Source: DNA Money - 28th November, 2005
A paradigm shift has begun in the market, and it will continue over the coming years
“Those who forget history are condemned to repeat it,” said George Santayana. History tells us that it is never different, there is no ‘New Deal’.
Yet, there have been paradigm shifts in different markets at different points of time, like the decade-plus moves resulting in multifold rises in the Nikkei and the Dow Jones indices.
The Indian equity markets have made unprecedented gains in the last two-and-a-half years with the benchmark Sensex gaining more than 300% in the period.
The breadth of the gains is further demonstrated by the out performance of the broader indices — BSE -200, BSE-500 and the sectoral indices. The experiences of Indian investors during the last two bull markets in India during 1989-1993 and 1999-2001 have been transitory and bitter. Reflecting them, most Indian investors are either not participating in the current rise or are doing so with a great sense of insecurity.
I think they are influenced by their experiences of the previous bull markets, forgetting the course markets have taken since time immemorial.
I, for one, believe that there has been a paradigm shift in the economic performance of this country and as a consequence, we are set for a multi-decade structural and secular bull market in India.
This seismic shift reflects a structural change in fundamentals, which has to be inevitably followed by an alteration in perception. The question we seek to address is “Is it different this time in India?” and “Is it sustainable?”
For the answer, we have to look at the reasons and the reasons behind the reasons for the Change that is taking place.
We believe India, too, has begun its journey on such a paradigm shift in its equity markets, which is a reflection of the structural changes in India’s demographics, critical economic mass, policy frameworks, and corporate competitiveness and governance. Would you have expected the following for India?
1. Sustained 7%+ real GDP growth for more than four years
2. 40% rise in consumer credit and 56% growth in mortgages
3. Consumption boom across categories - mobiles, cars, 2-wheelers, watches, jewellery
5. Infrastructure spending at $20 billion
6. Rising employment, with wages rising even faster
The quality of corporate performance has undergone a sea-change. This is more than adequately reflected in the DuPont analysis shown below for India’s top 200 companies. There has been a sustained improvement in the return on equity for the corporate sector, despite lower tariff protection, lower inflation and deferred tax accounting.
The fixed-asset efficiency as well as the working capital efficiency has improved. The revenue and profit per employee has improved significantly. India Inc has among the highest return on equity in the world.
India is in the midst of a consumption boom, and we believe that a capital expenditure boom is around the corner.
Can you believe that until recently India was saving more than it was investing? In spite of a superior incremental capital output ratio compared with peer countries, India’s investment to GDP ratio is significantly lower.
The thrust on infrastructure build-up over the last five years and improving cash-flow profiles of India Inc combined with the reality of higher utilisation and increased competitiveness mean a capital expenditure cycle inevitable. If there is a confluence of capital expenditure and consumption cycle in the coming decade, India’s economic and corporate performance will surpass all expectations, and we could see high double-digit GDP growth.
The institutional framework in India is now vastly superior to what it was a decade ago, and is probably among the best in emerging markets. The Indian banking system is much more evolved and robust compared with other emerging markets. The Indian equity transaction framework (including electronic trading systems and dematerialisation) have very impressive trade densities, lower transaction and impact costs; and robust, effective regulation.
The breadth of the sectors, business models and companies provide a very wide choice for investors. IPO disclosures, listing obligations, and quarterly results with segmental reporting make India an investor-friendly market.
All these have been achieved under democratic conditions. Democracy is deep rooted in India. This is reflected by the fact that although there is no single party in power in the Parliament in the last 16 years, all the necessary institutions of democracy such as the Supreme Court, the defence forces and the Reserve Bank of India are all working perfectly and all changes in the government have taken place in accordance with law.
Whatever knowledge of history I have tells me that no society has achieved economic growth and sustained it without a democratic framework and what would growth mean without human right and freedom?
Growth is surely slower but more deep-rooted and sustainable under democratic conditions.
I believe that all growth is an evolution and all success is chemistry. I feel that India has had bottoms-up growth in a perfectly evolutionary manner — growth has not been thrust down India’s throat.
Although there are always risk factors in any economic system I believe that there could be intermittent periods where growth could slow down because of various factors; but you can only slow and not reverse India’s march to inevitably being one of the economic powers of the world.
A very large part of the index gains are driven by the corporate earnings growth, with valuation expansion hardly playing a role.
This is usually the case in the first phase of a structural move in equity markets. The next phase would have to inevitably reflect improved valuation in the composition of index gains.
Such valuation improvements will also be driven by a sustained increase in equity exposure of domestic investors from the current minuscule levels.
The following chart shows the level of savings house hold savings in India. These savings are projected to go up from $175 billion in the financial year ended March 31, 2005, to $355 billion in the financial year ended March 31, 2010.
Household exposure to equities in India as per the latest statistics is only 1.5% compared with between 15-25% in most developed, and some emerging market, economies.
Even if 15% of the fresh household savings is to flow to Indian equity markets by 2010, you are talking about $50 billion of domestic money entering into the local markets.
You can well imagine what this will do to the price-earning ratios of Indian stocks. The increased penetration of insurance and the need to develop a modernised pension system will further fuel the fire of equities.
As one can observe, all of the above are factors that are unprecedented for Indian equities.India is now on the radar of multinational corporates as well as global investors. The addressable markets for India Inc have expanded multifold.
The mindset, confidence and attitude of India Inc is superlatively different from ever before.
The taxation environment for Indian equities is the most favourable that it has ever been. Alternative investment opportunities offer poor returns.
Indian pension and provident funds as well as the public sector banks have no significant exposure to equities.
The Indian mutual fund industry have come of age, and now has distribution and management capabilities to cater to the needs of Indian investors to enable them to put a greater component of their savings in equities.
So, let me reiterate our hypothesis:
1.We have seen rapid earnings growth over last three years, and we expect about 20% average earnings growth over the next years decades.
2.The quality of earnings has improved dramatically, and the quality of earnings will sustain going forward.
3.There is endemic under-exposure to equities in the Indian savings basket, which we expect to correct over the coming decade.
4. The institutional framework to make this possible is now in place, and will continue to improve in the coming years.
We believe that the paradigm shift of Indian equities has begun, and will continue over the coming years. The changes are structural and unprecedented. The critical mass of change is upon us, and the pace of change will accentuate.
The markets will reflect the reality of this change sooner or later, but the perception of this change is gaining momentum.
Investors will be well advised to respect this structural change and not focus on short-term factors. We truly believe “This time it’s different” and time will judge our conviction, though it may test our patience.
