Few doubt the economy is on a roll. What's important is the impact on the market once profits fall with the huge capex and higher interest rates.
Manish Sonthalia,
Market Strategist and Portfolio Manager, Motilal Oswal Securities
The markets look expensive and scary, but there has been a fundamental shift in corporate profitability, and more important, this is sustainable.
With 28 per cent growth in sales and a 48 per cent hike in profits, Q2 earnings have been better than expected. On average, corporate India should see profit growth of over 20 per cent in 2006-07.
The rally from a low of 9,875 to a level of 13,200 has seen the Sensex give a return of 34 per cent. However all stocks have not participated. Many mid cap and small caps are still languishing. The rally has been a "smart" one in the sense that only performance has been rewarded and we will see this trend going forward as well.
In the fourth year of bull run, a figure of 13,000 plus on the Sensex does make the markets look expensive and scary but there has been a fundamental shift -- corporate profitability which has ranged between two and four per cent of GDP has moved to 5 per cent and beyond.
A nominal GDP growth of 13 per cent is seeing a 20 per cent plus growth in corporate profits. Given the momentum, this can be sustained.
India remains a higher valuation when compared to other emerging markets. On a PE basis we are at 19.5x FY07 and 16.5x FY08 earnings. One reason for this is because we have the software sector with very low book values and commanding high PE multiples.
The higher book values and higher price earning multiples can be sustained. It is the composition of the market and the companies therein which make it look expensive. We have more secular business than in other emerging markets, which have more of commodity companies.
It also helps that India is more of a domestic economy than an export-led economy and hence is less vulnerable to a slowdown in the US. About 65-67 per cent of our GDP is because of domestic demand.
However, if things do become severe in the US, equity as an asset class would become less attractive An out flow from equities could be expected from the developed markets and if that happens, foreign funds would definitely not be interested in looking at emerging markets like India.
Even though the markets have risen very sharply, they do not seem to have any scam element in it. The surveillance and monitoring of SEBI and the stock exchanges is very strong. Corporate governance standards are also getting better.
Even though the outlook seems good, one needs to be cautious. Negative surprises could come from unknown things and things one never thought about. Inflation remains the biggest worry and could be the only single reason for the rally to end.
The RBI could tighten liquidity in the system to curb inflation. There are big ticket IPOs in the offing which could suck out a good amount of liquidity from the markets. After all, one of the key prerequisites for a bull market to thrive is good liquidity.
Naresh Kothari,
Head of Institutional Equity, Edelweiss
Lots can go wrong in a 3-15 month period. PEs are already very high, the huge capex along with higher interest rates will lower profitability.
An economy that is growing at more than 8 per cent per annum, is constantly threatening to go even faster. A corporate sector that is growing at over 15 per cent yearly and is showing a confidence never seen before -- to the extent that doing billion dollar acquisitions, almost overnight, now seems to be the norm.
A young population that is spending as if there is no tomorrow . . . it's difficult to not be bullish. On a three to five year horizon, we too believe that the structured growth of the Indian economy will continue and domestic consumption, infrastructure, outsourcing and agriculture will be the key factors that will drive the markets to 20,000--25,000 levels.
Over the next one to three months, the market has the potential to attract larger and larger capital, especially one that is seeking momentum and therefore sustains itself. It is in the intermediate term -- 3-15 months -- where we believe there are reasons to be cautious.
Though Q2 results were better than expected, we believe the markets have factored most of it. The Nifty is currently trading at a PE of 21.5x, having crossed the all-time high level of 21x in March 2004.
The Nifty is trading at a 50 per cent premium to the average emerging markets' P/E multiple. This significantly increases the risk in the event of an external shock or any earnings disappointment.
Additionally, there is the substantial capex that the Indian corporate sector has incurred in the recent past. Current investor expectations are that higher capacity addition automatically equals higher profit growth. However, such large capacity additions take time to get absorbed. Most companies that have been operating at close to 100 per cent capacity levels will, over the next few quarters, see their operating leverage reduce and this, coupled with higher interest rates, may lead to slower profit growth, impacting return ratios in the intermediate term.
Another aspect is the supply of paper that one typically sees in a bull market. Although the Government has been absent in this role this time around, significant supplies from sectors like real estate and energy can cap valuations.
Other than domestic factors, any slowdown in the global economy could also spoil the party. Although India is relatively insulated, the May collapse was triggered by a global meltdown. Any negative news on the recent huge spate of foreign acquisitions could make investors cautious and thus, impact valuations of acquiring companies.
We advise investors to stay in partial cash (10-15 per cent) and wait for sharp dips in the markets before considering further investments. We also recommend adopting an active portfolio management strategy with sector rotation and bottom-up stock selection as the differentiators for performance.
The views expressed are personal.
