Valuations may remain relatively more stable than in the past

Written by Devangi Gandhi | Updated: Dec 23 2013, 07:14am hrs
With the economic growth turning relatively strong across the world, the equity market valuations may remain relatively more stable in 2014 compared to last year despite the commencement US Fed tapering believes Manishi Raychaudhuri, Asia-Pacific Strategist, BNP Paribas Securities. In an interview with Devangi Gandhi, he says that even as the RoE of Indian market may improve along with its Asian peers, the current market valuations may already be discounting this rise.

The US Fed has finally commenced on its tapering exercise. What would be its impact on EM equities given that this move was expected since last six months

We believe US authorities have significant degree of certainty about the sustainability of the growth recovery, now that they have started QE tapering. If they had any doubt that the growth recovery is not very strong and sustainable then it is unlikely that they would have embarked on this exercise. However, I dont think that we have too much to worry about the equity market valuations since growth sustainability is the precondition for tapering,

We have observed that in the initial stage of growth expansion, when the US bond yields are growing from 1% to 2%, the Asia Ex-Japan earnings yield actually tends to decline. That is, the price earning multiples or equity valuations expand. In the later stage, when the yield grows from say, 5% to 6%, inflation becomes the driver of this rise and the expansion of P/E (price-to-earnings ratio) multiple stops.

So in the current scenario, when the yield expansion is due to improving growth outlook I dont think there should be increased concerns around the equity market valuations. However, to some extent the kind of volatility that we had seen in mid-2013 could repeat itself. Therefore, countries with high Current Account Deficits (CADs) in the emerging market universe including India, Indonesia, Turkey and Brazil may witness a round of de-rating and market volatility. With the economic growth turning relatively strong across the world, the valuations may remain relatively more stable than in the past.

What are your current portfolio weights on the EM equities

Substantial weight of our portfolio is assigned to North Asia including Hongkong, China, Korea and Taiwan. In the entire Asean regain, we have a significant underweight since we think that the region is relatively more risky. We currently have a small Underweight on Indian equities compared to the benchmark weight assigned to India in MSCI India. However, our underweight is not so severe since we think that the stock selection is relatively easier in India. If you look at the top 25 to 30 companies, they are still generating significant profits. On top of that, another feature of Indian market which is not present to the same extent in other markets is that the profitability of a significant proportion of companies is inversely correlated to the currency. Collectively, revenues of such companies account for nearly 30% to 35% of the frontline indices. However, for us to get seriously positive on India, a recovery in the investment cycle is necessary.

What is your view on the overall macroeconomic profile of India

In case of India, there are two main problems that the country is facing; the external sectorcurrent account and fiscal deficits- and sticky inflation. There have been some key efforts to curtail the CAD but we think the root cause of this is not been attacked yet and we do need some painful adjustments as far as the fiscal side is concerned. Even for handling the sticky inflation, we need a lot of fiscal discipline which, under the current circumstances, is difficult to enact.

Two of the four key GDP components are driving the economic activity in India. Exports are growing significantly on the back of depreciated currency. Secondly, a part of private consumptionthe rural consumptionis growing thanks to significant minimum support price increases and welfare programmes like NREGA. However, the investment has slowed down significantly simply because corporates dont have confidence. Companies that we interact with are still wary of investing in PPP (public-private-partnership) projects. Many of the clearances are not coming out in time while there have been issues with the resource allocations. For this scenario to improve, government decision making is the key variable that needs to change. However, it may not happen till second half of 2014.

Do you think foreign investors would prefer China to India in the coming year given that it has announced some significant reforms recently and the market is trading

The valuation of Chinese market compared to Asia ex-Japan is abysmally low compared to log long-term average while that of the other South East Asian regions are significantly above their historical averages. Indian market is also trading slightly above the long-term average. So, in the near term there is a valid argument behind investing in China and possibly in preference to India.

Having said this, I must also point out that if we consider the basic building block of an economy to gauge the likely growth rates going forward, then it is almost an inevitable conclusion that the Chinese economic growth is going to slowdown.

China for the last two to three decades has been dependent on capital investment for growth generation through. However, this effect is dramatically reducing as visible through the trend in Chinas ICOR (incremental capital to output ratio). It shows that the capital efficiency or the ability of capital expenditure to generate incremental economic growth has declined dramatically. For India, it has happened but to a limited extent as compared to China.

If you look at another key building block of growth, the demographics of a country, within Asia there are only two countries which are likely to have positive demographic dividend over the next 25 to 30 yearsIndia and Indonesia. In these two countries the working age population is going to increase over this period and hence the dependency ratio is going to decline.

What is your view on Indias current market valuations and state of the earnings downgrade cycle

We think that along with the rest of Asia the RoE (return on equity)of Indian market is also going to improve in 2014 as rising global demand may add to the asset turnover of Asian companies. However, the current valuations of India, at 14.5 times price to earnings and 2.3 times price to book value, have already discounted this rise.

The historical valuation of Indian market, (15.2 times price to earnings multiple), captures a very high growth period of 2003-2007 when the RoE ranged between 23% to 27%. I dont think that we are going back to those days in a hurry. We are slightly cautious on the valuations at which the Indian market is trading at. We think that while fundamentally we are past the worst, the current valuations are possibly over discounting those positives.

The consensus earnings estimates for FY14 and FY15 is somewhere between12% to 15%. We think that they are overstated and may come down quite significantly in the next two quarters. If you observe, since FY08, there has been only one fiscal when Indian market witnessed a double digit earnings growth. So, in a year when you are expecting the GDP growth at 4-5% and sticky inflation at 9-10%, the earnings growth has to come down from current expectations.

There is a lot of euphoria on the current account deficit coming down and political vote getting factored in. However, the fundamentals may make us slightly apprehensive about the near-term.

So effectively, the earnings estimates downgrade cycle may not be over yet. While we may be in the last stages of decline in earnings estimates, we are still not through with it.

Have the export oriented stocks run their course given that most of the IT and pharma stocks have rallied a lot and valuations have also expanded

In case of IT, only currency depreciation has been discounted by shares prices but we think demand improvement has not yet been factored in stock prices. So far the Indian rupee has depreciated by 15% on net basis while the valuations of the front-line IT stocks have expanded by 20%. Given that the delta or rate of change in GDP growth for the developed market is upward slopping, indicators like the capex survey by Philadelphia Fed are indicating an improved degree of productivity. IT companies are likely to be top beneficiaries of this change.

How do you weigh the consumption linked sectors given that many companies from the space are trading at high valuations

Indias consumption theme has remained healthy, especially the rural consumption compared to urban consumption. One can play the rural consumption is through tractor manufactures, two-wheeler producers or consumer staples with the likes of ITC. We are very selectively positive on Indias consumption universe and not on a wholesale basis. A very large section of the space is not only overvalued but also faces the danger of earnings downgrades going forward. If you look at the household and personal care companies, they are very big users of soft commodities whose prices have moved up by 12% to 15% in US $ terms during the last three months. It is extremely difficult for these companies to pass on these costs to consumers. As far as the consumer goods universe is concerned we are underweight on the space and like certain companies very selectively.