You may attribute some returns to mega announcements made in the recent past, including the bank recapitalization and the Bharat Mala Project, both of which have brought life back to ailing PSU banks and Infrastructure companies.
The most developed countries, including the US, Japan and Germany are witnessing a surge in equities led by the earnings growth of 10-15 percent for the first time since 2010.
India, meanwhile, has seen declining earnings growth on account of economic disruptions including demonetisation, RERA, GST, Benami Property Act etc.
Despite the confusion and disturbance caused by the government interventions to structurally reform the country, the capital markets are surging. The Nifty and Sensex have scaled new heights. But the important questions one needs to ask is:
Should one be worried about entering at current levels?
Is the market too expensive to deliver returns within a one-year time frame?
Will FIIs enter the markets next year?
The S&P BSE Sensex and Nifty gave returns of 29 percent in the year 2017. Will they replicate the performance in 2018? You may attribute some returns to mega announcements made in the recent past, including the bank recapitalisation and the Bharat Mala Project, both of which have brought life back to ailing PSU banks and Infrastructure companies.
But, a large part of returns this year has come from liquidity.
Before we proceed further, let’s first understand what drives returns? There are only 3 factors, let’s take each one of them in detail:
1. Valuations
2. Earnings
3. Liquidity
Valuations:
Valuations of the indices are nowhere close to the undervalued zone. Last year-end, we saw Sensex price to earnings multiples at 19 times trailing and should end at around 24 times in Dec 2017.
Price to book, another measure of valuation, stood at 2.6 times and should cross 3 times in the current calendar. These are historical methodologies devised by Western economists and may not be relevant from an Indian perspective. Let me explain this.
Most earnings multiples take into account discounted cash flows from future. They discount the cash flows at the weighted average cost of capital. Also, DCF is generally taken for 8 -10 years as most valuation experts believe they can’t see the future beyond 10 years.
The beauty of the Indian markets is that there are some companies which grow 2X to 2.5X as compared to the weighted average cost of capital on a long-term basis.
This can deliver sustained EPS growth over longer periods of time, beyond 20 – 25 years in many cases. The beauty of the Sensex lies in the fact that as companies stop growing or generating significant earnings, they have constantly been thrown out of the indices, making the system more efficient.
Also, if the price to earnings multiple remains constant for longer periods of time, only EPS will drive returns.
Now the question one should be asking is whether a PE expansion is expected in the next 1 year? The answer to that is - a marginal jump, and hence PE expansion will not drive returns to a great extent.
Earnings:
Between last calendar and this calendar Sensex or Nifty earnings are expected to grow merely by 600 to 700 basis points; the Sensex has already delivered 29 percent returns in CY17. One may argue that this year may be flat.
I generally don’t disagree with that, but the Indian economy is projected to grow nominally, at 11 percent, and if Sensex or Nifty remains flat, there will be companies giving robust earnings beyond the ones which are part of the indices.
Again, the argument could be that unlisted companies may grow faster than listed entities. Generally, listed entities have better corporate governance due to higher disclosure norms, independent board of directors and cheaper cost of capital and hence listed should do better.
Reforms implemented last year and this calendar will benefit a large number of compliant companies which will see a drop in the cost of capital, consolidation of demand in their favour with unorganized players leaving the scene, higher efficiency in the working capital cycle.
In essence, many companies will deliver earnings and in turn price returns in excess of 20%. The question remains - can you find them?
Liquidity:
We have constantly seen that any large move from the government in terms of reforms is accompanied by bouts of FII selling. In Dec 2016, the month of the demonetization, FIIs sold 1.3billion USD in equities.
Immediately after GST implementation, when the Indian business community was struggling with GST implementation, FIIs again sold almost 2billion USD in August 2017 and 1.65billion USD in Sept 2017.
For calendar 2017, FIIs bought 8billion USD in equities whilst DIIs bought 18.50billion USD in equities. This may just the beginning of savings moving into financial assets, mainly into equities from fixed deposits.
Only 13 percent of total savings in India are in financial assets and only 6-7 percent of such savings have gone into equities. Investment avenues, barring equities, generating potentially north of 10 percent returns have dried up and hence if anyone needs to beat CPI + wage inflation, one is left with little or no option for growing the savings beyond quality equities.
Also, 4 NDA ruled states and a large southern state is staring at elections in 2018. Together with this, marginal victory in Gujarat may force NDA to be populist than reformist for next one and a half years. Thus not major disarrangement is expected for NDA's residual tenure.
Broadly, all the factors mentioned above are related; but for now, liquidity will continue to drive the momentum followed by sustained earnings multiple and growth in earnings.
Thus, I can’t assure you that Sensex of Nifty will deliver returns north of 20 percent but surely clean and well-governed companies which have managed to maintain their moats will give a repeat performance.
MORE WILL UPDATE SOON!!
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