Equity Strategy: Comfort on uptrend

Updated: Sep 1 2014, 07:36am hrs
Returns of Indian equities have largely been driven by earnings growth over the past 15 years. In contrast to this long-term trend, this year has witnessed a 27% return, of which 19% is due to multiples expansion. While this could be due to raised expectations on the back of a change in Indias political leadership, we believe that positive earnings momentum is required to sustain these returns.

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Indian markets not expensive yet: Despite a 27% YTD (year-to-date) return, the forward P/E (price-earnings) multiple of the BSE-100 index is 16.5, modestly above its 10-year average. Other valuation multiplesincluding P/B (price-to-book ratio), EV/Ebitda (enterprise value/earnings before interest taxes depreciation and amortisation) and Price/Sales also indicate the markets are not expensive compared to their 10-year history. Further, the P/E premium of MSCI India (Morgan Stanley Composite Index) over MSCI World is currently at 10% compared to the past 10-year average of 14%.

Returns in CY14 largely led by expansion in multiples: Expansion in P/E multiples has contributed to 19% (out of total 27% return YTD) for the BSE-100. The contribution of forward earnings growth has been lacklustre at 7%. Analysing the past 15 years of market performance, we note that years of multiple expansion usually have stronger earnings growth than what has been seen in the current year.

Earnings remain the key driver: Our analysis indicates that over a 15-year period, earnings remain the biggest driver of market performance, not only at the index level but also for sectors.

Early signs of improvement give us comfort: Bloomberg consensus forecasts for the Nifty suggest EPS (earnings per share) growth of 16% in FY15 and 17% in FY16 post an insipid 9% in FY14 and have exhibited positive momentum in past three months. Economic data is also positive with a strong improvement in IP (industrial production) and an increase in auto sales growth. While we believe that markets could correct in short term, positive earnings momentum and strengthening economic data give us comfort on the medium-term uptrend.

Over cycles, Indian markets have been driven by earnings: When we look over past cycles, we see that Indian markets have largely been driven by earnings. Looking at the two seven-year cycles in the past 15 years, we note that the returns were completely driven by earnings growth with a rather minor contribution by change in valuation multiples. This is also largely true for most sectors.

Index returns are closely tied to earnings growthIndex (BSE-100) returns over cycles in India in the past 15 years have been almost completely driven by earnings. In the CY99-06 cycle, of the total returns at a CAGR of 28.6%, 19% was generated by earnings growth. Over the CY07-13 cycle, earnings delivered a c12% CAGR compared to market returns of c8%.

this has also been the experience with sectors: We note that this trend has largely held for the sectors as wellnotable exceptions are Financials and Telecom which witnessed significant multiple expansion over the CY99-06 period. Both these sectors underwent significant transformation during this period. In Financials, credit costs for the banking sector structurally declined and private sector banks, which attract higher valuations, gained market share. In telecom, a slew of policy reforms led to rapid growth in the telecom space, leading to a sustained increase in valuation multiples.

Barclays