…AND IS NOW HEADED TOWARDS A SUPER BUBBLE
The Indian market has a history of mini-corrections (of ~20%) once it has reverted to mean . Whilst there are some factors which in the current environment could create such a mini-correction , the balance of risks points towards the emergence of a large bubble:
• There are very few large stockmarkets that appear as attractive as India at present. Given the country’s low export dependence and high domestic savings, it is perhaps the only large economy which is not going to be meaningfully held back by the deleveraging process in the Western world.
• At 38%, India’s savings ratio is the highest in the world after China but only 3.5% of India’s total savings enters the stockmarket. Even if this ratio rises by a mere 50bps over the next 12 months, another $15 bn of domestic capital could enter the stockmarket over and above, say, another $10 bn of net foreign inflows (average figure for FY04-08). With earnings growth close to zero at present and with economic growth likely to stay at a modest 6.5% for the next 12 months, such inflows of capital into the stockmarket are likely to create a valuation bubble.
• As is well known, the Indian market has poor liquidity (ADV 0.28% of market cap vs 0.53% in Japan and 0.64% for China). This makes it very susceptible to rapid run-ups even when if only modest amounts of capital enter the market.
• The Coppock Indicator, a measure of how sustainable a recovery is, points towards a long rally ahead for the market . Going forward we will continue to focus on free cashflow valuation rather than fiddling our models to chase stock prices. However, we will also give investors our understanding of the relative strength of companies’ franchises and of relative valuation so that those who need to ride the bubble can also derive value from our fundamental research.
THE BROADER ENVIRONMENT POINTS TOWARDS A BUBBLE
Very few markets appear as attractive as India : The global slowdown has decimated economists’ growth forecasts . However, some economies have shown resilience on the back of their low dependence on exports and high domestic consumption. India is one of the few such countries which are expected to grow strongly (~5%) in CY09 on the back of its low dependence on exports (21% of GDP). Although India is trading at a premium to other emerging markets (such as Brazil and Indonesia), relative to the only other major economy which has growth comparable to India i.e. China, India is trading at a significant discount on a forward PE basis.
More capital is highly likely to enter the Indian market : The volatility of the S&P 500 Index (measured by the CBOE VIX Index) is a major driver of FII inflows into India. One possible reason for this correlation is that as volatility decreases in their home market, the appetite of FIIs invest in the more volatile markets like India increases. The VIX Index has come down in the recent months and $6.2 bn of FII capital has entered India over the last two months. Moreover, out of India’s total annual savings of ~$395 bn in FY08, only ~3.5% came
into the equity market. However, over the last four years Indians have increasingly directed a higher share of their savings into equities (3.4% in FY08 vs 0.6% in FY05; see Figure 4). This trend is highly likely to continue because of rising income levels (per capita income expected to grow at a CAGR of 5.3% during 2005-25) and favourable demographics (60% of population < 35 years). Supposing equity investments as a % of savings double from 3.5% to 7% by FY12, that would bring average annual flows of $25 bn into the equity market over FY10-FY12. The fact that sort of quantum of domestic capital is waiting in the wings, clearly plays on the minds of professional investors in the Indian market.
The Indian market is illiquid and hence the impact of new capital is magnified.
The Indian market is one of the most illiquid markets amongst the major stock markets in the world because of its low free float . The lower liquidity in the Indian markets leads to a rapid run up in prices whenever new money comes into the Indian market eg. the 53% rise in the Sensex in FY10 on account of $6.2 bn of net FII inflows in YTD FY10. Hence if foreign and domestic capital continues to enter the market along the lines highlighted above, it is almost inevitable that we will see a super bubble emerging.
WHAT COULD PREVENT A BUBBLE
The Indian market has a history of minor corrections once it has reverted to mean. There are a few factors which in the current environment could create such a mini-correction. We list these below and then highlight why these risks are relatively muted at present.
Lack of economic reform
Since 9th March 2009 MSCI Emerging Markets has risen by 63% whereas the BSE 100 has risen by 92%. This extra 29% surge in the Indian market is arguably due to the decisive result in the April-May 09 elections which has generated numerous broker notes highlighting a “paradigm shift” in Indian politics and an “inflexion point” in the Indian economy. The argument that the optimists make is that with a near majority in Parliament and with the Left no longer in the ruling coalition, the Government can now pursue economic reform unhindered by Parliamentary mathematics.
This optimism could be premature given that:
a) Opponents of economic reform in India (from trade unions, the beauracrats, the shopkeepers’ trade bodies, etc) are alive and kicking.
b) With the Left not being part of the Government, it has every incentive to block economic reform through protests, strikes and other disruptions.
c) The latest Cabinet does not contain many politicians (other than the 3-4 longstanding champions of reform) whose names one would automatically associate with economic insight and reform. If the current unbridled optimism regarding economic reform proves to be unfounded, a 20-30% correction could well be in order. The 2nd July Budget will be the first test of this Government’s reformist credentials.
Credit availability in India
As per simple measures of liquidity, there is an abundance of it in the Indian market with money market conditions being benign and with banks parking ~Rs.1.2 tn with the RBI in its reverse repo window. However, the longer end of the market is yet to witness firm signs of revival. In sharp contrast to the trend in the equity markets, where mid and small caps have outperformed the large caps, news reports have surfaced of revival of credit only to the large corporates with the tap yet to be opened to small and medium sized companies. This is reflected in the continued decline in overall credit disbursements of the banking sector.
In the absence of a broad based recovery in disbursal, it is unlikely that there will be a sustained recovery in capex and hence in industrial production.
All of that being said, our latest discussions with bankers suggest that, partly due to Governmental pressure and partly due to a recovery in underlying liquidity, credit growth is likely to edge up from the current 15% to around 20% over the next six months.
Return of risk aversion in the western world
Looking out over the next 12 months, by far the biggest risk is a slower-than-expected economic recovery in the developed world which will then increase the risk aversion of FIIs and could lead to capital flight from India. Capital Economics, an independent economic forecaster based in the UK said on 8th June, “The big picture is that we expect the recent rebound in risk appetite to be sustained over the summer, but then to fade towards the end of 2009 and beyond as the strength of the economic recovery disappoints.”
Like Capital Economics and other forecasters, we believe that the macroeconomic newsflow from the Western world in H2 CY09 will continue to be positive largely because of the strength of the fiscal and monetary stimulus injected over the past 12 months. Hence whilst for the next 3-6 months, the skies look relatively clear, beyond that there is a distinct possibility of the VIX rising again and FII fleeing India again.
Too many capital raisings could dampen investor appetite
There has been a flurry of QIPs (private placement of shares with qualified institutional buyers) in India in the recent past and as many as 32 companies have joined the queue, hoping to raise a combined $8bn through QIPs. The amount will be the highest since 2006, when the market regulator allowed promoters to raise money
through QIPs for the first time.
In the last week alone, as many as 14 companies have announced their plans to raise money through QIPs. However, the sharp increase in the share prices of some of these companies in the last month has complicated matters as a pricing disconnect emerges between promoters and investors.
SO WHAT DO WE PROPOSE TO DO?
Cashflow based valuation will continue to underpin our research. Whilst in years like FY08, the Indian market tends to lose sight of fundamentals, years like FY07 – when strong companies clearly outperformed weaker ones – tend to be norm. So for us to revert to other/newer valuation metrics would be foolish. However, in light of the market’s tendency to pay less heed to fundamentals in a bubble, in addition to our fundamental valuation, we will highlight more clearly in our research:
a) the relative strength of a company’s franchise; and
b) relative valuations.
This we hope will allow clients who need to ride the bubble, greater ability to use our research for investment decisions.
The charts below contain our first attempt in this regard:
– The vertical dimension in these charts differentiates between companies based on whether they possess sustainable competitive advantages (eg. brands, intellectual property, strategic assets such a licenses, an “architecture” which allows them to constantly innovate, etc).
– The horizontal dimension focuses on valuation. As one would expect, if we use relative valuation, rather than absolute valuation, we would be able to justify “Positive” recommendations on many more stocks!
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