On various valuation models we use, the long-term growth that seems priced into Indian equities is tolerable.
There are several examples from history when high growth has not translated into robust equity returns. In our view, for high macroeconomic growth to translate into strong equity returns, two conditions are necessary: 1) a sensible starting point of valuations (i.e., the growth story should not already be in the price); and 2) the ability of companies to translate macro growth into earnings, which in turn needs discipline on equity capital supply or, put another way, reasonable returns on equity (ROE). India seems to score well on both counts.
Valuations look reasonable
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 5.5% (implying a long-term rupee return from equities of around 13.5% using the 10-year bond yield at 8.0%). The regression of historical P/B multiple to long-term equity returns suggests about 14% returns over the next 10 years. Implied returns using market cap to GDP indicates returns in turn of about 10% during the next decade.
The ROE debate
The cyclical pressure on ROE has been quite evident in recent years. ROE has started coming off decade lows—albeit it is still a muted rise due to the large non-performing loans in the banks. ROE went from its previous high of 22% in 2006 to a low of 12% in 2015, driven down by a steep fall in net margins as well as asset turnover. India’s ROE is likely to rise in the coming 24 months with improving asset turn and a mean reversion in net margins from close to all-time lows. We believe ROE gains will come across the board, with banks likely leading the charge. Indeed, the profit share in GDP is at close to all-time lows, and given the repair work done in the macroeconomy over the past four years, a mean reversion is quite likely in the coming three to four years. This could lead to earnings growth compounding at around 20% over the period.
Domestic liquidity is here to stay
For over two decades, foreign investors have been the largest stakeholders in Indian equities. While that remains the case, domestic institutions have been driving incremental equity demand up in recent years. The key enabling factors to this shift are the DREAM factors. It represents falling age dependency and low risk aversion (as is typical of a young population) on the demand side, combined with macro stability and initiatives to educate investors, as well as progressive regulations, on the supply side.
Demographics and macro stability tend to boost financial saving. And, within that, regulatory changes, education, and rising risk propensity lift equity saving. Government mandate on retirement funds to invest into equities has added to mix. Given the backdrop of these factors, we expect domestic equity mutual funds, insurance, provident funds, and National Pension System to size up and simultaneously drive equity saving over the next decade. The character of the domestic mutual fund industry is changing with demand for equities shifting home as India will remain in the midst of a domestic liquidity supercycle over the medium term, driven by the DREAM factors.
Given the likely persistent bid from domestic investors who are raising equity allocation in their balance sheets, it is quite possible that Indian stocks trade at higher multiples than in the past. In turn, this means nominal INR equity returns could be lower that the trailing performance in the coming decade, albeit with lower volatility.
Edited extracts from
Morgan Stanley report