There is much fascination around the levels of the Sensex and the Nifty. The two markets are today near their highs and the general belief is that the markets are expensive, have moved up too sharply and should correct, going forward. Around two months back we saw a series of reports from FII brokerages projecting the Nifty to be at levels between 5,600-5,900 a year from now. The actual market move has taken most people by surprise. I still believe that the markets are cheap and will give strong returns over the long term. There are three main reasons for it.
The market capitalisation-to-GDP ratio is near the lower end—the value of the companies listed on the stock exchanges will always have some relationship with the total output in the economy. Ideally, as the economy grows the market capitalisation will also grow. However, these moves tend to be in cycles; where there is a cycle of huge gains, where this value goes much higher than that can be justified, and then there are cycles of loss in value. The market capitalisation of companies on the BSE peaked out in January 2008 at a level of Rs 75 lakh crore. In that year the GDP of the country was Rs 50 lakh crore thus giving a market cap/GDP ratio of 150%. Incidentally, when the move started in the year 2003 this level was as low as 45%. Over the last five years the GDP of the country has grown and the estimates for this year are at Rs 112 lakh crore. However, the overall market capitalisation stands at just Rs 68 lakh crore thus giving a market cap/GDP ratio of 60%. Now if we break down the drivers of the markets in the current up move they have been largely stocks from the FMCG, IT and pharmaceutical industries. The move in the IT and pharmaceutical industries has been largely due to the export market, as most of their profitability comes from there and as such has not been driven by the domestic economy. Today in the Nifty these companies have nearly 40% weightage. The rest of the market has largely underperformed. On the other hand if we take most developed markets like the USA, Germany, UK, etc the market cap/GDP is today above the levels of 2007 despite these economies not doing very well in terms of growth. As such the nominal levels of the indices have little meaning. The overall market capitalisation is today trading near the lower end of the historical band. There are cycles of euphoria and despair and we are more near despair levels today.
Profit margins of companies are depressed—now one of the reasons for a compression in the market value of companies has been depressed profitability. Contrast this with the sharp move in the markets of countries like the USA despite slow economic growth.
The profit margins of companies in the USA are today 40% higher than the last 30 years average. The drivers for this have been low growth in wages due to high unemployment and low inflation, record low interest rates which have cut down the interest expenditure of corporate hugely over the last five years as well as stable to low input costs for companies due to the global slowdown. This lends credence to the saying “markets are a slave of earnings”.
But the reverse has been true in India. Higher inflation has led to greater demand for wages, input costs have been high for companies despite the prices being down globally due to rupee depreciation and high interest rates have eaten into the earnings of companies. This has also combined with a significant slowdown in the economy because of which the operating leverage of companies has also gone down. The good thing, however, is that most companies have been using the downturn to become leaner and as such when growth picks up the improvement in profitability will be sharp. Although statistics on profits-to-GDP are not readily available, the net margins data gives a good picture.
Growth and governance discount
The other factor that has kept the markets cheap has been the growth and governance discount. Growth in the economy is at a ten-year low. Now what low growth does for a company is that it reduces its price-to-earnings ratio. Similarly, low growth in the economy will also reduce the value of the companies listed on its stock exchanges. As the growth in a company picks up and the trend of growth becomes faster, normally the P/E ratio also expands. Similarly for an economy as the growth picks up, the valuation will also pick up.
Another factor has been the governance discount. The federal government has not been able to take many growth supportive steps over the last three to four years. Various corruption scandals have shackled the government and the lack of decision making has hit the previously high-growth segments like roads, power etc. Similarly, on the central bank front there has been a credibility gap that has built up over the tenure of the last governor. I have always believed that “A smart central bank is much more important than a smart government”. With Raghuram Rajan coming as the RBI chief we now see some confidence and credibility come back for the RBI. The key will be to see what kind of government we get next year.
Positive changes in the RBI and a stable central government will lead to a revaluation of the markets. A part of this revaluation is already evident as the markets have started to build in the possibilities of a more progressive government next year.
I believe that the Indian stock markets have been held up due to various factors. Most of these are looking to reverse, going forward. The last six years have been of suboptimal returns from equities, the next five could be very different.
The author is a Mumbai-based fund manager