Equity outlook: Despite run-up, Sensex valuation close to long-term average

The run-up to the 2014 general elections has been an exhilarating experience. The timing is opportune. With the world emerging from the backdrop of a financial and economic crisis, India looks to reclaim the era of high economic growth and exploit its rightful potential on the global economic stage. The strong results of the recent elections have shown the decisiveness of the electorate to vote for a constructive change in development and governance. This will enable the new government to take policy decisions without the constraints of coalition politics and assist a speedy repair and adjustment of our economy.

In the medium term, the ruling coalition's focus would be on nation building. The manifesto talks about various reforms and a development agenda; the key will be taming inflation and reviving the investment cycle. The new government hopefully understands the structural nature of inflation and will take steps to address supply-side constraints, to anchor inflationary expectations at lower levels. Measures such as altering the APMC law and releasing excess buffer stocks of foodgrain are expected to address food inflation worries. With currency stability on the back of an improved trade deficit and influx of foreign capital, depreciation-induced inflation becomes a thing of the past. A continuously prudent fiscal consolidation would further reinforce the moderating trajectory of inflation.

The government is likely to take swift actions to unbundle the policy logjam and recalibrate the current (work in progress) investments. As policy unbundling happens and investor sentiment improves, companies would be able to access markets and raise capital to repair their balance sheets. The capital raising cycle will help fund additional projects and augment existing and stuck projects. Over the medium term, the road map for large-size longer term investment remains a key for fostering sustainable economic growth. Based on its manifesto the NDA coalition is likely to focus on urbanisation, surface transport, a comprehensive energy policy and large-scale industrial clusters. As we see investment unclogging and fostering the longer term investment cycle, it would create a foundation for stronger economic growth.

The equity markets have run up both before and after the election. Despite this, the Sensex is at a one-year forward price to earnings valuation of 16.5 times, just above the long-term average. Expectations from the new government are high and there might be a risk of under-delivery in the near term. However, many investors, domestic and foreign institutional ones, have still not been able to participate, and the liquidity which could flood the market might not provide the meaningful correction most investors expect. Hence, it would be advisable to look at the long-term opportunity for wealth creation and participate before the market becomes irrational.

As the economic cycles turn favourable, revenue growth tends to accelerate, margins to expand and corporate profits to rise. We are at the beginning of an expanding growth environment, which can take the exit growth rate close to eight per cent annually at the end of five years (average 6.5 per cent annually during the period). This can translate into annual revenue growth of 15-17 per cent (in the previous cycle of 2003-08, revenue growth was a little more than five per cent above nominal GDP growth) and earnings growth of 18-20 per cent annually over the next five years.

Equity returns should track earnings growth and could be even higher if valuation multiples expand, as confidence on future earnings growth improves. In a scenario where economic growth is recovering, sectors linked to the domestic economy such as banking and financial, capital goods and consumer discretionary products stand to be primary beneficiaries.

The author is co-chief investment officer (equities), Birla Sun Life AMC