The remarkable rally in the stock markets over the past few months, fuelled largely by local liquidity, has pushed up India’s market capitalisation to a shade over $4 trillion. So strong is the sentiment that investors seem little bothered about the very rich valuations that stocks are trading at—price-earnings (P/E) multiples of 30x and 40x are par for the course these days and many companies are trading even at multiples of 70x or 80x. With the economy growing at a good clip, and political stability more or less a given for the next five years considering the spectacular showing of the ruling party in the recent state elections, investors believe corporate earnings will keep pace.
The near-frenzy for equities is being driven by prospects of better returns from this asset class as interest rates near their peak both overseas and at home. The average inflows of an annualised Rs 2 trillion into Systematic Investment Plans (SIPs), mostly into equity schemes, are a clear indication of this. Indeed, equities as a share of net household financial assets went up to as high as 14.7% in FY23 from just 4.5% in FY21. Foreign portfolio investors (FPI), for the most part, sat out the rally, and recent inflows have come from higher reallocations to India in the absence, just yet, of a sustainable economic rebound in China. The current earnings yield for Indian stocks is around 3.6% versus a much better 8.8% for China; yet, flows to India remain strong.
As interest rates come down, P/E multiples will trend up further, mainly for large-cap companies that promise secular medium and long-term growth. One reason for this is that the number of such companies today is finite; in a sense, the demand is overwhelming supply. Not too many companies that are capable of generating stable cash flows for five or more years are being created; many new age companies run the risk of being disrupted by the competition and technological innovation. This explains why established fast moving consumer goods players are trading at multiples of 70-80X; investors are confident they will be around for a long time. For the moment, investors are basking in the glory of the India story, which is undoubtedly a promising one.
While valuation multiples are expanding, a true re-rating of the markets would reflect in a higher market-cap-to-GDP ratio of about 1.2-1.3x, up from the current levels of roughly 1.1 x. For perspective, the US market, which is more than ten times bigger than India’s with a market cap of $44 trillion, commands a market-cap-to-GDP ratio of about 1.5-1.6x. But it’s not simply about the ratio. At the end of the day, the economy needs to grow at a faster clip and attain a size of $5 trillion or so. Ultimately, companies must scale up their businesses and generate profits on a sustained basis so that investors have a bigger universe of stocks to choose from. Having clocked in an average growth of about 5.8% in the last 10 years, the economy is currently growing at around 6.5-6.7% or so and should reach $3.6 billion by March next year. For this growth rate to become a compounded 7%, a far bigger quantum of investment and many more entrepreneurs are needed. Critically, it should become easier to do business. Importantly, if somewhat ironically, a strong economy would also call for deeper debt markets.