Given that returns from equities will come only in the long run and alternative investments are not faring that good either, investors just have to go by historical trends.
Sometimes large contradictions are concealed within public data. For example, official projections suggest that 2008-09 GDP growth will be somewhere between 6.5-7.1 per cent, depending on Q4 results.
The interim Budget seems to project 2009-10 GDP at around 5 per cent – a drop of 150 basis points compared to 2008-09. The political establishment is patting itself on the back and claiming its do-nothing policy is vindicated by the fact that India’s 2009-10 GDP will outperform most other nations.
There’s general consensus that this is the worst recession since World War II. There’s also general consensus, borne out by the share of trade (including invisibles) in GDP, that India is more globally integrated than ever. Ergo, India may suffer its worst recession since 1991-92. Well, the projections don’t gel with hopes of a fast rebound. In the past two recessions of 1997-98 and of 2001-02 through 2002-03, GDP dropped to 4.3 per cent or lower. If this recession is worse, it should bottom at below 4 per cent. Advisories suggesting bottoming out at 3 per cent seem more credible than 5 per cent growth in 2009-10.
Whatever the nadir, it’s better if it’s reached quickly. Given the state of official statistics and the politicisation of projections, it’s likely the contradiction will be resolved. The Budgetary Estimates will prove optimistic and the Revised Estimates will nosedive.
But doubts about GDP translate automatically into shifting ground for corporate valuations. On historical evidence, Indian corporate earnings growth is 2.5 times GDP growth plus inflation or approximately (2.5x GDP) +WPI. The WPI year-on-year is down below 2.5 per cent and liable to fall further, given price spikes in May-September 2008. Let’s say it averages out at 3 per cent for 2009-10.
In that case, with 3 per cent GDP growth, we’re talking about 10-11 per cent EPS for India Inc. If it’s 4.5 per cent GDP, the EPS would be around 14 per cent. These are crude back-of-the-envelope calculations but sophisticated models offer similar numbers.
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There are major differences in index levels when those numbers are plugged into standard valuation models. Two perfectly respectable models throw up a valuation range where the top-end of the most optimistic valuation is 120 per cent higher than the bottom-end of the most conservative.
If fair-value with a PEG ratio is assumed to be 1, the market PE could be anywhere between 10 and 15, depending on GDP growth and corporate EPS multiplier. That’s a 50 per cent difference.
Using an interest rate model, with the risk-free 364 Day T-Bill at 4.5 per cent and inverting earnings yield, we get an equivalent fair-value PE of 22. Commercial lending rates are still far higher at around 9-10 per cent and suggest fair value PEs of 10-11.
During a recession, investors turn instinctively conservative. Let’s assume that PEs of 10 or less will be in demand. That too, only with corporates capable of scoring 10 per cent EPS growth or better.
As far as can be figured, the Nifty’s PE over the EPS of the past four trailing quarters stands around 12 and it bottomed at below PE 11 in October 2008. That implies there are lots of blue chips in the target zone for conservative investors. A glance at other ratios such as price-book value and dividend yield also suggest many shares are trading at fair valuations or lower. But that’s no reason why the market index couldn’t lose more ground. If 2009-10 EPS growth struggles to reach double-digits, the Nifty could be placed at around 2100 in the next 12 months. Of course, if 15 per cent EPS growth is achieved, commercial rates slide and the interest rate models hold good, it could rise to over 4400.
Given the paucity of cash and the risk-averse nature of investors at the current moment, it’s difficult to imagine the upper end of that valuation will be reached. There is also a big question-mark over the quality of governance of the next coalition.
Most likely, capital gains from equity investments will accrue only over a two-year timeframe or longer. The problem is, alternative investments don’t promise much more. This seems a situation for gritting one’s teeth and keeping faith with historical trends. Equity always pays the most in the long-run but it will be the long run.