The Hindu Business Line : Why the Sensex fall is overdone

Exports being 14 per cent of GDP, India is less vulnerable to external shocks than many other Asian nations. Besides, India’s exports are diversifying, reducing the risk emanating from a slowdown in a region or a country such as the US.

Sunil Kewalramani

Once the darling of global investors, the Indian stock market has fallen from favour. The MSCI India index is already down 30 per cent this year in US dollar terms and is among the worst performers in its peer group. Past bear markets in India have seen indices falling 40-55 per cent. Family silver is beginning to come out, in a dramatic act of capitulation. But the India story has not ended, else $200 billion with institutional investors would have fled for safer waters. It is indeed surprising that though the epicentre of the sub-prime crisis is the US, the tremors are being felt in India. The loss of market cap in the US is only 14 per cent vis-À-vis 38 per cent in India.

Still on solid ground

The structural factors underpinning the India story appear on solid ground. By 2009-10, over 50 crore Indians are expected to have a household income of over Rs 4,50,000 per annum (in Purchasing Power Parity) terms. India’s middle-class will grow ten-fold from its current size of 50 million to 583 million people by 2025. India is expected to achieve a 50 per cent share in global IT and BPO services by 2008. One-fifth of Fortune 500 companies have set up R&D centres in India.

India’s frontline IT companies are skill-based and have a global competitive advantage. Over the long-term, programming the world’s computers and networks may be much more value-accretive than, say, digging up iron ore and copper mines and selling the underlying now-hot-now-cold commodity.

With GDP having grown 9 per cent three years in a row, the economy was reaching its limits in terms of spare capacity, thus leading to build-up of inflationary pressures. Running a tight ship and keeping debts low is strongly ingrained in Indian companies. Exports being 14 per cent of GDP, India is less vulnerable to external shocks than many other Asian nations. Besides, India’s exports are diversifying, reducing the risk emanating from a slowdown in a region or a country such as the US.

FII selling not the only driver

Though the Sensex fall is widely attributed to FIIs pulling out, that’s not the complete explanation. While the flames of the credit crisis began to devour the developed world, the Sensex rose rapidly from 14,500 in early April 2007 to 20,000 by end December 2007.

The last leg of this rise was not supported by FII buying. In fact, FIIs, who were net buyers in October 2007, turned net sellers in November and December 2007 to make up for the losses on account of the US sub-prime defaults. Fast forward to 2008. When the Sensex began its fall in January 2008, FIIs net sold Rs 17,227 crore, but followed this up with net buying in February and March 2008, FI. Surprisingly, when the Sensex rebounded to 17,800 in May 2008 FIIs were net sellers. This shows that the movements of FIIs and Sensex are not directly correlated. Various extraneous factors have caused the FIIs to sell, and their selling has been absorbed by other market players.

It is believed that the credit crisis mark-to-market impact in India is less than $2 billion. Total corporate profits of India are $85 billion so the mark-to-market losses are hardly 2 per cent of the total. Corporate India may lose 2 per cent of earnings to the crisis, but underlying stocks have lost 30-40 per cent.

No historic oil link

Most common investors are led to believe that oil and stocks have an inverse relationship. If you graph historic oil prices against the S&P 500 of the US from 1982 to 2006, you will find that oil and stocks have a correlation coefficient of -0.11, which is a negative correlation. Besides, R-squared which shows the relative relatedness of the two variables (oil and stocks) is 0.01, which means that only 1 per cent of stock movements can be associated with oil. The malaise is much deeper, and not just oil as most data-mining commentators, are making it out to be.

Whither Liquidity

China, India, South Korea and APAC cumulatively represent 28 per cent of World GDP in Purchasing Power Parity terms but have just a 5 per cent weight in the MSCI World Index even after strong stock market appreciation in the recent past. In sharp contrast to this, the US now represents 19 per cent of World GDP in Purchasing Power Parity terms but has a 42 per cent weighting in the MSCI World Index. The rebalancing between the stock valuations of emerging economies and the developed world is inevitable, and this will only enhance the inflow of liquidity to emerging economies such as India.

Savings in India have risen at a historic rate of 35 per cent on the growing GDP base; 17 per cent of this is in gold, commodities and real-estate while financial savings represent 18 per cent of GDP. Even this is skewed towards deposits — both banking and non-banking, while the percentage of savings in shares and debentures is a mere 6.3 per cent. If this percentage goes to 25 per cent, it would amount to $40 billion of incremental money being diverted to capital markets.

Fair estimate of Sensex

Assuming a GDP growth rate of 8 per cent, earnings growth of 28-30 per cent for Sensex companies and an interest rate of 7.5-8 per cent, the average earnings per share of Sensex companies can be estimated at Rs 1,300 for FY 2009 on a free-float basis. A price-earnings ratio of 18-20 on this EPS gives us a Sensex estimate of 23,400 to 26,000 for FY09.

The ‘embedded value’ of under valued assets that are housed in the balance sheet of the Sensex companies (Reliance Gas Reserves, value of insurance business of ICICI Prudential, etc), have the potential to add another 2,000 points to the Sensex. Historical trends in Sensex valuation suggest that “value” in Indian equity markets may re-emerge at about 12,500 levels.

(The author is CEO, Sunil Kewalramani Global Capital Advisors. )

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