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As the Indian equity markets scaled a new high on Thursday, the benchmark 30-share BSE Sensex — which was trading below its average historic valuations for most part of last two years — came within touching distance of the aggregate barometer.
The benchmark is now priced at 15.9-times its one-year forward earnings, as per Bloomberg consensus data, against an average of 16.1 for the last nine years. As a result, Indian equities stand at their highest relative valuation to their EM counterparts since February 2011, shows the P/E ratio of relative MSCI indices.
However, it would be interesting to see how long this convergence holds true, given that valuations in the last five years were largely driven by a weakening trajectory of India's GDP growth and moderating earnings growth of India Inc.
In the last one decade, Sensex earnings grew nearly 2.5 times India’s annual GDP growth. During the five years ended fiscal 2007-08 — when India's economy, on an average, grew 8.7% per annum — the earnings growth turned particularly strong at nearly 24% a year.
However, in the subsequent five years ended FY13 — when the mean GDP rate came down to 7.2% — the average earnings growth stood at about 9%.
Last week, BNP Paribas upgraded India to “overweight” from “underweight”, playing on the improving macros while waiting for elections. It also acknowledged an improvement in India's earnings environment with Sensex consensus earnings estimates seeing a 2-3% upgrade in the last few months. BNP currently sees the benchmark Sensex EPS (earnings per share) for the fiscal 2015 at R1,554 against R1,478 at the end of September 2013.
As such, a further expansion in valuation will also depend on rising hopes of a favourable outcome of the 2014general elections and a bottoming out of economic activity, which are driving the latest market rally. Although a number of headwinds, including high interest rates and lurching capex cycle, besides sluggish earnings growth, loom large, foreign institutional inflows have steadied in the recent past. In the last two weeks alone, FIIs have purchased $700-million shares.
While the benchmark indices continue to realise new highs, the number of blue-chip stocks contributing to the rally appears to be coming off. In December 2013, when the Sensex scaled a new high in three years, as many as 40 Nifty constituents traded above their 200-day moving average (DMA). Currently, only 31 Nifty stocks are trading above this gauge of the long-term price trend.
As per Kotak Institutional Equities, the current prices of quality stocks from the IT, pharma and banking are largely discounting their fiscal 2015 earnings. Hence, investors face a difficult choice between either holding these stocks for FY16 earnings-based expectations or dabbling in a few ‘reform’ stocks in the banking, energy and industrial space on expectations of a good result in the general elections and economic recovery over the next 12-15 months.
“We see limited scope for re-rating of multiples of quality stocks. Most of them are trading well above long-term average multiples, which is relevant in the context of more moderate earnings growth over the next 2-3 years,” the brokerage said in a recent strategy note.