The equity markets in India have had a decent start to the year. The markets are up about 10 per cent year-to-date in dollars and are among the best performers in Asia. Unfortunately, the pattern of the last few years continues; foreign institutional investors (FIIs) are buying and local institutions are selling. Given that FIIs already own more than 40 per cent of the free float, hopefully this pattern will reverse. What has distinguished this rally, however, has been the different composition of the advance. After many years, mid-caps are leading the move up. Mid-cap indices are up approximately nine per cent in rupees compared to six per cent for the Nifty. Even on a sectoral composition basis, in a total departure from the last few years, this rise has been driven by public sector banks (up 24 per cent year-to-date), capital goods (up 18 per cent) and cement (a 10 per cent rise). Technology stocks - the darling of 2013 - are actually down four per cent for the year.
The changing composition of the market rise indicates that investors are now becoming more hopeful about the economic outlook and are feeling more confident that the slowdown has bottomed out. Instead of shunning sensitivity to the broader economy, they are now willing to embrace it. Though mid-caps, public sector banks and capital goods stocks were screened as being very cheap, it is only now that investors have mustered the courage to buy them. This sectoral rotation is still early, and if the markets continue to gain traction, this wide dispersion in performance between economy-sensitive stocks and the defensives will only continue. Value as a strategy will also come back strongly, which will drive continued mid-cap outperformance.
Investors are now reaching a stage where they will have to be willing to look through the valley of growth and earnings. The markets are already at valuation levels in line with long-term averages. Trading at about 15 times 2014-15 earnings, this is not deep value territory, and is at a substantial premium to other emerging markets.
After the elections, if we get a reformist government and the markets rise strongly on the back of this, valuation multiples will expand and cause heartburn for value-conscious investors. As the markets rise, this will not be accompanied by any improvements in earnings. Earnings will take at least a year to start showing any tangible improvement and get into an upgrade cycle. Most analysts expect about 10 per cent earnings growth for the broad market in 2014-15; this is not going to move to 20 per cent overnight. Our economic travails are not purely cyclical. Getting back to anything more than six per cent growth will require hard work. We need to see sustained revenue growth of 15 per cent plus for operating leverage dynamics to kick-start corporate earnings.
However, investors will have to have the stomach and confidence to see through a period when valuation multiples will be expanding, stock prices will be surging and yet earnings will continue to be weak. The natural temptation at this time will be to bail out of your stocks and exit India more broadly, because both will look very expensive. Investors will have to be willing to look through the valley of weak earnings. This is the dilemma investors will face: do we sell and take our profits, or bet on earnings coming through very strongly in the future? The temptation to take quick and easy profits may cause you to lose out on a secular up-move.
This is not unusual; most market rises after very weak economic growth start this way. The equity markets move first, earnings with a lag. The difference, however, is that, in most such cases, interest rates are falling and liquidity conditions easing. The reduction in rates supports the multiple expansion as the markets rise in the absence of earnings support. Eventually earnings kick in and valuation multiples normalise, as the economy gathers steam and the market grows into its valuation. The market moves from falling rates to earnings as being its primary driver.
In India, however, it seems unlikely that rates will come down in a hurry. If the dreaded El Nino strikes, we may even have rate hikes. Liquidity conditions are also not hyper easy.
In the absence of falling rates, what will give investors the confidence to stick with the rally? Why will they be willing to bet that earnings will eventually catch up? What will give them the confidence to stick with their positions even as multiples rise?
In India's case, it will have to be policy action. Investors will obsess over the first few weeks of the new government and the economic signals it sends out. We need to show clear steps to improve the investment climate and make the country more hospitable to business. We need to see clear measures on the stability of tax policy, the reform of administrative processes and the re-prioritisation of subsidy spend. These steps will give investors the confidence to look through the upcoming weak earnings reports of corporate India. Once investors are convinced that the new government (of whichever party) supports growth and understands the link between growth and inclusion, they will be willing to stay invested. Indian corporate profit margins are significantly below long-term averages. One can easily make the case that if margins normalise, we would see an extended period of 15 to 20 per cent earnings growth for the broad market. It is easy to underwrite this earnings trajectory if you have confidence in the country and its governance.
In the initial euphoria surrounding a new government, the markets can have a quick and sharp rise. Lacking earnings support, as the markets rise, valuations will start looking steep very quickly. It is important that the new government quickly delivers policy change and signals its desire to improve the investment climate to ensure that investors have the confidence to look through the valley of weak earnings.
It is important that the markets remain buoyant, for they are part of the solution to get us out of this economic funk we find ourselves in. The lack of private sector investment that everyone is moaning about is really due to two or three issues. One, of course, is the whole policy paralysis, lack of clarity in regulatory environment and lack of co-ordination among different arms of the government. The other equally important constraint has been the lack of balance sheet capacity among project developers. Many simply do not have the money to start or complete their projects. They also have no access to new funds - either debt or equity - since even banks have now turned cautious and sensitive to non-performing asset accretion. The only way to unclog this is through recapitalisation of balance sheets, either through asset sales or raising equity. Both these solutions require robust equity markets. Strong equity markets are not an outcome of a robust economy but part of the solution to make sure we have an economic revival.
The writer is at Amansa Capital
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
