India's premium to emerging market peers at 15-month high

Sensex trades at 17.2x its one-year forward earnings compared to 12.2x of MSCI EM index

The valuation premium commanded by the Indian market over the MSCI EM (Emerging Markets) Index, a gauge for the performance of developing-nation equities, has hit a 15-month high. According to Bloomberg, the benchmark Sensex trades at 17.2 times its one-year forward earnings estimate (higher than its long-term average of 15.5 times). In comparison, the MSCI EM index trades at just 12.2 times. 

In other words, the Indian market is 41 per cent more expensive than the emerging markets basket. The Indian market has traditionally traded at a premium to the EM index; however, the gap has widened to the highest level since January 2016. Notably, the Indian markets had plunged 12 per cent between January 2016 and February 2016.

Both the Sensex and the MSCI EM index are up around 10 per cent each so far in 2017, indicating that the increase in premium is largely on account of muted earnings outlook for Indian companies relative to other EM peers. 

In a presentation to investors, ICICI Prudential Mutual Fund has highlighted that during the rally in the Indian markets in 2003-2008, earnings growth was much higher than multiple expansion. However, the current rally has been led more by multiple expansions than earnings growth. 

“We believe that the valuations are fair. However, as earnings increase, price-to-earnings (PE) can re-rate towards the higher-end. Hence, PE may expand more than its long-term average,” the fund house says. 

Despite high valuations, ICICI Pru MF expects the domestic equities to do well as it expects earnings to catch up.

“We believe investors should continue to remain overweight in equities, as reasonable growth is expected from equity markets over the next two-three years. The returns in equities could be front-ended—returns can come before earnings growth is reported,” it says in a presentation.

Bank of America Merrill Lynch (BofA-ML) in a note said consensus forecasts for FY18 and FY19 are “too optimistic”.

The brokerage expects aggregate profit growth for the Sensex companies in FY18 and FY19 to be around 12 per cent and 14 per cent respectively, while the consensus forecasts are around 16 per cent and 20 per cent. 

BofA-ML says the possibility of earnings downgrades coupled with high valuations make the current risk-reward unfavourable. It expects the markets to remain range-bound in the remaining part of the year.

Kotak Institutional Equities, in a note, says headline valuations still look reasonable because certain stocks such as state-owned banks, commodity companies and utilities — despite high weightage — have low valuations.

“The overall market valuations look palatable but hide super-rich valuations of ‘growth’ stocks and expensive valuations of companies with mediocre business models. It seems to us that the market has largely accepted the high valuations of ‘growth’ stocks as ‘normal’ valuations without questioning the sustainability of the factors that have supported the re-rating of multiples (low global bond yields; the cycle has already turned) and expansion in margins (due to sharp decline in commodity prices),” the Kotak note says.