The Hindu Business Line : Earnings growth may settle at a sustainable 15-20% per annum

On a daily basis, many of the Asian markets appear to move in tandem but over longer timeframes our research shows that the correlation of Indian markets with other Asian markets is low.

Mr Sukumar Rajah, CIO-Equity, Franklin Templeton Investments.

Aarati Krishnan

Franklin Templeton, among the first Indian fund houses to flag off an international fund in the form of the Templeton India Equity Income Fund, recently broad-based its menu of overseas funds by adding Franklin Asian Equity Fund to its por tfolio. ‘Are Indian market valuations overstretched? Is Asia really “decoupling” from the developed world?’ Mr Sukumar Rajah, CIO-Equity, Franklin Templeton Investments, fields a few questions from Business Line on these and other issues.

Excerpts from the interview:

Stock price gains in Indian markets over the past year have been driven mainly by expansion in P/E (price/earnings) multiples. The Sensex P/E has expanded from 18 times to 26 times earnings in one-and-a-half years. Are the earnings expectations reflected in current valuations attainable?

We have been stating that margin growth is expected to be moderate due to the high rates witnessed in the past. Over the last five years, earnings growth on an average has been at a higher level, which is not sustainable. Typically the multiplier (of earnings for Indian companies) is not more than 1.5 times the nominal GDP growth.

Hence, we could see earnings growth settling at a sustainable rate of 15-20 per cent annum. In the light of this, there could be volatility over the short term if the high growth expectations are not met. But from a 3-5-year horizon, we are positive about earnings and economic growth.

Recent economic data has been suggesting a strong likelihood of a US slowdown. Do you agree with this view? Which of the Asian economies (apart from India) are better placed to weather this slowdown?

Yes, most of the recent data is pointing towards moderation in US economic growth. Investors continue to monitor the possible implication of credit market tightness and housing sector weakness on the US economy.

However, economic growth in other developed markets such as Europe and Japan appears to be steady at this juncture.

The Asian region is far better placed now than in the 1990s to weather a slowdown in the developed world, helped by increased intra-regional trade and growing domestic consumption.

Trade flows outside emerging Asia roughly tripled between 1990 and 2006, inter-regional trade involving emerging Asia rose five times, and intra-regional trade within emerging Asia increased 8.5 times. However, the speculation over de-coupling has been overdone.

Given the major role played by the US in the global economy, it would be premature to talk about a complete ‘de-coupling’. Any sharp slowdown in the developed economies will have an impact on Asian countries, but the impact would be far lower compared to the past.

Other factors such as high forex reserves, current account surplus, strong financial systems and improved quality of corporate balance-sheets (reduced exposure to debt) are also in favour of Asia.

The key point to note is that GDP projections for the Asian region continue to be far higher compared to other regions at present — 8.8 per cent (as compared to Euro area, 2.5 per cent; US, 2.2 per cent; and Japan, 1.9 per cent).

And in purchasing power parity terms, Asia’s contribution to global GDP growth between 2002 and 2006 stands at over 40 per cent.

Will domestic drivers compensate for an export slowdown and how long will this process of substitution take?

We are already seeing signs of domestic consumption increasing in regional economies of Asia, excluding Japan. Strong growth is being witnessed in the investment-to-GDP ratio (driven by infrastructure spending) and domestic savings rates.

It is the latter, which is likely to provide support to regional economies as consumers start spending more in the future.

Increased affluence and growing urbanisation in the region should translate into higher growth, consumer spending and consumer credit.

Household credit remains low as a percentage of total private sector credit, which could bolster consumption growth.

How vulnerable are these economies to higher oil prices?

Asia as a whole is a net importer of oil (demand is driven mainly by China and India), despite oil-producing countries in the Southeast and Northern regions. IEA estimates that China and India together will account for 45 per cent of the increase in global primary energy demand between 2005 and 2030.

Also, the impact of high oil prices has not been fully passed on to the consumers due to subsidies and, as a result, inflation in these countries doesn’t reflect the current high oil prices.

Do you believe that diversifying overseas can help an investor earn better returns than from the Indian market alone? Or is it to be viewed only as a diversification option?

We believe that it is a mix of both — diversification through exposure to companies in different countries and access to growth potential similar to that of India.

This has been one of the reasons for us to offer potentially a 100 per cent exposure to Asian markets through our Franklin Asian Equity Fund.

If we look at the performance of different Asian markets, Indian markets haven’t finished on the top even for one year during the last 10 calendar years.

As a result, it would be fair to assume that an investor with a long-term view is likely to benefit from a portfolio diversified across the region and generate better risk-adjusted returns especially in a scenario where the correlation of the Indian markets with other Asian markets is quite low.

The various Asian markets appear to move in tandem on most trading days. Will diversification into other markets help an Indian investor reduce volatility or change the risk profile for his portfolio?

On a daily basis, many of the Asian markets appear to move in tandem but over longer timeframes our research shows that the correlation of Indian markets with other Asian markets is low.

In fact the R-Squared (a statistical measure of the relationship between two variables) calculated for a timeframe of five years shows that the correlation of MSCI India ranges from a low of 0.08 with MSCI Philippines to a high 0.37 with MSCI Singapore. This indicates that diversification into other Asian markets would help an Indian investor to reduce portfolio volatility and get potentially similar returns to that of India.

Among your international funds, Franklin Templeton already manages a fund which focuses on the emerging markets and is now launching an Asian Fund. How do emerging markets differ from Asian markets in their relative attractiveness?

We believe that both Asian and emerging markets offer good growth potential to investors, with most of the leading emerging markets being in Asia.

In that sense, both investment universes offer similar risk-adjusted returns. However, from an adoption perspective we found that Indian investors are more open to a pure Asia Fund as a diversification.

Though Indian investors have been urged to moderate their return expectations for some time now, select stocks have continued to deliver stellar returns, with even index heavyweights such as Reliance & L&T turning out to be multi-baggers over the past two years. Are returns over the next 3-5 years already priced into current stock valuations?

One of the key reasons for the strong performance of such stocks have been new drivers — organised retail, growth in financial services, unlocking of value through listing and infrastructure spending, and so on.

While valuations in certain pockets of the markets appear to be overstretched, we continue to expect a 12-15 per cent growth in earnings for well managed companies that are actively taking advantage of macro trends such as increased capex, consumption and infrastructure spending over a 3-5 year period.

What are some of the interesting sectors that are under-represented in the Indian markets, which Indian investors may get access to through an international fund such as this?

Some of the interesting sectors that are under-represented in the Indian markets which Indian investors may get access to through such a fund are Internet services, semiconductors, travel, coal mining insurance, food processing, retail, gaming, etc.

Any reasons why you think a growth-oriented approach to investing will work better than a value-oriented one, in the Asian markets?

Growth and value styles of investing tend to outperform each other during the different phases of an economic cycle and these funds can be complimentary in one’s portfolio. We think both investment styles have a place in an investor’s portfolio — we manage a value style fund at the Asia level along with a growth style fund.

This is consistent with Franklin Templeton’s aim to provide a complete range of investment products across asset classes, investment styles and geographies. The Franklin Asian Equity Fund is adopting a growth biased investment style to offer Indian investors potentially a similar product in terms of return potential, but reduced risk due to the additional diversification.

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