On the Sensex Index, Indian stocks have increased nearly 28% since January 2005, despite a market correction of 11% in October 2005 (7,795). The current rally is more than two years old, with the market having risen 164% since April 2003 (2,949). Investors are cautious of the current climate, having seen historical rallies in India in 1992, 1994 and 2000 all ending with painful retrenchments.
So this begs the question, is recent movement a healthy correction or is it the first signs of a downturn in the market?
It is important to put the current market rally in context. 1992 was a period of considerable exuberance in Indian equities. With the market PE reaching 41x, the momentum-led rally was brought to an abrupt end by a stockmarket scam. 1994 was another period of market exuberance which saw the market PE reach 25x on the back of excessive bullishness over the country's growth prospects, as international investors clambered to gain exposure to high growth emerging markets such as India. In February 2000, the collapse of the TMT bubble, which had resulted in wildly over-inflated PEs for Indian software stocks, saw the market PE of 25x fall to 15x during the course of the year.
What appears to be different in 2005 is the fact that this rally is supported by earnings growth. This has meant the market PE has not moved into the bubble territory of previous rallies - despite the substantial run-up in share prices over the past two years - at 15x the prospective market PE is just below its historical average. Saying that, it is clear there are certain areas of froth in the market, primarily some of the private banks and a number of the small and mid caps, where investors are substantially long at the expense of the larger more defensive index heavyweights. It is also worrisome that certain company managements are rushing to issue low quality paper at inflated valuations. The consensus amongst the offshore dedicated India managers is that we could see a correction of around 10-15% at some stage, while the onshore managers feel a correction of anywhere up to 20-25% is possible. Our statistical analysis on the current downside risk in the context of the past 16 years puts the risk of a market fall of 10%+ at 27%, while there is an 11% chance of a fall of 25%+. Looking at the period since 1 January 1997, excluding the bubbles of 1992 and 1994, these figures fall to a 25% risk of a 10%+ market fall and a 9% risk of a fall of 25%+.
What is apparent is that, despite the froth in certain hot areas of the market, the managers are still finding attractively valued companies. The fund managers we speak to are still able to find stocks trading on PEs of 5-6x. One of the main domestic mutual funds still has an overall portfolio PE multiple of 10x. In both instances, the managers do not find the market PE excessive versus historical valuations and they do not expect earnings growth to slow any time soon.
Whilst investors always wish they had invested at the bottom of the market which, in India's case, was in April 2003 when the Gulf War resulted in massive risk aversion, it is clear there is a long-term story for India, primarily in terms of the major structural changes that are taking place. These are changing the landscape of its economy and increasing its potential for earnings growth.
The main themes coming through from Forsyth Partners' interviews with the India fund managers are:
Infrastructure - where the government's substantial 13,000km road-building programme is expected to lead to a similar phenomenon to that of the US in the 50s, when the massive growth generated by the expansion of its road network was recycled into the broader economy.
Life insurance and retail loans - which have only recently started to gather pace, supported by historically low interest rates and a whole new generation that borrows according to what it can afford to pay back each month versus their parents who refused to borrow;
Consumer-related - the Indian consumer is still in his infancy as television continues to become more widely accessible and rising middle class incomes lead to greater disposable wealth. The emergence of the consumer will have wide-ranging implications, not least for the construction and auto sectors, where demand is already showing signs of burgeoning growth;
Outsourcing - India's wealth of universities and specialist colleges and its highly educated and English-speaking population is helping it to capture an increasing share of the global outsourcing market across a number of high value added areas such as IT, engineering and pharmaceuticals.
To conclude, whilst there are clear risks to the market, such as a sudden unwinding of the speculative long positions in the small caps and private banks, a political crisis or an external shock which drives investors into safe havens, our opinion is that the current market rally has not reached the bubble territory of the previous extended bull runs for the market as PEs are close to their historic average and valuations are well-supported by earnings growth. We would advocate a strategy of focusing on quality and experienced fund managers who invest in quality stocks that are still trading at sensible valuations. Our focus is very much on capturing the upside in earnings growth whilst limiting the downside risk by avoiding the hottest areas of the market.
Source: Citigroup (Mumbai)
