Indian equity markets have rallied by more than 30 per cent in the last one year. FIIs have invested more than $13 billion so far in this calendar year. Domestic investors are back with equity mutual funds receiving record flows in last six months. Equity capital raised by India Inc so far in this financial year has already exceeded in what was raised over the last financial year. Equity returns have been driven to a lesser extent by the earnings expansion and to a greater extent by improvement in price-to-earning ratio or expansion-in-valuation multiple.
Small cap index has delivered almost triple the return of large cap index and mid cap index has given almost double the return of large cap index in the last year. Many investors, especially ones in retail, feel left out as equity returns have zoomed past other asset classes returns.
Most global strategists see India’s GDP growth picking up, inflation coming down, the interest rate softening and corporate earnings growth accelerating, They are recommending India as a must invest/overweight destination. This is partially driven by the fact that other emerging markets like Russia — due to Ukraine crisis and governance related issues, China — due to slowing growth and credit concerns and Brazil — weaker macros and current recessionary situation have to sort out their problems before investors can participate. All this peers are trading at a significant valuation discount to India. Brazil is trading at about 33 per cent discount , Russia at about 66 per cent discount and China at about 50 per cent discount to Indian valuations on a forward basis. In some sense Brazil, Russia and China are at Udipi Restaurant pricing / valuation whereas India is at a five-star Restaurant pricing/valuation. Clearly, Indian delivery in terms of earnings and governance standard have to be much superior to other peers to justify premium valuation. From a flow point of view while US Fed has officially withdrawn quantitative easing, Japan and Europe will continue to provide easy liquidity. As the experience of Japan suggests, revival of economy through monetary stimulus is like riding a tiger — easy to start but difficult to stop. The developed economies at the current level of consumption will not be able to grow rapidly. The monetary stimulus will find its way into emerging markets where growth is superior and valuations are reasonable.
Indian economy is today in a sweet spot. Lower commodity prices, especially crude at $85 per barrel have given significant boost to the economy in terms of lower trade deficit , lower petrol subsidy and lower inflation. Diesel deregulation, albeit at lower oil prices, has given confidence to the market on reforms push. Drop in commodity prices is bringing inflation both at wholesale as well as consumer level to RBI’s comfort zone. Softer inflation has created room for policy rates to come down despite potential rate hikes in US. Market yields have already started discounting softening policy rates. Even FIIs have joined the party with more flows in debt market this year than in equities.
Lower oil subsidy has eased burden on fiscal deficit. The Centre now has more funds at its disposal to invest in capital assets, health care and in the education sector. This, along with proactive decision making, can push growth to a higher level. The market is expecting the government to take appropriate reforms measures to accelerate growth.
However, there are significant challenges ahead. Local entrepreneurs are struggling with the high price of land, low productivity of labour, high cost of capital, high cost of power, poor infrastructure, multiple regulations and delayed approvals. Debt funded investment boom of last few years in sectors like power and real estate has now reached its logical end with stress building up in the banking sector. The market expects the government to ease the land acquisition process and allow speedier acquisition of land at affordable prices, draft flexible labour laws, build a supply of skilled labour force, reduce interest rates, create a regulatory environment which facilitates commerce like introduction of goods and service tax, time bound approvals, lesser discretionary power in enforcement of regulation, clear cut policies for use of natural resources and build infrastructure to facilitate trade.
Indian equity markets have been rerated and now trades at a significant premium compared to its BRIC and emerging market peers. Now the return from the equity market is likely to come more from corporate earnings growth and less from the rerating or valuation increase. The difference in valuation of small, mid and large cap stock is lot narrower compared to historical average. The big outperformance of small and mid cap stocks last year is unlikely to get repeated.
It is likely that in the near term large caps will deliver better risk-adjusted return than small and mid caps. Cyclicals and financials have outperformed market and defensives like FMCG, pharma and tech in the last year. Going forward, sector rotation and stock selection is likely to drive outperformance. Many of the stocks with high valuation will under perform stocks with moderate valuation but delivering better corporate performance.
There is almost a consensus that Indian equity is in a multi-year bull run like in 2003-2008 period. Improving economic fundamentals, India’s positioning among emerging market peers, global liquidity levels, low level of local equity ownership, government’s commitment to push reforms and most importantly just around historical average valuations gives comfort that there is limited downside in the equity market and every dip is a great opportunity to invest in the market. However the journey of equity market in the coming weeks will not be immune to volatility. There will be a roller coaster ride of usual ups and downs. We are trading at a premium valuation and hence there is expectation of top notch delivery on revival of investment resulting in better GDP growth and higher corporate earnings. At life time high level of market in terms of indices, (not in terms of valuation) small disappointments can create disproportionate impact. Such correction will provide great opportunity to go overweight on equities.
Retail investors should do regularly invest in large cap stocks or mutual funds. They need to behave as investors and not traders. They have to invest in equity markets even though they missed last years rally. They need to have long term investment horizon rather than get deterred by short term corrections.
– NILESH SHAH
(The author is MD & CEO, Axis Capital)