It is by now abundantly clear to anyone investing in Indian equity markets that valuations are not cheap. Those stocks that are cheap have good reason to be so - being plagued by either balance sheet or governance stress, or by a failed business model. Quality, however defined, is expensive. The stocks most investors want to own are trading in most cases at near their peak multiples. With the markets hitting new highs on a daily basis, equities are now trading at more than 20 times trailing earnings, and probably 17 times 2015-16 earnings. Not cheap by any definition. Yet the markets keep moving up. And inflows continue from both global and domestic investors.
What are investors seeing that keeps them bullish even at these levels? One obvious observation is that, from a relative perspective, India does stand out compared with most of its peers in the emerging-market (EM) universe. No other large economy has a combination of rising economic growth, falling inflation, declining rates and accelerating earnings. India even has a dash of structural reform thrown in for good measure. This can be a potent combination for equity returns. In a growth-starved world, any growth asset will naturally be bid up.
With these levels of multiples, however, more than anything else, investors are making the fundamental bet that earnings growth will kick in over the next two to three years. Most sell-side analysts and strategists have pencilled in 20 per cent earnings growth for the broad market over the 2014-17 period and beyond. This is no trivial number or ambition, especially when global growth is struggling at 3.5 per cent, and India at 6.5 per cent projected gross domestic product (GDP) growth (in 2016-17, according to the International Monetary Fund) will supposedly become the fastest-growing economy in the world.
The Indian markets' own history shows the difficulty of the task. From 1992-93 to 2014-15, the Sensex has delivered a cumulative annual growth in earnings of about 14 per cent. The past few years have been very tough, with Sensex earnings compounding by only about eight per cent (2007-15). The current financial year's earnings estimates are being cut once again, and we will end with less than 10 per cent growth for this year. The cycle of continuous earnings estimates cuts seems to have no end.
So why is everyone so confident about 20 per cent going forward? This is a critical assumption and debate. If the market does not deliver the expected earnings, it is unlikely investors will make any money from here. The phase of multiple expansion is coming to an end, and there has to be a handover to earnings growth, as the market grows into the current valuations.
The answer largely lies with margins, and where they are today compared with their long-term averages. As Motilal Oswal Securities Ltd (MOSL) points out in a recent strategy note, Ebitda (earnings before interest, taxes, depreciation and amortisation) margins for their coverage universe in 2014-15 will be about 19.5 per cent, compared with an average of 21.8 per cent and the peak of 25 per cent in 2006-07. Consider also profit-after-tax margins, the MOSL universe (except oil and finance companies) will have margins of 10 per cent in 2014-15, compared with a long-term average of 12.7 per cent and peak of 15.5 per cent in 2006-07. Even from the perspective of net profit's share of GDP, we are currently only at about four per cent compared with the peak of over seven per cent.
The thesis seems to be that as margins normalise, and economic growth accelerates, this combination will easily deliver greater than 20 per cent earnings growth.
While this all sounds perfectly reasonable, the reality is that globally, analysts have a horrendous track record in predicting profits. Data from the United States (although equally true in other markets) give no confidence at all. Bottom-up consensus estimates for market earnings have been in existence only since 1976. The January sell-side earnings expectations have been too high for the coming calendar year in 33 of the 39 years for which these estimates exist (according to Morgan Stanley). On average, analyst expectations in January were for earnings to grow at 14 per cent for that calendar year; by December the actual earnings growth for the year came in closer to six per cent. Analysts seem to be serially too optimistic on earnings across the world. Why should India and our analysts be any different?
We have a better shot at being right, given where we are in the economic cycle. I actually think our analysts will turn out to be too conservative and earnings estimates in 12-18 months will start being upgraded. The bull market of 2004-08 saw earnings growing at 25 per cent, with estimates being upgraded every quarter.
All the six years when the January sell-side earnings projections in the United States turned out to be too low were years immediately after a recession, when the economy had begun to recover. Exactly our situation today - two years of 4.5 per cent economic growth is akin to our own recession, and 2015-16, the first year of recovery. Analysts globally find it very difficult to forecast and anticipate an inflection point in either direction.
Secondly, all the Reserve Bank of India (RBI) data show that we are running at sub-optimal levels of capacity utilisation across sectors and industries. This is one of the main reasons to not expect a quick recovery of the private capital-expenditure (capex) cycle. As capacity utilisation improves, it will enhance profitability and return on equity. Incremental profitability and cash flows will be very high as capacity gets filled, with no immediate need to fund capex.
Third, while we have seen commodity and oil analysts bring down earnings expectations for their companies globally, including in India (the main reason for further cuts in estimates this quarter), I am amazed that there has been no earnings upgrades in those sectors that should benefit from the commodity sell-off. In India, we have $60 billion in savings from the oil price decline alone. If we add the decline in palm oil, coal and fertiliser prices, the benefit will exceed $75 billion.
Many economic players will benefit from this import windfall. In some cases, companies will raise profit margins. Consumers will use the savings to spend more. The RBI can be bolder with rate cuts, or the government can spend its savings on public investment. Our corporate sector has a total profit pool of about $80 billion; how can a positive terms-of-trade shock of $75 billion not lead to earnings upgrades?
Finally, in many sectors analysts are scared to assume growth going back to trend. In cars, for example, the long-term trend is for a 15 per cent compound annual growth rate in volumes. The last three years have seen zero growth. To get back to trend, you will need to see a couple of very strong years of at least 25 per cent growth. No analyst is willing to go out on a limb and put that in his or her forecast. With great difficulty, they may plug in 15 per cent. When the big year comes, earnings will be sharply higher than forecasts.
So while history shows that analysts are normally too bullish on their market earnings forecast, the opposite will hold true for India. Expect earnings forecasts to soon enter an upgrade cycle. This will hopefully underpin our markets.
The writer is at Amansa Capital. These views are his own
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
