Stock Markets On Its Way To 50,000

The script gets better — and even better. We are barely half-way into 2016, and the Indian stockmarket has clambered its way up from the gut-wrenching slowdown and sticky spells to the start of something new. Even after the shock of Brexit vote and the unfortunate end of the Reserve Bank of India’s governor Raghuram Rajan era, the stockmarket is not meandering, nor side ways — but is poised on course to scale uncharted territories.

This is a four-month old revival, fuelled by the rise in financials, consumer goods, and agri-stocks. But it has rekindled widespread hopes of a broader market rally. Now there is talk of the Sensex hitting 50,000.

Market experts, no doubt, see the target as challenging, but not unachievable. “It’s not an unrealistic figure,” says Manish Chokani, director, Enam Holdings. “There has been no meaningful growth in the last five years. Now we are at the start of what is proving to be a cyclical uptick. In a few years, this could turn broadly secular, and that would be uplifting for our markets.”



The rising earnings growth has turbo-charged the markets. The last quarter was surprising to the markets as revenue growth spiked up to 7 per cent, a notable feature that was absent for the previous four quarters. It signalled that the wheels of the economy had begun to move, and that corporate growth was picking.

Many pieces of the jigsaw are falling in place. Says Nirmal Jain, founder and chairman of financial services player India Infoline: “Domestically, there are other fundamental factors that have more weight. The monsoon, goods and services tax (GST), increasing reforms, and rising government infra spending are all influencing market forces.”

The key to any market revival is earnings growth and return on equities (RoE). Indian companies have made peak return on equities of around 24 per cent in the past. But now, domestic behemoths are doing a sluggish 15 per cent return on equity. This return is very low. RoEs have been so low only on two occasions in the past 20 years.



Now, after two years of deceleration and sputtering growth, signs of a recovery are on the cards, and building strength. “The positive points are that the earnings downgrades are bottoming out and, in the recent quarter, topline growth has been positive, which is encouraging” says Chris Wood, author of CLSA’s weekly Greed and Fear letter. “On a relative basis, I am overweight on India.”

With the earnings cycle bottoming out and a cyclical recovery now clearly underway, the markets are looking at higher returns on equity. “We are making 15 per cent RoE now, and if we see a mean reversion of profits touching 6-7 per cent of gross domestic product (GDP), from the currently depressed 4-5 per cent, an earnings uptick of 75 per cent in four years is more than likely. On that, 50,000 should be attainable,” says Chokani.

Agrees Ajay Bodke, CEO and chief portfolio manager at stock broking firm Prabhudas Lilladhar: “We can easily double from these levels in three years. The markets are forward looking and a leading indicator of the economy; the cycle is starting to turn.”



The earnings recovery is due to a host of factors, particularly higher public spends and the rise in urban consumption. But that could get even better with the revival in monsoons. Says Nilesh Shah, managing director, Kotak Mutual Fund: “The earnings recovery is driven by government spending in roads, railways, infrastructure. With the outlook for monsoons getting better, we will do well on public expenditure, urban and rural consumption. The only thing we will lack is private capital expenditures, which anyway will take time to recover.”

Historically, Indian markets were always trading at above-average valuations. The high return on equities of Indian markets gives a high degree of comfort to investors to assign premium valuations to the markets. The stockmarket is currently trading at a private equity (PE) of around 17 times forward earnings. An improving earnings outlook coupled with good inflows is the perfect combination for a long-term revival and even a re-rating of the Indian markets.

Besides, global investors are increasingly looking at India, and other emerging markets, to fuel global growth. With India’s above-average growth rates, many foreign investors are beginning to look more favourably at the India growth story. Says Kaku Nakhate, president and country head, Bank of America Merrill Lynch India: “India stands out in that emergingmarket basket. Our macroeconomic fundamentals are distinctly better, and continue to improve. The economy is more domestic consumption-led; public spending is going up, and the GST Bill, if passed in the monsoon session, could turn out to be the big kicker.”



Following Brexit, stock markets surged 4.6 per cent, and the rally is covering nearly all segments of the market. While the stock market surge began a few months ago, it was gathering pace even before Brexit happened, and a major hiccup for the European economy has not deterred the market’s upward movement one bit. Says Ramesh Damani, member, National Stock Exchange: “The Indian markets are within the street’s word of a bull market. We are seeing a recovery in corporate earnings, interest rates have come down and that is fuelling the markets.”

Globally, India has already emerged as the fastest-growing economy in the world. It has overtaken Brazil and Russia to emerge as the second-largest economy (after China) in terms of nominal GDP. Says Nakhate: “We will probably cross France and UK in GDP to emerge as the fifth-largest economy, overall, by 2019. So the India story is hot.”

Global investors, too, are looking at India favourably; now, with the Indian economy perking up, they are lapping up more equities. In the emerging markets basket, among all other similar markets, India has been put in the overweight category. Since February, foreign investors have bought stocks worth Rs 35,884 crore, and remained invested despite the global uncertain situation.



At the same time, no good economic growth stories seem to be emerging across global financial markets. Even in the last two years, when foreign investors were selling emerging markets, India was relatively less sold. Wood says that despite the earnings slowdown, foreign investors did not sell too much in the Indian markets last year because there is a lack of good stories across the globe.

In the next few years, foreign investors are expected to increase their allocations to India. Says Nakhate: “India is in a position of relative strength compared to other emerging markets. Foreign institutional investors are, therefore, overweight on India.”

It’s not just foreign investors who are looking favourably at India. Domestic investors, too, are increasingly looking at investments in the stockmarket. SIP inflows into domestic mutual funds are said to be averaging Rs 2,000 crore every month. Since January 2015, net fund inflows have scaled to Rs 76,721.73 crore, substantially higher than in the past. Domestic investors have been continuously pouring into the stock markets via mutual funds.



Demand for Indian offerings is on the rise. Domestic initial public offerings (IPO) are commanding oversubscription figures as never seen before. The recent offering of Mahanagar Gas was oversubscribed 65 times, and was among the top three IPOs in recent times. In fact, the total number of applicants in the Mahanagar Gas IPO is about 1 million. It’s estimated that this number can go up to 3 million for future IPOs in the next three years.

In fact, such phenomenal oversubscriptions in IPOs are becoming increasingly common. The Rs 400 crore IPO of Quess Corp, too, saw demand worth Rs 50,000 crore. The norm nowadays within merchant banking circles for good consumer facing well-priced IPOs are targets of at least 15 times oversubscription.

It’s little surprise that the consumption theme is driving the Indian economy forward — and the stockmarkets upward. The Indian burgeoning middle class with the majority of its working population below the age of 30 years is not only lapping up new bikes and cars but also stocks.

Valuation-wise, stocks are fairly valued. The Mcap-GDP ratio, popularised by billionaire investor Warren Buffett, shows that the markets are near fair valuation. At its peak, the valuation was stretched to 100 per cent of GDP in 2008, but right now, it is just in the right zone at above-average valuations; it’s at nearly 70 per cent, just about fair valuations. With the GDP growth expected to surge following good monsoons, this indicator is bound to contract on current stock prices.



Besides, on the earnings multiple, stocks are trading at just a tad above historical valuations. The market’s current PE is around 17 times earnings, compared to 15 times of historical earnings.

But that is because of the strength of the Indian economy, and the premium in valuation it has historically commanded among other emerging market countries.

One indicator of India’s growing edge in the recent past is that the domestic economy is increasingly decoupling from the rest of the world. While Indian exports have slipped to a 13-month low due to a slowdown in the global economy, the economy is still managing to set a good growth rate of over 7 per cent. As a result, the Indian economy is not dependent on global growth to oil its economic wheels. Instead, the economy is increasingly looking inward for growth.

This, is turn, is making the market resilient and more thickly insulated against global swings. In the carnage of the 2008 Lehman crisis, the Indian markets dipped to valuation levels in single digits. But, in the recent fall, despite the sharp deceleration in profits and 20-year low RoEs, stock valuations barely hit the 15-PE average of past valuations before quickly rebounding to current upbeat levels.

Says Mehraboon Irani, principal and head, private client group at broker company Nirmal Bang: “The Indian investor is getting savvy and looking at future earnings. Markets are always right, having got a whiff of improving earnings a lot earlier than it happened.”

Add to that, the stability in rupee that is attracting more foreign investors to the Indian markets, and insulating them further from macroeconomic shocks. The current-account deficit is likely to continue within control at less than 1.5 per cent for FY17 despite the rise in oil prices. A comfortable forex reserves position of over $340 billion is helping stabilise the damage caused by global choppiness. The Indian rupee has held up nicely despite the several breaches beyond Rs 68 in recent times.

Even as Brexit drove the rupee briefly to Rs 68, the rebound was swift because of the strong external account.

Global commodity prices are also in a sweet spot for the Indian economy. With oil hovering around $50 and a small recovery in commodity prices, the Indian economy is in the goldilocks spot. At this level, oil prices do not impact the costs of the Indian economy keeping the external accounts under control. At the same time, this also signals that the global economy continues to strengthen.

In January 2016, when oil tumbled to levels not seen in years — of nearly $20 — the international financial markets began to panic and the contagion effect rubbed off on the Indian markets.

That said, Indian markets are increasingly able to withstand global shocks. Initially, after the surprise Brexit vote, the BSE Sensex plunged a 1,000 points. It quickly recovered though. And even volatile global markets have not dented the gains in the Indian market, which has surged 4.6 points after the fall.

Because of the slow, but steady, cyclical recovery in the Indian markets, most experts feel that it is time to get exposed to Indian equities as and when the market dips. Says Motilal Oswal, chairman and managing director of brokerage MotilalOswal: “Volatility is a friend of investors because it allows them to buy when prices are lower.”

The confidence springs from the fact that there are several triggers for the Indian markets. Experts point out that the salary hike by the Indian government according to the recommendations of the 7th Pay Commission is likely to increase the spending power of individuals. Around Rs 1 lakh crore is expected to be disbursed due to these pay increases. That will add to the spending power of Indian consumers.

While this could stoke inflation in the near term, India’s inflation situation has structurally changed. With lower commodity prices and better external accounts, the pressure on inflation would be eased, and it is likely to hover around 5-6 per cent in the medium term.

As a result, interest rates are expected to be low in coming months. The 10-year G-sec yield has dipped from 7.8 per cent in June last year to 7.4 per cent this year. And in coming months, the interest rates are expected to slip to levels of 7.2 per cent, according to experts.

Lower interest rates act as a catalyst for stock markets. Indian companies show better profitability when the interest tumbles, which boosts earnings growth.

That said, one of the key things that is holding back growth in India is private sector capital expenditure, which has dropped from 12.8 per cent of GDP in FY11 to 7 per cent in FY16. Private project implementation is weak, while public-project implementation is strong. CLSA’s Wood reckons that privatesector capital expenditure is one of the most critical indicators that he will be watching over the next year or so. He reckons that unless there is a revival in private capital expenditures, markets are likely to consolidate for the next 18 months.

“Private sector capital expenditure (capex) will depend greatly on the recapitalisation and clean-up of banks in the near term,” says Wood. “I would put that as the single biggest factor the market will watch out for.”

To be sure, one of the large overhang of the market in the next three years is the recapitalisation of banks. The government had provided Rs 25,000 crore for this, about 17 per cent short.

Non-performing loans are in the range of around 17 per cent of state-owned banks’ balance sheets, and the clean-up of the banking sector needs to continue for them to be able to fund capital expenditure requirements in future. A strong banking sector is vital for the growth of private sector capex, which would be the ultimate sign of a revival in corporate sector profitability.

To be fair, private sector capex also depends on external revival and higher capacities in the corporate sector. Hence, in the initial phases of a recovery, private sector capacity utilisations would have to rise from the present 70 per cent or so. But, as consumption demand picks up, greater capacity utilisation could take 4-6 quarters to play out.

Apart from capital expenditure, the structural story driving growth in the Indian economy has to traverse the next 4-6 quarters.

And much of that would depend on the rural economy. For now, the rural economy constitutes just about 17 per cent of GDP, but it plays a huge factor in the consumption story. Two-wheeler sales, seen as a proxy for rural demand, has picked up in the last four months.

While we are crystal-ball gazing into the future, three years is a long time way. And anything can derail the market revival, especially in this increasingly interconnected economy.

A key factor in the recent optimism in the market has been the above-average forecasts of the monsoon. So far, a 12 per cent deficiency in rainfall has not dampened the market mood.

This year the monsoon has revived. But for markets to do well in the long term, the monsoons have to be good for the next two or three years. Says Oswal: “While confidence levels are high, there is a broad-based revival due to rural consumption. For the markets to see a significant revival from here in two years, we will need to have good monsoons.”

In some respects, the earnings of the Indian markets will have to grow at 22 per cent compound rate for the next three years. At present levels, the Sensex earnings per share stand at the levels of Rs 1,600. At a 20 per cent compound growth rate, earnings could surge to nearly Rs 2,900. Applying normal levels of valuation of 18 times, the Sensex could reach the coveted 50,000 target in three years.

Markets, however, could be more restrained than that. Says Vikas Khemani, president and CEO at brokerage Edelweiss Securities: “For the markets to grow at that rate, there needs to be a significant rush of tailwinds. So my own guess is that growth will be around 18 per cent.”

Even if the recovery is a lot slower, the fact that the RoEs are expected to rise in the near future is a vital signal that investors will be looking for. In fact, a lot of investors are taking exposure in the market in the hope of a strong revival.

One word of advice from the experts says that investors can buy good businesses at all times. Says Damani: “Buy great businesses at cheap prices, whether they are large cap or small is not particularly relevant. We look for high-quality businesses, the market is misunderstanding and we are market capital agnostic.”

In this market, where should investors focus? A better part of the market has run up, taking along with it a large number of mid- and small-cap stocks to higher levels. So, it’s advisable to be picky and choosy in this market. Sectors that are looking good are housing finance, sugar, cement, banking and financial sector. But as a lot many stocks have run up, investors are advised to buy on dips. Says Oswal: “The nature of the markets is that they will show some dips in the future. In the best interest of investors, buying the dips is always advisable.”

Quite a sizeable number of small stocks have raced up tremendously in the past few months because they were beaten down. In some of these counters, investors should exercise caution when investing.

In fact, from October 2013, the BSE Mid-cap index has been on a structural rally, and corrections have been minor for small periods of time. The index has more than doubled from 5,300 in October 2013 to 11,857 points currently, a rise of 223 per cent. Says Khemani: “In a bull market, the growth profile of mid-caps ends up being better. But it must also be said that they come with a lot higher risk. And it depends on the risk appetite of the individual. Obviously large cap will lead the rally, then the cycle shifts to other segments.”

Obviously, a target of 50,000 on the market implies compounded annual returns from here of 23 per cent in the next three years. However, analysts believe that the number might be a little stretched for three years. Instead, analysts are working around a CAGR of 18 per cent return on the bellwether index, which means that investors can see levels of 44,000 on the Sensex in three years, and 50,000 in four years.

That’s still a return that is good enough to make investors happy in the long run. Just hope the script plays out in the bull zone.

The Choicest Sectors
Sweet sugar: Globally, sugar prices are rising on the back of growing demand and lower production. Indian sugar production is expected to be at around 25.5 million tonnes, a drop of 10 per cent from previous years, according to ICRA. That will keep domestic sugar prices buoyant. Sugar stocks have already surged in anticipation, so keep an eye out for dips.

Resurging housing finance : A housing shortage of 22 million units is fuelling the demand for housing loans. In the past year, interest rates on housing loan have come down from 12 per cent to below 10 per cent. Some housing finance stocks are trading at inexpensive valuations. It’s an unfolding long-term story, and some stocks are trading at inexpensive valuations.

Consolidating cement: The rise in domestic public expenditures is triggering demand for cement. The capacities of cement companies were underutilised, and incremental capacity utilisations were driving profit growth. Cement stocks, however, have run up in the recent past, hence tread with caution.

Booming financial services: Financial services companies are increasingly becoming the proxy for private sector consumption. These companies can derive better operating efficiencies for every incremental increase in business because of their unique position. A monsoon revival will also drive rural consumption. While stocks have run up too soon, the story is still unfolding.

Perked up PSU banks: Despite a 17 per cent bad loan problem, the clean-up in PSU banks will see banks emerge with stronger balance sheets. Retail loans are growing at a faster clip for PSU banks. The government is re-capitalising PSU banks which will provide capital for future growth. Some banks are still at single-digit valuations.

Cutting-edge chemicals: The chemical sector is undergoing a structural change, thanks to a slowdown in overseas production. However, most stocks have run up significantly on the back of improved sales and profit numbers. Lower commodity prices and improving demand are driving up margins of specialty chemical companies. One must, however, watch out for the valuations.

clifford.alvares@gmail.com:
@cliffordalvares