The Hindu Business Line : Are Indian equities all that expensive?

With reforms slowing perceptibly, FIIs may fear that the growth engines are fast running out of stimulus. If such fears prove unfounded and listed Indian companies continue reporting earnings growth of over 15 per cent in the next four quarters, the FII flows will be back with a bang.

THE downgrade of Indian stocks to `sell' by the investment bank Merrill Lynch on November 8 may have been ignored by the stock market but may return to haunt the market sooner rather than later.

Merrill's view essentially captures the mindset of foreign institutional investors, who have been reacting to the retreating global liquidity and the strengthening of the dollar. Slower and lower FII flows now have to be reckoned as a likely outcome.

Fence-sitters in India, wondering whether to put fresh money into the markets, may have already been stung to the quick by the call. Investors who have already put money into stocks may have felt a chill going up their spines. For them, this strange beast called the market may now resemble a bear. But this is precisely the wrong message to take home.

For Indian investors, it still makes sense to put money into Indian stocks. The fair value of stocks can be at a higher level than it is for overseas investors, especially when the rupee is declining in value. You can wager that fund managers at DSP Merrill Lynch, the Indian mutual fund, will fully endorse such a view.

Not for Indians: The call of Merrill Lynch to `sell into strength' is applicable more to foreign institutional investors. They have the option to invest in various emerging markets. Indian investors have limited options in this regard.

For foreign investors, if the rupee declines by 3 percentage points every year, the total return from Indian markets will dwindle to about 5 per cent or lower if equities deliver returns of only about 8 per cent per annum. That is not attractive considering the risk involved in emerging market equity investments. Maybe, even US stocks will deliver more than 5 per cent. That is not so for Indians.

Among the asset classes available to them, equities will still be the asset class to stay in. Debt will fetch, at best, returns of 7 per cent post-tax for investments made now. Gold is out of the reckoning. And Indians are over-invested in real estate.

The liquid stock market that will in all probability beat debt and inflation is thus always attractive. And more so if stock prices decline by 20 per cent in the short term. Over a longer term of five years and beyond, equity investors are highly unlikely to lose.

Fundamentals to fore: The Merrill call also surprises when it says that "India may well be the greatest long-term story within emerging markets" but goes on to suggest that the "Indian market is the most expensive within GEM (global emerging markets)". Declining FII flows, the principal driver of equity returns, and the weakening rupee may have forced the call rather than any sudden change in estimates of earnings growth of Indian companies.

Comparisons to markets such as Korea, Brazil and Russia also do not convey much. Korea may be cheaper than India but it has to be classified along with developed markets. Sales growth in Korea and return on net worth of Korean companies over the past few years do not compare favourably with that of India.

The potential offered by India, too, is at a higher level compared to Korea. Indian GDP growth over the next decade may well be double that of Korea. There are about 700 listed companies in the Korean exchange. The number of reliable listed companies in India is already higher, at about 750, and growing every year.

Comparisons to Russia and Brazil are truly disappointing. A recent BBC programme showed that armed gangs in Russia forcibly takeover private businesses, giving a new twist to the term `hostile takeover'. The short-term interest rates in Brazil are about 19.5 per cent, while they are 5.5 per cent in India. Such high short-term rates are indicative of an economy beset with problems.

Though these issues may not be indicative of the economic growth potential of Russia and Brazil, it does highlight how different India is from many other emerging markets. India offers developing countries economic growth backed by standards of corporate governance and trading systems that are on par with that of developed countries.

One would hope these factors justify higher multiples. If they do not, it may be a reflection on the pace of economic reforms. With reforms slowing down perceptibly, FIIs may fear that the growth engines are fast running out of stimulus. If such fears prove unfounded and listed Indian companies continue reporting earnings growth of over 15 per cent the next four quarters, the FII flows will be back with a bang.

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