Chetan Ahya, in his report entitled China and India: New Tigers of Asia, Part III, dated August 13, 2010, argues that India?s growth will accelerate to a sustainable 9-10% by 2013-15, after an average of 7.3% over the past decade. The combined effect of demographics, structural reforms, and globalisation will help create a virtuous cycle of productive job creation, income growth, savings, investments, and higher GDP growth.
There are several examples from history when high growth has not translated into robust equity returns. In our view, for high macro-economic growth to translate into strong equity returns, there are two necessary conditions: (i) a sensible starting point of valuations (i.e., the growth story should not already be in the price); and (ii) the ability of listed companies to translate macro growth into earnings, which, in turn, needs discipline on equity capital supply or, put another way, reasonable ROE (return on equity.)
India seems to score well on both counts. On various valuation models we use, the long-term growth that seems priced into Indian equities is tolerable. Our residual income model implies that the equity risk premium is around 6% (implying a long-term rupee return from equities of around 14%, using the 10-year bond yield at 8%). The regression of historical P/E and P/B (price-to-earnings and price-to-book) multiple to long-term equity returns suggests similar outcomes, and so does a regression analysis on the value assigned to future growth.
In summary, valuations are offering equity investors an acceptable level of equity risk premium.
The ROE debate: The cyclical pressure on ROE is quite evident. The MSCI Index ROE has dropped to its decade-low, driven down by a fall in net margins and asset turnover. No doubt, India?s nominal ROE will fall over the long run as long-term interest rates decline (with the progress of time, the potential growth rate falls, and with enhanced productivity, inflation expectations should also drop). However, the excess ROE over interest rates will likely remain intact for some time to come. Our arguments are: (i) GDP growth, industrial growth and earnings growth correlate well in India?a higher growth should translate into earnings growth; (ii) balance sheets are under-levered lending upside surprise to ROE?Indian corporations have historically exhibited good discipline on raising equity though easier access to global capital flows is the downside risk; and (iii) India?s growth dynamic—including its balanced economic model?is lending itself to lower cyclicality in earnings as we have seen over the past ten years. All in all, Indian companies may experience a decline in nominal ROE, but the spread of ROE over long-term interest rates appears to have a good case.
An additional factor that helps is the structural liquidity story: The side-effect of the demographic dividend is the structural liquidity story. As domestic savings rise, a younger population will likely take more risk with its savings, causing higher flows into riskier asset classes like equity shares. The flow of savings into equities is supported by a strong capital market infrastructure. The starting point on capital markets is a good relative to the physical economy, i.e., the financial economy seems more well-developed than the physical economy.
For now, we do not believe that long-term returns from Indian equities are likely to move significantly from recent trends?the trailing 10-year CAGR (compound annual growth rate) in returns is 14% in rupee terms. The valuation and ROE levels should be watched closely.