10,000 leagues above the sea! Will we sink?

The Sensex crossing the 10,000 mark has made global news. Fund managers and investors are raising questions about the sustainability of India?s stock indices. Some say that with its current price-to-earnings ratio of 18, which is well above that of other Asian and emerging markets, India?s Sensex is already overvalued and investors need to tread cautiously in Indian markets.

Such analyses do not take us very far, for the simple reason that valuation comparisons across markets have limited relevance. There are no hard and fast rules about valuations and these make sense only when seen in relation to expected returns. It is easily evident that economies that are growing faster than others will have markets with higher PEs than those growing slowly. This is best illustrated by stock behaviour in the Indian market.

Typically, companies that have demonstrated high earnings growth or are expected to realise faster growth in the future are the ones that are traded at much higher PEs than others. For instance, India?s leading IT companies that have shown consistent earnings growth of around 30% or thereabouts, and enjoy a higher PE of 30-plus than leading cement companies, whose PE will be around 20 or less. This does not at all mean that IT companies are overvalued in relation to cement companies. All it means is that the market expects IT companies to deliver higher earnings growth relative to cement companies. Cross-sectoral comparison of PEs in the Indian or any other market is meaningful only to the extent it sheds light on differing expectations about the future growth potential of different sectors.

This is the nub of it. The issue is not whether in PE terms India is overvalued, but whether the expectation of earnings growth being higher here than in other markets is justified. The second issue is whether the list of those willing to buy the India story will continue to expand or will it shrink. That is, would inflow of funds into Indian stocks continue at the pace experienced last year or would it go down? A priori, the answer to both questions is yes.

First, the Indian growth story remains intact and would continue. However, there is a possibility that the 8% GDP growth expected this year could moderate a bit in 2006-07. Unlike in the past, the reason this time round would not be lack of demand. Indeed, India is witnessing economic action across the board, and this is likely to continue. In fact, in some sectors, like infrastructure and construction, the action has just about begun.

What has added to the robustness in this area is the dramatic improvement in the performance of the railways and we can expect some acceleration in investment in this segment, too. Another segment that could add to the momentum in infrastructure this year is power, where one could expect an increase in the pace of investment.

The problem that India may face this year is not lack of demand but of supply. In the mid-90s, India?s growth dipped because of oversupply and excess capacity. The conservatism that bred in terms of creating new capacity is precisely what will constrain growth this time round. In sector after sector, there are signs that capacities are getting stretched.

Even in service sectors, sustaining growth is becoming a problem because of lack of trained people. For instance, even in construction, there is anecdotal evidence that suggests not enough contractors are available to carry out construction orders. Similar capacity constraints are visible in parts of manufacturing. For example, the one reason India has not been able to take advantage of the recently freed global textiles market is lack of manufacturing capacity.

While there has been a substantial jump in new investments, it is obviously taking time for new capacity to become operational. This lag could operate in a number of sectors where creation of new capacities could take some time.

Investors in the Indian market would, therefore, have to assess the extent of topline growth feasible in sectors and companies they find attractive. The capacity issue and the time taken to create it is one of the reasons many companies are now seeking growth through acquisitions. This is one activity inves-tors need to monitor very closely, particularly in sectors where the capacity constraint is getting more pronounced. Overall, there could be moderation in topline growth and this in turn could cap earnings? growth of companies.

But then, more money could be chasing limited earnings and PEs could inch higher. This is because the world has just begun to notice the India story and a fraction of the funds have discovered the taste of India. Many more would enter India, particularly those with a long-term appetite, such as pension funds. Adding to the inflow of funds is that new regions are discovering India. If last year it was Japan and Korea, this year the flood could come from the Middle East.

The more interesting play could be the growing appetite of domestic investors and their discovery of Indian mutual funds. The past three years is the first time Indian investors have tasted stable returns from Indian mutual funds and this is likely to erase bad memories of the losses suffered during the Harshad Mehta and Ketan Parekh episodes. Also, the Indian fund manager has become more mature and is delivering more value to the investor than he did in the 90s.

Fund management in India is still in its infancy and there would be very few managers with more than 10 years experience. One could expect Indian investors developing more faith in Indian mutual funds and we could perhaps see the beginning of a large flow of Indian savings to the capital market. All this augurs well for the market. The Indian story continues to look promising, provided confidence is not shaken by unexpected developments in Iran or in coalition politics at home.

The writer is an advisor to Ficci. These are his personal views