The Hindu Business Line : Temper optimism with caution

AMONG emerging economies, the vote of institutional investors has decidedly swung in India's favour. A substantial proportion of cross-country flows has come the way of Indian stocks since March 2003.

Indian companies finally fired the global imagination by improvements in their efficiency, their spirit of enterprise catching the investing world by surprise. Since expectations were pegged at artificially low levels, the stock prices initially played catch up with earnings growth, but have now gone ahead.

As stock prices scale fresh peaks, the burden of earnings growth expectations keeps mounting. Indian industry's GDP growth of 9 per cent plus for the third year in succession suggests that such expectations are not unwarranted. Will industry deliver or buckle under the weight of expectations? So far, the earnings growth each quarter has been above that 15 per cent mark. On the weighing scales, earnings growth has matched expectations, supporting the valuation levels. If industry dithers even for a couple of quarters, however, the slide will be swift. Institutional investors would then vote out Indian stocks with as much alacrity as they are voting them in now.

Capacity to deliver: Over the past three years, industry dug itself out of a hole. Pushed into a corner by declining import tariffs, falling commodity prices and dormant domestic demand, it fought back admirably by cutting costs and debt. These efforts bore fruit when domestic demand came roaring back to life. Now, the balance-sheets look unquestionably attractive.

Profitability of companies in most industries is comparable to the best in the world. Studies have proved that the return for a rupee invested in India is far higher than what can be earned in China. At the end of March 2005, more than half the companies comprising the CNX-500 index enjoyed return on net worth of over 15 per cent.

It is this high return on net worth of 15 per cent that is now built into stock prices. Investors in the stock market now believe that companies are capable of delivering earnings growth of about 15 per cent per annum over the next five years. Doubting Thomases, however, abound.

People on the other side of the divide believe that the high return on net worth is a mirage. Falling depreciation and interest costs have been cited as the principal reasons for the increase in profitability.

As Indian companies start investing, depreciation and interest costs will rise. Presto, profitability will again decline, they argue. This will curb their capacity to deliver earnings growth of 15 per cent.

There is certainly merit in this argument. There is, however, evidence to believe that, globally, companies have learnt from economic cycles. Outsized capacity expansions and inventory build-ups may become things of the past. For instance, despite a spectacular increase in cash flows, companies have not been in a hurry to spend. Their size, too, is an advantage.

With smaller expansions in their equity capital relative to the past, they are now able to finance projects that will deliver earnings growth. Cyclicality in profitability could thus be much less than it has been in the past.

The believers also expect strong domestic demand to be sustained offering companies enough opportunities to grow.

Mean reversion: So, if you too believe that earnings growth will be about 15 per cent per annum for the next five years, then you can expect returns of about 8 and 10 per cent per annum from stocks. Expected returns will be below earnings growth because a decline in price earnings multiples over the next five years is guaranteed.

As of now, most companies trade at a price-earnings multiple of more than 20. Given that high earnings growth of 15 per cent cannot be sustained indefinitely, this PE multiple will decline, reducing expected returns.

The expected return from stocks is a function of earnings yield plus earning growth adjusted for changes in the PE multiple. In March 2000, the average PE ratio of stocks forming part of S&P CNX 500 was about 10, and the average return on net worth was about 10 per cent.

Without changes in the PE multiple, you could have expected returns of about 10 per annum. If you expected the PE multiple to expand to about 15 it would add another 5 percentage points to expected returns. Actual returns for the S&P CNX 500 between March 2000 and February 2006 were about 16 per cent per annum.

For the next five years, decline in PE will reduce returns by 5-6 per cent per annum for S&P CNX 500 stocks. The earnings yield now is about 4 per cent. Expected earnings growth, on an average, is about 15 per cent.

Plugging these numbers into the equation, we get expected returns of about 8 per cent. Is this attractive? It certainly is, if we consider the tax efficiency of equities. Debt, in contrast, can only provide post-tax returns of less 5 per cent.

Reckon with cyclicality: Expected returns of about 8 per cent are, however, based on assumptions that earnings and stock prices grow in a linear, undisturbed fashion. Reality is, however, seldom as unexciting. Usually, stock prices swing between extremes. We are now enjoying an extended period of optimism. This spell could take stock prices to further higher levels.

Most stock market investors do not relish single-digit returns. Consequently, they will unwind their positions. Liquidity will decline and a downtrend will set in. That volatility could knock you down.

This caution does not mean investors should stay away from equities now. They have to be convinced about their investment ideas.

Stock selection is now of paramount importance. Excessive caution and a healthy dose of scepticism are now warranted. To paraphrase the former US Fed chief, Mr Alan Greenspan, history has not dealt kindly with investors who expect periods of optimism to last.

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