digit returns.”[PAGE BREAK]

One of the key factors that will help contain the downfall is the high free cash flow (FCF) yield of India Inc. According to a report by Standard Chartered the forward FCF yield for the Sensex is now at 4.5 per cent which is even higher than post Lehman Brothers crisis of 2008- 09, when it was around 4.3 per cent. Compared with other asset classes like fixed income too, equities are trading at a lower valuation with a good potential upside. The gap between the earnings yield of the Sensex and the 10-yr Gsec bond is still negative but is narrowing and is currently trading at below the median difference of 2.38 indicating that it is a good time to enter the market. All this is already getting reflected in the improving performance of the MSCI India Index, which is gradually improving in its rank among 21 other emerging market indices having moved up from 17 in last three months to 12 currently.

So, as far as valuations are concerned, investors with a slightly longer term view of more than six months can start entering the market (see table: Opportunity To Enter) as an entry at current valuations has always been rewarded handsomely.

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Corporate Growth Set to Improve

One of the most important matrixes which determines the future course of the markets is corporate performance. The results for the quarter and year that ended in March 2012 have reflected the economic slowdown. Except for a few sectors, there have been no major outperformers as far as corporate growth is concerned. Well, the reasons for such a lackluster growth are not new. Rising costs and higher interest rates have been the nemesis of a good showing by corporate India. However, these factors are all but set to reverse. Though an immediate reversal may not be on the cards, we have already begun moving in that direction. One of the most important factors is the decline in crude prices. Crude prices are currently trading at an 18 month low and have come down to trade in double digits. This alone provides a good amount of confidence in terms of bringing down the cost side pressures on corporate India  (provided the rupee remains stable) as a fall in crude oil price has a cascading effect in terms of reducing other costs. A fall in the crude oil prices will also help the Government to improve its fiscal situation as lower crude prices mean a lower subsidy outgo and a lower import bill.

According to a study, fall of crude by USD 10 per bbl will reduce the fiscal deficit by almost 0.8 per cent. Regardless, other areas where we will have visible impact of lowering crude oil is in lowering of headline inflation. According to a report, every USD 10 drop in crude oil per barrel could reduce 1-1.5 per cent of headline inflation. This is what RBI is looking for to take any assertive action in reducing the interest rate.

We believe that if the slide of crude oil continues or even stabilises at these prices (USD 85-90/bbl) and rupee averts its one way fall, we may definitely see headline inflation coming down, which may provide RBI elbowroom to reduce key policy rates in its next meeting. There will be nothing like this as this will help Indian corporates in two ways. First it will help it to reduce the interest burden and boost profitability as interest cost is 36 per cent of the net profit of India Inc (excluding financials). Other way it will help is to revive the capex plan as it will improve the internal rate of returns of the projects.

So what is the scenario that one should be building about corporate growth? According to Independent Portfolio Strategist Prakash Diwan, corporate earnings have been much lesser disappointing that what one would have expected. “There is a distinct element of good companies and businesses having managed to clock some topline growth while the bottomlines may not have shown much of resilience.”[PAGE BREAK]

Pankaj Pandey, Head of Research at ICICIdirect.com feels though earnings growth was dismal in FY12, the last quarter surprised with almost 70 per cent of Sensex companies reporting better than expected profits, resulting in approximately 7 per cent earnings growth for the Sensex versus flattish expectations. “The subdued expectations highlight the high amount of pessimism built in around corporate performance. We believe there may not be further downgrades in earnings, going ahead. In fact, there could be upgrades in certain cases if the macros start falling in place” says Pandey.

Government: Its Actions And Repercussions

One of the most important factors being held responsible for the state of the economy and growth hitting a roadblock is the government’s inaction on the policy front. A complete policy paralysis at the centre has stalled reforms; considered to be a key element in fuelling growth. The government seems to have faltered on every step over the past couple of years. From its failure to pass many bills considered desirable for fuelling growth to holding its house together on critical issues there is nothing that has gone the right way for it. But its inactions and failures have already been priced in. Can it get worse? We don’t think so. The elevation of Pranab Mukherjee to the President's post seems almost imminent. This could probably see Dr Manmohan Singh returning to the finance ministry and also lend the UPA some confidence to move ahead on the reforms front. With elections not too far, it is in fact an imperative for the UPA to prove its pro-growth image with the electorate. This could see the government moving ahead with at least some reforms.

Our above line of thinking is amply supported by market intermediaries. Shah of Kotak Securities is in fact very optimistic that the reforms process will start soon and is positive that once that starts the RBI will also start acting on the interest front which will be positive for the Indian corporate sector.

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Global Factors: A Cause For Concern?

The only area which could probably spring up a negative surprise is what happens on the international front. The Euro Zone crisis is yet to get out of our way and with growth in the US economy yet to pick up there seems to be some amount of uncertainty on the global front. However, we believe that impact of Euro crisis on our economy is overdone as our direct exports to the EU at the end of 2011 was just three per cent of our GDP. Other major area of concern is full blown European banking crisis; in that case too we are fairly protected as European bank lending to India is just seven per cent of our GDP at the end of 2011. One of the silver linings to that emerges from the global happenings is the probability of a slowdown in China as China is a more export oriented economy and larger part of economy is exposed to the external sectors. The slowdown in other part of the world will directly impact the Chinese economy and as we know it is the Chinese economy that drives the prices of commodities. Any slowdown there will directly reduce the price of commodities. This is already reflecting in the movement of S&P GSCI index that dropped by 13 per cent in May alone, the biggest monthly decline in two years. This is one factor that could help in bringing down prices of key commodities and thereby help usher in better growth for corporate India.

All in all, the situation that we presently are in, the future does in no way look to be bleak. India has and will continue to be a structurally strong consumption-led growth story. It is only about time that factors impeding its growth dissipate in strength. We are not at all suggesting that this could happen in a hurry. But as usual, at Dalal Street Investment Journal, we tend to help our readers read the signs of good times well in advance so as to be prepared to seize the opportunity as it comes. It is to build strength into our conviction that we spoke to a wide range of personalities from top economists and industry leaders to market intermediaries. While many have been quoted at appropriate places in our story, we thought it would be a good idea to present some very important views independent of what we feel. Read on to find what the best and the most important minds think about the present state and future course of the Indian economy, and, the probable direction of the market.

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We have presented an analogical view on why we think investors should not be unduly worried about the present condition of the economy, as also why we see markets improving going forward. Of course, we are fully aware that there could be some short-term hiccups. In a bid to strengthen our conviction further, we spoke to top economists, business leaders and market intermediaries who have more or less echoed the same sentiments as we do. Here are some of their thoughts on issues impacting the economy and growth right now and why they believe the structural growth story of India is still very much alive...

Keki Mistry

I think there are a number of things that have gone wrong with the Indian growth story. On the international front there are problems which are well known especially in Europe and the US. These have resulted in negative sentiments which impact the fund flows into the country. Fortunately the outflow has not started so far but you are not seeing fresh money coming into the country either. Other issues like Vodafone and GAAR are further hurting investment sentiments. So money is not coming into India and markets are in a state of flux. Liquidity is less and the shortage of liquidity has created higher interest rates. So that’s the international part.

On the domestic front, the reforms process as you are aware has been very slow. We have taken a couple of positive steps and then retreated because of political imbroglio. This is creating a feeling of negativity among people. Inflation has been very sticky and has not come down which is again an area of concern. Inflation would have come down because of global events and the resultant fall in crude and commodity prices but because of a weak currency we have not benefitted from the fall in commodity prices especially Crude. Lastly the most important thing is we haven’t seen too many fresh investments happening in terms of industry creating new capacity. So capacity creation has slowed down and hence the supply side stagnated.

On whether we can bounce back, I would say that we can of course bounce back. But can we bounce back to 9 per cent in the next one year ,the answer is obviously a big no. To put in fresh investments into the system and get returns out of them takes a while. You cannot be looking at 9 per cent growth in the next couple of years. But over a period of time we can certainly expect it. At this point in time what is required is that the reforms process needs to be expedited and roadblocks of doing day to day business need to be eased or eliminated.

One of the biggest worries is that the foreign money is not flowing in and this is causing the rupee to depreciate. We need a policy framework to attract foreign investors. There has to be a clear hint that the government is serious about reforms and that all possible steps are being taken to correct the maladies if any. This will certainly boost the economy and foreign money will flow into the Indian markets. There are people who are still saying that with the rupee at 57 to a USD and the stock markets at these levels, how much worse can you go.

International factors lead to a change in sentiments or the weakening of the stock markets or for that matter even the currency being impacted because money does not flow in with that degree of ease. Some companies which are exporting to countries in Europe could see a slower demand. But structurally for the country as a whole I don’t think we should be that negative because of the problems of the western world.

Corporate India has seen a slow down for more than a year now. Businesses which are dealing with infrastructure and projects where approvals are hard to come coupled with high interest rates are getting impacted. But businesses that are dealing with consumers continue to grow. India is a domestic economy. It will feed on itself. As long as we create jobs, growth will remain strong.

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S. Gopalakrishnan

If we compare ourselves with countries that are growing at anything between zero to two per cent, we are certainly well placed as we are growing at 6.5 per cent. But, as compared to our own potential of growing at 8 to 9 per cent we are certainly below that. For countries like India which need to create 15 million jobs every year growth is very important and that is why there is a concern in the present circumstances.

Many people including me believe that there are some solutions that are required to be implemented. For example, the GST implementation is slated to add 1.5 per cent to the GDP. We need to accelerate the reforms process. Reforms have to be carried out to put our economy back on track.

There are very limited things that a monetary policy will do. So the scope of RBI helping in putting the economy back on a growth path is very limited. What we really need is for the government to act.

Talking of the impact that global events have had on us, it has indeed affected exports. Exports have not fallen per se, but have been affected. I firmly believe that we are in a two to three year recovery cycle rather than a quick recovery. If we do not accelerate growth it will have a long term impact. If we do not act fast unemployment will rise. If reforms like land acquisition, FDI and GST get a boost, it will help us to attain a turnaround.

As compared to other regions, the Indian economy is growing faster. The challenge is the depreciating rupee. Right now investments are moving to other secure geographies like USD etc. That is one reason and the second one is the deficit which we have not been able to reduce. I believe that industry is strong and has done reasonably well in the past couple of years. Working with the government will get us the growth back. I am actually optimistic that we will start the reforms process that will drive growth.

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Shubhada Rao

We have been trying to figure out for ourselves as to, are there any positives that we can realistically expect or are we then, because of the inability of the government to take difficult steps going back in terms of our growth trajectory by a few years not just cyclically but structurally as well? Are we endangering some of the strengths that India has acquired or has been able to achieve over the past couple of decades?

There are a couple of factors that structurally remain strong. Although savings and investments have seen some correction and are likely to see some more of it, the fact remains that as a ratio to GDP they have improved from the mid 20s to the mid 30s. The second point that many miss out on is the inherent strength of the balance sheets of Indian companies. Even with all the stress on the economy, balance sheets of banking companies have remained strong. The corporate sector on the other hand has witnessed a slowdown but balance sheets have remained relatively strong there too. Nobody is talking about a collapse of earnings. What we are seeing is a pruning of earnings and a pressure on margins. But this does not take away the fact that corporate balance sheets have been able to demonstrate much more resilience than they would have say a decade ago. These to my mind are the strengths that India possesses structurally and these I believe are a good starting point which will help India bounce back.

However, there are a few facts that are staring us in the face. What are they? The government has not been able to take difficult decisions. The first one is fiscal adjustments. This is a something very sensitive with respect to the coalition partners. At the end of the day it will certainly have an impact on inflation.

When the RBI cut the CRR in April, it sent a clear signal to the government that it had done what was expected from it and now it was the government’s turn to act. But, in the span of these three months nothing has been done by the government. This has taken a toll on the sentiments of global as well as domestic investors.

I will not say that the government lacks in spine. The way the candidature for the presidential polls have been set, it gives you a clear indication that the government has understood that they do not have much time left and have to start acting. If you hope that we can see some stern steps taken before 19th July, I would say let’s not hope for too much. Some positive developments can certainly be expected post the presidential polls.

Where will interest rates go? There are two issues that will govern the interest rate outlook going forward. One is the inflation scenario which will not ease in a hurry. Even for the present fiscal we are looking at an average of 7.5 per cent. CPI could still be in double digits. Having seen the inflationary backdrop, is there a chance of 100 to 125 bps rate cut? I doubt that. We expect a 50 bps cut in FY13. In the second half we could see a 100 bps cut in the CRR for this fiscal that will give the markets the required liquidity.

In terms of growth, the first two quarters could be difficult but overall we see the economy growing at around 6.5 per cent but with some downside risks. The factors that will aid a recovery is a global economic recovery. We cannot get to a 9 per cent growth without a global recovery. Also, we need serious reforms to revive the investment cycle. Getting back to 9 per cent growth by 2014 seems challenging.

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Dharmakirti Joshi

I think slow decision making is hampering clearances of projects. Further, bottlenecks in natural resources like mining is contributing to a manufacturing slowdown. A high inflation which does limit the scope of interest rate cuts and lack of reforms are among other factors that are hurting growth.

The government needs to announce measures to boost confidence. Some bold steps on subsidy reduction, introduction of GST and speeding up of project clearances will create an upside to growth.

Drop in oil prices and gold imports are good news. It will help in reducing current account deficit as oil and gold account for 40 per cent of total imports. If oil prices stay low, it will help in reducing fiscal pressures. Despite this we expect the current account deficit to be at around 3.6 per cent of the GDP and Fiscal deficit to come in at 5.7 per cent of GDP in 2012-13.

As for growth, we expect GDP to grow at 6.5 per cent in FY13, with agriculture at 3 per cent, industry at 5 per cent and services at 8.7 per cent.

On the interest rate front, another 50 basis point cut in the repo rate in FY13 is what we expect. We expect volatility in rupee to continue in the near term. In the best case scenario, expect the rupee to appreciate from current levels (Rs 57 per dollar as of June 25, 2012), to settle around 50 per dollar by March-end 2013. We assign a 60 per cent probability to this event. The key underlying assumption is that Euro zone situation does not worsen, but in fact improves towards the first quarter of 2012 which will improve risk appetite and enable return of capital inflows. 

This will be accompanied by some easing of the current account deficit in 2012-13 as global crude oil prices soften and gold imports decline. This also assumes no further worsening of domestic growth and inflation scenario.[PAGE BREAK]

Dinesh Thakkar

Cooling of crude prices is a major positive for India. The rupee has depreciated significantly by more than 20 per cent. This will help revive our exports and curb imports in the coming months. Secondly, the core inflation is also more moderate than overall inflation numbers. So, if core inflation remains at 5 per cent levels or dips further, then that too will provide RBI some headroom to cut rates in the coming months.

I am especially positive on some of the cyclical sectors such as banking, capital goods and infrastructure. At this juncture, investors are getting high quality companies in these sectors at cheap valuations, not because there is anything structurally wrong with these companies but because of the short-term economic slowdown – which is likely to start improving due to reasons.

One of the issues that have baffled policy-makers and markets alike has been that in spite of significant decline in growth, inflation has remained very sticky in India. Supply constraints in coal and other minerals are unfortunate as we do have good domestic reserves. So, this is one area that the government needs to get its act together and galvanize growth and capacity additions, by speeding up clearances, passing the necessary legislations on land acquisitions, etc. and basically getting the momentum going on this front.

FDI inflows are to some extent important – opening up of more sectors will be good for the economy, but we’ll have to wait and see how much action we can get on this front. But I don’t see any policy hurdles or contentious issues surrounding a further push in infrastructure which can ease supply constraints. So that is one easy low-hanging fruit that should get priority from the government in my view.

Greece has opted for a pro-bailout government. Earlier, even Ireland by referendum had ratified austerity measures. This is despite their high unemployment problems. I think their election results also may be reflecting their electoral characteristics of having relatively older age populations, where the people worried about de-valuation of their wealth and economic turmoil resulting from Euro exit outnumbered the people impacted by unemployment. So, as of now, it looks the Euro is set to survive in its current form, removing a key uncertainty facing global markets.

At this juncture market valuations have de-rated over the last few years because of our GDP growth expectations coming down from 8-9 per cent to 6-7 per cent. With the markets underperforming since so much time, understandably, valuations are also at multi-year lows of just about 12 times FY2014 earnings. But time-tested wisdom tells us that it is in such times that equity investments can give handsome long-term returns.

We remain optimistic that India can deliver a 7 per cent GDP growth in FY2013 and FY2014. In the present scenario it is recommended that investors take this opportunity to invest in high quality companies, especially those who are leaders in their respective sectors or belong to high-entry barrier businesses, such as the ones that I have described above. In times like these, when market sentiments are weak, these are the kind of stocks that become available at really cheap valuations, making them ideal for adding to ones long-term portfolio for healthy returns.

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Ambareesh Baliga

We are almost 15-16 per cent cheaper than trailing 12 month average PEs; thus purely on valuation outlook, it looks to be a comfortable time for investing in the markets, but flows will not happen till one sees light at the end of tunnel. International issues have been weighing on our currency thus affecting our markets. Though the news from Greece has provided some relief, the global environment continues to undergo pain. We have only pushed the inevitable a bit further. Closer home we still have an economy which is growing faster (albeit slower than earlier) than the rest of the world, the flows can restart if we are able to put our act in place especially on the policy front. There is enough pressure from within as well as outside for the government to break the inertia as we are currently in a ‘do or die’ situation. Also if the incumbent government is serious about it’s attempt to come back in 2014 elections, it needs to act now. The presidential race has resulted in changing political equations. With the dependence of the government on TMC reduced, UPA II would be in a better state to withstand political compulsions. Also with less than two years left till the 2014 elections and the amount of criticism faced by UPA II for policy paralysis; the government is expected to push through some of the reforms such as FDI in retail and aviation signaling an end to the policy paralysis juggernaut, thus building hopes for reforms in pension, land, DTC and GST.

Corporate earnings for FY12 were mostly in line with market expectations with a few disappointments.

The season of downgrades may continue for some more time as the Q1FY13 could report some pain in terms of earnings. Corporate profitability is currently affected by problems on the economic front such as high interest rates, depreciating rupee in turn resulting in high commodity import prices and policy inaction by the government. Though currently offset by a depreciating rupee; most of the factors like metal, oil and other raw material prices have corrected, which could support corporate profitability if rupee were to appreciate. Hence the rupee reversing its trend could be the biggest trigger and this would happen if the government acts fast to bring back the confidence.

We expect the export-driven sectors such as Pharma to perform better in the first half of FY13 on the back of depreciating rupee. Also the policy action and subsequent thrust on Infrastructure should kick start the sector along with capital goods, banks and automobiles. A lower interest rate scenario will be a further trigger.

Indian markets are trading cheap. The global economic uncertainty notwithstanding, factors to look out for are inflation, monsoons, crude prices, currency and Government action. We are in a vicious cycle of high inflation – depreciating currency – high interest rates – low profitability. The only way this can be broken is through policy action. Those who are skeptical should look at the first signs of reforms process to buy and for others who belong to my camp, I would suggest to utilise any “adverse news” to increase their equity exposure. Any positive surprise on the parameters mentioned above could lead to a better outlook for investors.