Over the last six quarters, whilst real GDP growth has averaged around 7 per cent, earnings per share (EPS) growth for the Nifty has been non-existent. Now, even revenue growth for Nifty companies has conked off. The last such sustained period of weak growth in the stock market profits took place in the wake of the 1991 reforms — in the three years following the New Economic Policy of July 1991, the Sensex’s profits barely moved. We are half-way through a similar economic reset in India, a reset that large, oligopolistic corporates will find hard to deal with.

Modi + Rajan + TechnologyThe reset engineered by the Prime Minister: Over the past year, Prime Minister Narendra Modi has engineered three resets: (1) shift India’s savings landscape away from physical assets towards the formal financial system through a crackdown on black money; (2) disrupt the traditional model of crony capitalism in sectors such as utilities, oil & gas, engineering & construction, real estate, mining and telecom, that has been central to driving capex in India; and (3) redefine India’s subsidy mechanism which saw subsidy spend compound almost 20 per cent per annum during the 10 years of UPA rule.

These resets are likely to structurally lower inflation while reducing the cost of the factors of production. While a structural decline in inflation, corruption and the cost of factors of production are likely to make several businesses viable, at the same time these are also likely to reduce barriers to entry in most sectors, thus challenging the super-normal profitability of many large incumbents.

Rajan’s anti-inflationary policies : The RBI Governor has deliberately focused on, and largely succeeded, in achieving the following: a) bringing down inflation, b) keeping real interest rates positive; c) reducing currency volatility; d) changing the rules of the game for creditors through the Strategic Debt Restructuring (SDR) regime and the draft Bankruptcy Code; and e) rapidly creating new payments banks and small finance banks.

Whilst these steps are likely to bring down the cost of capital for borrowers on a sustainable basis, they have also resulted in greater foreign appetite for Indian corporate debt. Although this is positive for borrowers in general, the deepening of the bond market that this entails is posing a threat to the profitability of well-established Indian lenders. Secondly, while the SDR and the new Bankruptcy Code will simplify matters for creditors, in the short term they are likely to further increase stress in the financial system.

The technological revolution : The disruption created by advances in technology, coupled with easy access to low-cost funding, has resulted in the competitive moats around incumbent duopolists/monopolists shrinking. These disruptions may range from the relatively obvious ones (like Flipkart for brick-and-mortar retail and Paytm for financial intermediaries) to more complex ones like e-commerce players with access to vendors’ credit history also stepping in to provide financing to these SMEs (such as Ant Financial appears to be doing in China).

Economic impact of resets Both in nominal and in real terms, the borrowing cost in India remains among the highest in emerging markets. Modi’s attack on black money and his willingness to restrain subsidy spending should lower the cost of capital and cost of land whilst dampening wage inflation. Rajan’s focus on infusing competition into the banking system should lower the spread that banks generate over the risk-free rate. All of these forces should also lower the barriers to entry and increase competition.

Investment implications Of the 30 companies that were in the Sensex when Manmohan Singh introduced his New Economic Policy in July 1991, 20 of these were out of the Sensex within a decade. Then, after peaking at 67 per cent (or 20 replacements in a 30-stock index) in the decade following the reforms, the Sensex churn fell to a low of 27 per cent (just eight 8 replacements) from 2004 to 2014 as the economy ossified under the UPA. Given the economic-political climate described above, we expect a reversion to 50 per cent churn, implying that 15 companies will exit the Sensex in the next decade. So, which sectors will be most impacted?

Banking & Financial Services commands the highest weight in the Sensex (31 per cent) followed by IT (16 per cent). Whilst incumbents in the banking sector are likely to face earnings pressure from the introduction of new banks and from the bond market, the IT Services companies will have to deal with the impact of cloud computing over the next couple of years.

Further, in sectors such as oil & gas, engineering & construction, metals & mining, telecom, utilities, infrastructure — the Prime Minister’s unwillingness to let the rent seeking model operate means that growth prospects will stay muted at best in these sectors which account for 21 per cent of the Sensex.

Therefore, for at least two-thirds of the Sensex constituents, the Modi+Rajan+Technology reset implies structural pressure on EPS growth which, for the Sensex, will be in low single digits in FY16 and, at best, in high single digits in FY17. This implies that barring a miraculous re-rating of the Sensex’s P/E, investment returns from the frontline index will be in single digits over the next six quarters.

The writer is CEO - Institutional Equities, at Ambit Capital and author of Gurus of Chaos: Modern India’s Money Masters. Views are personal

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