At a time when the near-term outlook for Indian shares is negative, the 150-odd foreign investors participating in Merrill Lynch’s annual India investors’ conference would prefer to wait and buy stocks at lower valuations. Jyotivardhan Jaipuria, head of India research at Bank of America Merrill Lynch, tells Mehul Shah that sticky inflation, higher interest rates and possible earnings downgrades could drag the Sensex down by five to 10 per cent from present levels. Edited excerpts:
How is the mood among foreign investors who have come to your conference?
Basically, most people like and believe in the India story in the long term. So, everybody is looking for good opportunities to buy. From their point of view, it’s okay — we have to buy India, we want to add weight to India, India is like a five-year story for us – so, how much better valuation can we get? For a lot of people, India has been the worst performing market, year-to-date.
Of course, last year it was one of the best performing markets. Now, it has become relatively cheap from where it was six months ago, which is a good thing. Maybe over the next six months, we will get it even cheaper. There are some people who are starting to nibble into India, saying okay, probably it is the time to look at it, buy a bit and if you get some more pullback, it will offer an even better opportunity to buy.
What is the theme of your conference?
We have titled it, ‘India – going from strength to strength.’ The whole concept is, don’t look at this market for the next two months. It has been falling for the past five weeks and so people tend to lose focus on how GDP is going up and the market capitalisation which is going up year after year after year. In the past five years, India has become a much, much bigger weight in most investors’ portfolios. I think over the next five years, it is going to become an even bigger weight in their portfolios.
Which are the major concerns among foreign investors at this point?
The big focus at this point is inflation. It stems from inflation being very high, which means interest rates will need to be increased. Once interest rates are increased, do we see a slowdown in investments? In consumption? How much of a slowdown? Will the eight-plus per cent GDP growth which everybody talks about become slightly less?
Finally, markets always are driven by earnings. So, it is more like, will all these result in slower earnings? How much slower? Earnings probably will grow very strongly. But, there is pressure on margins because interest rates are going up, manpower costs are going up, commodity prices are going up. So, do these lead to some earning downgrades? Normally, when you have earnings downgrades, historically you have P/Es (price-to-earnings) coming off. That is what people are hoping, that we manage to get P/Es which are lower. So, we can get things cheaper.
At what levels do you think valuations will become very compelling in India?
Just now, we are trading around 15 times (price-to-earnings) one-year forward, somewhere in line with India’s long-term average. This is just around the fair value. The low point for India has been closer to a P/E of 10 and the high point is a P/E of 20. When you get closer to 20, you have to be afraid.
You get closer to a 10 P/E, you don't need to worry. You just go and buy the market. We are somewhere in that middle range.
There are two ways by which P/Es can fall. One is if you have the same index level for six-nine months. That's what I call the time-correction. So, that's possibly what you will have and then you could also have a bit of price correction.
Do you expect severe earnings downgrades going forward?
It won't be severe. Just get into some broad numbers for FY12 of the Sensex companies. We are looking at an earnings growth of around 22 per cent and I think that earnings growth will be more like 16-17 per cent. Typically, these downgrades don't happen in like one quarter. It takes some time to get downgraded. My guess is that over the next six-eight months, we will probably see this five per cent being shaved off from the Sensex EPS (earnings per share) growth.
A lot of analysts are saying another 10 per cent correction is likely from the present levels. Do you think it is possible?
10 per cent (correction) is a possibility in any market at any point of time. There is inflation, which probably will remain sticky. I think it's going to get a bit lower every month, but it's going to be a bit sticky. Interest rates would go up and possibly earnings downgrades could lead to a correction of five-10 per cent. It's always difficult to pinpoint a number to that.
What's your view on the third quarter earnings season so far?
Slightly disappointing, relative to where the analysts were. We were bracing for the quarter, where my view was that we would start seeing margin pressure. I think it is starting to come true. We have seen a lot of margin pressure in most companies. So, the incremental change is probably a bit negative.
Overall, I think analysts have downgraded their earnings estimates after this quarter for most companies, which is a good thing. From a market's point of view, the general expectation is analysts' estimates are too high at the moment and they need to come down. The faster it really comes down, the better it is for the market.
Is the political unrest in Egypt a major risk for the Indian market?
Not such a big risk. The only risk for India would be if the situation leads to a lot more countries in the Middle East starting to have some disturbances. Then it gets into a spiral effect. But it seems now that the Egypt crisis has been contained and not spreading to other countries. In which case, a few months down the line, it would be probably one of those glitches which keep happening.
The trade this year has been that foreign investors are taking out money from emerging markets like India where inflation is very high and investing in developed markets, which are recovering very fast. How long do you expect this to continue?
These are what I call tactical trades, which always work out because you have a great year in emerging markets and then the relative valuation gap becomes quite large. So, developed markets catch up on valuations. The structural trade for most people is to buy emerging markets and reduce weight on the developed markets. Cyclical, tactical trade now is to buy the developed market and sell the emerging market.
There is a push and pull factor. The developed markets were much cheaper than the emerging markets. Inflation and interest rate increases have become a problem of emerging markets, whereas the developed markets have low interest rates and high liquidity. It's a trade which plays out for some time, the valuations catch up and after that you start to have the reverse trade.
Ultimately, whatever developed markets do, the big thing is still going to be the emerging markets. Let's say India is going to grow at eight per cent. May be that becomes 7.5 per cent. But there is no way the developed market is going to come close to India on GDP growth. To that extent, the structural trade is still you buy emerging market and in between you get these tactical trades which play out for some time, where valuation gaps get narrowed, and then you don't really want to play up these trades.
What according to you is the major external risk the Indian market may face, going ahead?
For us, the biggest global risk is oil. A spike in oil prices will hurt our fiscal deficit, hurt inflation, hurt the current account deficit, etc. All the problems of India would come back into focus. That's our biggest risk to worry about.
