 "People come and tell me India is the only game in town: Ridham Desai")
From being one of the Fragile Five, India has emerged as the most sought-after investment destination. The massive mandate the Bharatiya Janata Party (BJP) got in the general elections has further given them the confidence growth will revive. Ridham Desai, India equity strategist and India Equity Strategist, spoke to Malini Bhupta and Vishal Chhabria on the eve of Morgan Stanley's 16th Annual India Summit on how investors view Indian equities and what to watch out for in six months. Excerpts:
A lot has happened in the market in three months, what is your take on Indian equities?
The markets have done a lot of work. The index is up 25 per cent in three months, which is a lot. The performance has spread to the broader markets, and there is a lot of value. If the economy comes out of the cyclical downturn, the smaller companies will do a lot better. Some policy choices are needed to ensure the cyclical recovery happens.
Yes, the re-rating has happened. Indian markets are trading at a 50 per cent premium to other global emerging markets. We are trading on a par with the US markets. India is the third-most expensive market on price/book basis. People tell me India is the only game in town. Sustainable or not, time will tell. I get nervous when prices go up in anticipation of change because the risk-reward is not in my favour.
What are the key things the government needs to do to revive growth?
I will take a step back to answer this question. There were some policy choices India made in the aftermath of the global crisis. The policies were focused on redistribution of income and the result was we slipped into a stagflationary situation. This caused inflation. Of course, there were other issues like subsidies and high government spending. Global environment was also difficult. So it was a combination of factors that worked badly for us. There are three key factors to watch out for, essentially the redressal of three big issues we have faced over four-five years.
The first is to de-anchor inflation expectations, which are very high and from where you can expect growth to recover. The central bank and the government need to act together on this. If real rates stay positive for some time, it will start impacting household behaviour. In five years, financial savings have declined by 500 basis points to 7.5 per cent. The government, too, has to keep spending in check. The outgoing government has set stage for lowering oil subsidy. If these two things are done, growth can revive.
The second is capital productivity has to improve. The incremental output ratio has halved for reasons well advertised. The main reason is many projects are incomplete or are complete but generating no output. Aggregate output is below potential and it depresses capital productivity.
The third is to deleverage the private sector. Projects need to be cleared to bail out some companies. I don't think rate cuts will help. If you see balance sheets, leveraging is at an all-time high. If you look at banks, the loan/deposit ratio is almost maxed out. To start a new credit cycle, the loan-deposit ratio of banks has to improve. For this, the capacity to lend has to increase. This would happen if real rates stay positive. Recapitalising of the banking sector is the second.
Do you think the government can achieve all these things?
The easiest thing to do is de-anchor inflation. The second one requires working with the state governments. If the first two happen, the third will automatically happen. In fact, the third one is underway. The stock markets are helping Prime Minister Narendra Modi.
Is the market's optimism sustainable?
The government needs to help retain the optimism of the market. The market is willing to pay 19x trailing earnings, and may be even 20x very soon, it is a very healthy PE multiple for companies to divest. As a fundamental analyst, you want stock prices to follow earnings, but I can almost argue the reverse. If the government does nothing to disrupt the optimism in the market, it will only help the government. To borrow a phrase from George Soros, this is reflexivity. There is a strong evidence of reflexivity in India when earnings tend to follow stock prices.
A rapidly appreciating currency could be a black swan event for the markets. How much of a risk could a stronger currency be for earnings?
A lot of people under-appreciate the importance of an undervalued currency to earnings growth. A slight undervaluation is better than overvaluation. The central bank will have to act in a forceful manner if there is a rush of dollars. Our import cover is still at eight months, just off its 20-year low. I think currency will be range-bound.
Does India still face a risk from global events?
Yes, the biggest risk to India is global. India needs a benign global environment. Any disruption in the global environment will make things a lot more difficult for India. India needs steady global growth to revive.
What about capital flows?
Capital flows are a function of confidence. Right now the confidence is very high. This is a Modi moment and the confidence is working.
For recovery in the economy you need three things?
First, you need improved level of profitability. Second, higher utilisation rate, because unless I am fully utilising my capacity, I am not going to invest. Third, confidence in future growth. Though confidence is high, the first two have not changed. But if the market does not see delivery, sentiment can turn fast.
What is your take on earnings?
The first thing is the base effect. Net margins for the broad universe are at seven per cent compared to the 12 per cent of the previous peak.
Historical average is nine per cent. There is a base effect at play. The second factor to watch out for is the gap between wages and profits. The share of corporate profit in gross domestic product relative to the share of wages has hit an all-time low so there will be a mean reversion. That is the second trigger. The third trigger is the revival growth. But these three events will happen in 2015-16 and it is priced into the market. Some recovery in growth is likely in four-eight quarters.
Which sectors will lag and which sectors will be early beneficiaries of this mean reversal?
The sector that will lag earnings growth is consumer staples as they have been big beneficiaries of wage hikes. So the profit growth of staples will be slower. The energy sector will see fair level of returns. For the last 10 years, none of the energy companies have been allowed to make fair returns as there has been too much government intervention. This intervention is expected to end. The best profit performance will be for energy companies. Cyclical sectors will do better than defensives. Urban discretionary companies will do well and banks should also do okay. Industrial and materials will also do well. Technology will also do well as the US is seeing a manufacturing renaissance and India will benefit from that. In the end, no sector will be left behind.
What is the outlook on US growth?
The US bond markets are at loggerheads with the equity markets. The US bond markets are bearish on growth and equity markets are bullish on growth. In India it is the same thing. But in the US bond yields are going down but in India they are not going down as inflation is high. If the bond markets are right, then it is a risk for growth. If the US bond markets are wrong and growth recovers then rates will go up. It means that the Fed has fallen behind the curve and it increases rates. Historical episodes suggest that Fed moves have created volatility. If this happens later in 2015, it will be fine but if it happens earlier, it will create a problem.
In India, there is a big mispricing between equity and debt. Our equity yield is 5.5 per cent and bond yield is 8.7 per cent. There is a negative gap of 3.2 per cent, which means equity market is saying there is a strong growth story coming, which is why I can have a premium over bonds. In the US, the bond yield is at 2.5% and equity is at 5.5% there is a 3% positive gap of between the two. Now, the difference between the US equity yield gap and the Indian equity yield gap is 6.5%. With this you can conclude how richly valued the Indian equity market is versus the rest of the world. The bond market is saying inflation is not coming down in a hurry and equity is saying inflation is story of the past. Usually, bond markets are right and equity market is not. It's too early to conclude yet on that as far as India is concerned. There is an opportunity for asset allocators.
The finance ministry is looking at some key capital market reforms. What should be top of the agenda?
If you look at stake of foreign investors in Indian companies, it is at an all-time high. There is very little free float left for them to buy. If you ask me then releasing more free-float for FIIs to buy is an urgent reform. Now there is not that much left for them to buy so you need to create more free float.
What about FII flows? Are these sustainable or is it hot money?
There is a long-term money that has come into India in the last five years. Despite negative dollar returns over the last few years, FIIs have reposed more faith in Indian equities than domestic investors. Along with long-term money, there may be some hot money that is coming into India, but we should not be frightened. A lot of people tell me that India is the only game in town.
Do you think that an El Nino situation could impact stock markets?
I don't think that the markets will be impacted much. The year 2009 saw the worst drought in many years, but the stock markets multiple went from 19x to 24x. That quarter was bad for agriculture. If El Nino strikes, poor and marginal farmer suffers. The response to that will matter to the economy. If minimum support prices are lifted as a response, it will be a generalised solution for a specific problem.
What are foreign investors saying at this point of time?
FIIs are optimistic and they believe it is a Modi moment.
A lot has happened in the market in three months, what is your take on Indian equities?
The markets have done a lot of work. The index is up 25 per cent in three months, which is a lot. The performance has spread to the broader markets, and there is a lot of value. If the economy comes out of the cyclical downturn, the smaller companies will do a lot better. Some policy choices are needed to ensure the cyclical recovery happens.
More From This Section
Corporate earnings are not improving this year, and yet markets have risen a lot. Does it mean markets have been re-rated and investors will be willing to pay a higher multiple for stocks?
Yes, the re-rating has happened. Indian markets are trading at a 50 per cent premium to other global emerging markets. We are trading on a par with the US markets. India is the third-most expensive market on price/book basis. People tell me India is the only game in town. Sustainable or not, time will tell. I get nervous when prices go up in anticipation of change because the risk-reward is not in my favour.
What are the key things the government needs to do to revive growth?
I will take a step back to answer this question. There were some policy choices India made in the aftermath of the global crisis. The policies were focused on redistribution of income and the result was we slipped into a stagflationary situation. This caused inflation. Of course, there were other issues like subsidies and high government spending. Global environment was also difficult. So it was a combination of factors that worked badly for us. There are three key factors to watch out for, essentially the redressal of three big issues we have faced over four-five years.
The first is to de-anchor inflation expectations, which are very high and from where you can expect growth to recover. The central bank and the government need to act together on this. If real rates stay positive for some time, it will start impacting household behaviour. In five years, financial savings have declined by 500 basis points to 7.5 per cent. The government, too, has to keep spending in check. The outgoing government has set stage for lowering oil subsidy. If these two things are done, growth can revive.
The second is capital productivity has to improve. The incremental output ratio has halved for reasons well advertised. The main reason is many projects are incomplete or are complete but generating no output. Aggregate output is below potential and it depresses capital productivity.
The third is to deleverage the private sector. Projects need to be cleared to bail out some companies. I don't think rate cuts will help. If you see balance sheets, leveraging is at an all-time high. If you look at banks, the loan/deposit ratio is almost maxed out. To start a new credit cycle, the loan-deposit ratio of banks has to improve. For this, the capacity to lend has to increase. This would happen if real rates stay positive. Recapitalising of the banking sector is the second.
Do you think the government can achieve all these things?
The easiest thing to do is de-anchor inflation. The second one requires working with the state governments. If the first two happen, the third will automatically happen. In fact, the third one is underway. The stock markets are helping Prime Minister Narendra Modi.
Is the market's optimism sustainable?
The government needs to help retain the optimism of the market. The market is willing to pay 19x trailing earnings, and may be even 20x very soon, it is a very healthy PE multiple for companies to divest. As a fundamental analyst, you want stock prices to follow earnings, but I can almost argue the reverse. If the government does nothing to disrupt the optimism in the market, it will only help the government. To borrow a phrase from George Soros, this is reflexivity. There is a strong evidence of reflexivity in India when earnings tend to follow stock prices.
A rapidly appreciating currency could be a black swan event for the markets. How much of a risk could a stronger currency be for earnings?
A lot of people under-appreciate the importance of an undervalued currency to earnings growth. A slight undervaluation is better than overvaluation. The central bank will have to act in a forceful manner if there is a rush of dollars. Our import cover is still at eight months, just off its 20-year low. I think currency will be range-bound.
Does India still face a risk from global events?
Yes, the biggest risk to India is global. India needs a benign global environment. Any disruption in the global environment will make things a lot more difficult for India. India needs steady global growth to revive.
What about capital flows?
Capital flows are a function of confidence. Right now the confidence is very high. This is a Modi moment and the confidence is working.
For recovery in the economy you need three things?
First, you need improved level of profitability. Second, higher utilisation rate, because unless I am fully utilising my capacity, I am not going to invest. Third, confidence in future growth. Though confidence is high, the first two have not changed. But if the market does not see delivery, sentiment can turn fast.
What is your take on earnings?
The first thing is the base effect. Net margins for the broad universe are at seven per cent compared to the 12 per cent of the previous peak.
Historical average is nine per cent. There is a base effect at play. The second factor to watch out for is the gap between wages and profits. The share of corporate profit in gross domestic product relative to the share of wages has hit an all-time low so there will be a mean reversion. That is the second trigger. The third trigger is the revival growth. But these three events will happen in 2015-16 and it is priced into the market. Some recovery in growth is likely in four-eight quarters.
Which sectors will lag and which sectors will be early beneficiaries of this mean reversal?
The sector that will lag earnings growth is consumer staples as they have been big beneficiaries of wage hikes. So the profit growth of staples will be slower. The energy sector will see fair level of returns. For the last 10 years, none of the energy companies have been allowed to make fair returns as there has been too much government intervention. This intervention is expected to end. The best profit performance will be for energy companies. Cyclical sectors will do better than defensives. Urban discretionary companies will do well and banks should also do okay. Industrial and materials will also do well. Technology will also do well as the US is seeing a manufacturing renaissance and India will benefit from that. In the end, no sector will be left behind.
What is the outlook on US growth?
The US bond markets are at loggerheads with the equity markets. The US bond markets are bearish on growth and equity markets are bullish on growth. In India it is the same thing. But in the US bond yields are going down but in India they are not going down as inflation is high. If the bond markets are right, then it is a risk for growth. If the US bond markets are wrong and growth recovers then rates will go up. It means that the Fed has fallen behind the curve and it increases rates. Historical episodes suggest that Fed moves have created volatility. If this happens later in 2015, it will be fine but if it happens earlier, it will create a problem.
In India, there is a big mispricing between equity and debt. Our equity yield is 5.5 per cent and bond yield is 8.7 per cent. There is a negative gap of 3.2 per cent, which means equity market is saying there is a strong growth story coming, which is why I can have a premium over bonds. In the US, the bond yield is at 2.5% and equity is at 5.5% there is a 3% positive gap of between the two. Now, the difference between the US equity yield gap and the Indian equity yield gap is 6.5%. With this you can conclude how richly valued the Indian equity market is versus the rest of the world. The bond market is saying inflation is not coming down in a hurry and equity is saying inflation is story of the past. Usually, bond markets are right and equity market is not. It's too early to conclude yet on that as far as India is concerned. There is an opportunity for asset allocators.
The finance ministry is looking at some key capital market reforms. What should be top of the agenda?
If you look at stake of foreign investors in Indian companies, it is at an all-time high. There is very little free float left for them to buy. If you ask me then releasing more free-float for FIIs to buy is an urgent reform. Now there is not that much left for them to buy so you need to create more free float.
What about FII flows? Are these sustainable or is it hot money?
There is a long-term money that has come into India in the last five years. Despite negative dollar returns over the last few years, FIIs have reposed more faith in Indian equities than domestic investors. Along with long-term money, there may be some hot money that is coming into India, but we should not be frightened. A lot of people tell me that India is the only game in town.
Do you think that an El Nino situation could impact stock markets?
I don't think that the markets will be impacted much. The year 2009 saw the worst drought in many years, but the stock markets multiple went from 19x to 24x. That quarter was bad for agriculture. If El Nino strikes, poor and marginal farmer suffers. The response to that will matter to the economy. If minimum support prices are lifted as a response, it will be a generalised solution for a specific problem.
What are foreign investors saying at this point of time?
FIIs are optimistic and they believe it is a Modi moment.