By Kashyap Javeri
The Indian stock markets, like most of the world stock markets, have been in a state of renewal for the past eighteen months. From their lows in March 2020, large indices are gaining nearly 100-110% and medium and small-cap indices are up 150%-200%. But this relates more to the low base and the crash during March 2020, so the long-term compound annual returns over the past 5 years and 10 years for the large and medium-sized caps are still in the 15-18% range. In fact, if one looks at the BSE Midcap Select Index which is a much narrower quality Midcap Index, it has generated compound annual returns of only 12.4% in the past five years.
Therefore, we believe that the recent market surge is a lot like catching up with the average and covering up the poor performance of previous years.
However, the recent rise in the broader indices has led to a sharp reassessment with the BSE 30’s PER index reaching 31.5 times, which may be the highest in the past 15 years. However, these valuations must be viewed in the context of two developments, (a) stock markets continue to offer better returns than similar assets.
BSE Sensex has a one-year forward dividend yield of 4.9% (including dividends), versus a one-year G-Sec return of 4.1%, (2) Even as the mid/small corporate indices rise significantly, the valuation premium for BSE Select Small and Mid-cap over BSE Sensex is still far from its peak.
Having talked about ratings, let’s draw attention to what can happen to earnings. We believe the Indian economy is now entering a robust multi-year earnings growth cycle. Our view of strong economic growth and consequent profit growth is backed by few developments (1) Inflation is back after many years. Although a lot of it is dangerous, very little of it during the 2014-20 fiscal year also discouraged industrialization (2) and government spending is clearly bouncing back hard in retaliation. Not only do we like the growth in government spending, but what we also like is its quality as the extra spending goes towards capital expenditures. (iii) Personal and corporate savings are on the rise, which is reflected in the strong growth in deposits/SIPs and the deleveraging in corporate balance sheets respectively. All these factors are reminiscent of the strong growth years from 2003 to 2010 and created a sense of Déjà vu.
We also believe that a turnaround in the corporate capital expenditure cycle is around the corner. The transformation looks much closer today than at any time in the past 7-8 years. Some of the reasons for this view are clear from above i.e. inflation which leads to capacity utilization and under-indebtedness in the balance sheets. But more importantly, there are several fundamental reasons why companies make these capex decisions today, (1) the cash return on capital used today for the manufacturing companies in the NSE500 Index was 21%+ for fiscal year 21, compare that to fixed deposit rates of 500 -600bp. It makes more sense for companies to invest in new capabilities than investing cash flows in bank deposits (2) Until now, access to bank financing for capital projects has been restricted by the unavailability of capital at PSU banks (they have 60% + market share). Today with the influx of liquidity and strong capital for PSU Bank, financing should be the least of the problems. Hence, we expect a strong recovery in the capex cycle by fiscal year 23.
However, one must be aware of the dangers inherent in the vicinity. Inflation has been a huge problem with CY21, and even with it receding a bit, it is still high. We believe that the problem is temporary in nature and one can clearly see the slowdown in some non-ferrous and ferrous metal prices, but crude oil still plays the role of a spoiler. Any sustained inflation will mean that central banks around the world may raise interest rates which will be a spoiler for equities. One also cannot ignore geopolitical risks, especially in our region, although it is almost impossible to predict the same. Third, we also have several state and general elections coming up in the next 36 months. Government stability will be just as important.
In short, Indian stocks are looking forward to an extended phase of a robust earnings growth cycle and turnaround capital expenditures over the next 3-5 years. With the risks outlined above, of course, markets will still be choppy in choppy phases. But this should not deter anyone looking to create long-term wealth that can only be generated through doubling. Corrections are always part of any bullish cycle and investors should use them to their advantage in times like these.
(Kashyap Javeri is a fund manager at Emkay Investment Managers. The opinions and investment advice expressed by the expert on the Indian stock markets are his own and for information only. Any advice the expert shares with the independent financial advisor should be reviewed before making any investment decisions.)