Stock Market: Have The Cake...

What we are now seeing is nothing short of magical. We have hit the coveted 30000 mark, and going by the way the confidence is shoring up, we are just about getting started. From the big picture perspective, we have nestled at base camp, with still a lot of distance to go.

But needless to say, this time the new found confidence — right after demonetisation and its challenges — warms the cockles of every investing heart. And yes, a celebration was definitely the way to go. Excitement was high, filling the alleys around Dalal Street as hundreds of people spilled out of their offices and swarmed around, marking the moment with cutting a cake with 30000 splashed across it.

Last year, BW Businessworld published a cover story (BW issue dated 25 July 2016; ‘Sensex In Next 3 Years’), stating that the fundamentals of the Indian economy and markets have shifted and that, within 3-5 years, the stock market would scale the magical 50000 figure. At 30000 now, we are still a long way off from that magical figure. Are we on the right track, though? And is this outpouring of optimism justified? Do fundamentals support the upbeat sentiment?

To understand this market, investors will have to bear with two lenses. One, at the short end, and a zoom lens that focuses far into the future.

In the short run, markets have probably run ahead of fundamentals. Market expert Ajay Bagga says, “The market is in an overbought zone. We expect a consolidation now and, even if it rises from here, there could be some more consolidation. That’s in the immediate future. But one has to note that this is certainly not a weak market.”

One of the grave concerns, surely, is that the equity market has not yet seen the kind of pace in earnings growth that, well, would justify such valuations. For some time now, India earnings growth has been hovering around single digits or about 5 per cent. Two years ago, earnings had sunk to even a negative trajectory. “The market is overheated. There is no valuation assurance because the earnings figures are still not good enough,” says Daljeet Kohli, director and head of research, India Nivesh. “There is hope that such figures will ultimately follow, but this has been the case for the last two years and, ultimately, has not happened,” adds Kohli.

Market Re-rates
In other words, without much earnings growth, in the last one year, the Indian markets have been producing exorbitant returns for investors. In the past year, the S&P BSE Sensex delivered 17.6 per cent returns, while in a three-year period it produced a compounded return (CAGR) of 33.6 per cent.



But with earnings growth not keeping pace with the rate of growth of stock prices, the price-earnings ratio has surged. From an earlier level of 15 times earnings, the BSE Sensex’s PE is now around 23 times earnings. In short, the stock market has been re-rated following sturdy inflows from domestic investors.

Kohli reckons that this is a phenomenon being seen across markets. Most of the market has seen a re-rating in stock prices, particularly of mid-and small-cap stocks.

“In two-three years, there is ultimately a base effect which will play out and, so, the key is to know what your entry valuation is,” points out Kohli. He further adds, “In the case of Force Motors, at Rs 2,000, you were paying 8-10 times earnings. Now, at Rs 5,000, you will be paying 20 times. It is difficult for valuations to further shoot up from twenty to forty times earnings. Now, stocks will appreciate only if earnings swell. But at 10 times earnings, a stock appreciated due to both earnings growth and a re-rating. Right now, are in a market where we have re-rated everything.”

Where Are The Profits?
Corporate profits ultimately reflect how well the stock markets will perform over time. And, over the past few years, corporate profits have been sluggish. At the peak of the market in 2008, corporate profits stood a tall 7.8 per cent of GDP. Now, they are down to 3.1 per cent. GDP itself has grown a dollop slower over the past few years, hovering around 7 per cent. Says Bagga, “It is mostly government spending and private consumption that is driving the economy; private capital investment has still not caught up.”



Which is to say that corporate bodies are not investing money in expanding capacities, at least not yet. Credit growth has been a sluggish 5 per cent, year-on-year, against 21 per cent growth in December 2007.

But the silver lining is that public spending on infrastructure is increasing, seen in the robust demand for cement and construction materials. Over time, the government’s infrastructure push is expected to drive growth in the economy. For instance, expenditure on infrastructure has swelled from Rs 7.7 trillion in FY12 to Rs 10.2 trillion in FY16. Sooner or later, this would reflect in corporate performance.

However, earnings growth next year may not be high. The markets may already be factoring in 20-25 per cent earnings growth; however, in reality, growth in earnings could be 12-15 per cent. In the longer run, though, earnings growth is expected to step up smartly as the economy picks up.

Driven On Liquidity
For now, we know what is driving the markets. Flows into the markets on a monthly basis, however, suffice to support present market valuations. Domestic investors are pouring in money, though foreign investors have started to press marginal sales lately.

Monthly inflows from domestic investors through systematic investment plans (SIPs) are nearly Rs 4,400 crore. Extrapolating this, the figure of investment in the market is likely to increase to about Rs 6,000 crore in the next two years. In other words, nearly $1 billion can flow into the markets. That is quite a tidy sum if all goes well.

Right On Course
Right now, there is no going back to levels of 25000 or so, unless there is a big event across the globe. But, of course, as this market has run up considerably post-demonetisation, investors should not throw caution to the wind at these levels. This market calls for a more systematic and steady approach to investing, according to experts, and it is only for investors with a longer horizon.

In the medium-to-long term, the stock market is likely to give returns of 15-18 per cent.

“In the longer run, we can look at 15-18 per cent return from the broader market, and that is roughly 2.5 times real GDP,” says Bagga. “Markets should grow at 2.5 times underlying GDP growth, which is about 7 per cent,” he says. Kohli agrees. “The longer term markets are looking favourably and a return of 15 per cent is quite possible.”

But there is no denying that investors will have to look at areas that have the most potential in these coming years. For now, since much of the market has re-rated some of the areas where the market is favourable is where the stocks have not run up significantly and where earnings growth is still to materialise. Some of these sectors are in the infrastructure space.

Kohli reckons that Reliance Industries (RIL) will reap the rewards of its capex push started a few years ago. This will drive higher revenues and profitability in the coming years. L&T is another big company that could expand its earnings as infrastructure and capital spends increase, and because the price levels of the company are still reasonable.

Analysts are bullish in the long run in sectors that are favourably placed. Sunil Sharma, chief investment officer, Sanctum Wealth Management says, “We are bullish over a longer time frame, but I would couch that by saying that it is critical to get the sectoral and stock selection call right, particularly given the rich valuations we are witnessing today. We regularly come across portfolios that are not invested in the right sectors and consequently miss out on performance despite being invested in the markets.”

However, there is little doubt that the key driver of the market is future earnings visibility. Analysts are expecting the economy to pick up over next coming years, but the pace of growth within sectors and stocks will be closely watched. Therefore, having exposure to the right sector and stocks will determine whether investors outperform the markets in the next few years.

So, when are we going to hit levels of 50000? A rough calculation suggests that at a 15 per cent return, the markets will hit 50000 levels in four years. But if we do a 17 per cent return, then the markets could come close to the 50000 mark in just three years.

That’s enough incentive for investors to remain invested as going by the way the earnings growth is expected to kick in, we are still early days into the bull market.