Risking returns

With the Sensex crossing the psychological 12000 mark for the second time within four months, the risk-return ratio too has skewed further.

The Sensex finally managed to cross the psychological 12000 mark again and is just 200 points away from its earlier historic high of 12671 hit last May. So is destination 13000 round the corner or is it correction time?

Compared with the last time when the market touched its all-time high amid rate uncertainty and spiralling commodity prices, this time the scenario is definitely much better.

Oil prices are receding, commodity prices are cooling off and the US Federal Reserve has paused its rate hiking spree for the second time. So should one take the plunge into the markets assuming double-digit returns? Though the fundamentals are relatively better, risks far outweigh returns.

RISK 1: Valuations
Market experts are unanimous in terming the relatively high valuation of Sensex as the biggest risk. The benchmark index is trading at about 17-18x for FY07 and, hence, is far from cheap.

According to data provided by Morgan Stanley Research estimates, India, along with New Zealand, Singapore, Hong Kong and Taiwan, is trading at one of the highest valuation of 14 x for FY07. 
 

INDIA'S COSTLY
	P/E (FY07E)	EPS growth (FY07E)	ROE (FY06E)
Australia	12.40	9.60	20.60
China	13.50	11.50	16.30
Hong Kong	14.10	4.70	13.90
India	14.00	16.10	21.30
Indonesia	11.90	13.00	23.20
Korea	10.00	13.50	12.50
Malaysia	12.80	10.40	13.30
New Zealand	14.00	2.30	17.50
Philipines	11.50	12.40	15.00
Singapore	14.00	7.10	12.30
Taiwan	11.90	18.30	14.20
Thailand	9.60	1.80	19.60
Source: Morgan Stanley Research Report, IBES, Datastream, MSCI, Bloomberg

A comparison of MSCI India and MSCI Emerging Market indices depict this fact properly.

However it must also be noted that India's earnings growth rate and return on equity are also one of the highest among other emerging markets and the rest of the world.

Still market participants are not comfortable with the current valuations though they are positive on the continuity of India growth story for next few years.

Says Tarun Sisodia, director, Anand Rathi Securities, "The markets have run ahead of expectations and are discounting even 2008 earnings."Adds Sandeep Shenoy, strategist, Pioneer intermediaries, "Markets are currently trading above their fair value."

So is a correction imminent? May be. But if there is any correction, it is a healthy sign and a good opportunity to buy, says Sumeet Rohra, analyst, Antique Stock Broking.

RISK 2 -- Earnings glitches
Sensex stocks, on an average, have reported a CAGR in the range of 20-50 per cent in sales and profits between FY04 and FY06. In Q1FY07 as well, companies delivered robust performance in sales and profitability. How sustainable is this growth is the big question.

Says Shenoy, "Any glitches in earnings growth of companies will have punishing effect on the market." However this does not seem to be an immediate risk as analysts are quite positive about the second quarter in the sense that they will either match or would perform better than the first quarter.

Adds Sandeep Nanda "Any slowdown in earnings is possible only from the third quarter onwards. Moreover that will be the make or break quarter."

According to consensus estimates, majority of the sectors are likely to continue their robust growth in earnings atleast in FY07E though they are expected to taper off in FY08. A strategy report of Motilal Oswal also points to this fact. 
 

SECTORAL GROWTH
Consensus Earnings  estimates (%)	FY07E	FY08E
Consumer Discretionary	20	24
Consumer Staples	21	19
Energy	16	1
Financials	9	22
Healthcare	35	19
Industrials	56	21
Materials	33	-7
Technology	35	25
Telecommunications	86	33
Utilities	18	9
Sensex	28	12
Source: IBES, Morgan Stanley Research

According to BS Research Bureau's study of 1425 firms, India Inc's capital expenditure touched a new high of Rs 1 trillion in 2005-06, 29 per cent higher compared with 2004-05. About 52 per cent, was spent on plant and machinery and rest in other fixed assets, such as land, buildings and capital work in progress.

Though this augurs well for the industry and the economy in the long run, analysts are worried about the impact it would have on return ratios.

High capex tends to depress earnings and impact returns adversely dragging down profitability of companies during the expansion phase. Any slowdown in demand or change in the economic scenario will especially impact commodity companies planning expansions.

RISK 3 -- US cooling off
Just two-three months back, the concern globally and mainly in the world's largest economy - the US- was inflationary pressures created by soaring energy prices, mainly crude oil, and high spending power of the people there.

However after 17 consecutive rate hikes of 25 basis points each and keeping interest rates unchanged twice at 5.25 per cent, the US Federal reserve has been successful in cooling off the economy. Data show that the US economy is slowing down. 
 

US IS WEAKNING
	GDP growth (%)	Residential investment growth (%)
2003	2.50	8.40
2004	3.90	7.90
2005	3.20	8.60
2006
1st quarter	5.60	-0.30
2nd quarter	2.60	-11.10
Source: US department of Commerce

According to International Monetary Fund (IMF), growth in the US is expected to slow from 3.4 per cent in 2006 to 2.9 per cent in 2007, amid a cooling housing market. This has led to fear of global economic slowdown adversely affecting exporting regions, especially Asia, and emerging economies, including India.

Many players contend that India is largely insulated from any slowdown in the US economy owing to strong domestic-led consumption and lowest exports to GDP of 21 per cent after Japan and that the co-relation between the US slowdown and impact on India's GDP is not direct.

However there are others who feel that it will definitely impact global business indirectly to most companies. They argue that in the case of slowdown, projects are delayed, market demand shrinks and, thus, competition gets intensified with the same number of players.

Says an analyst with a leading broking firm, "The period up to March is very crucial for the Indian economy as market will be in a position to sense how hard will the US economy be hit."

"Rather than the EPS, PEs will come down because of cautious sentiments as emerging economies are high beta markets and, thus, susceptible to volatility,"adds Sisodia. In case of softlanding of the US, India will not be affected.

RISK 4 -- Fund flows
While India is not to be affected so much by the slowdown in the US, any pick-up will lead to exodus of foreign money from India and other emerging economies, fear market players.

However, this may not happen overnight. Though India and other emerging markets saw a huge bout of selloff in May, they have regained the foreign investors' confidence with some cynicism. 
 

INDIA'S SHARE IN FLOWS
US$ mn	Weight in MSCI EM	2004	2005	2006YTD
Turkey	1.60	3490	4083	615
Korea	17.60	8760	-2799	-5879
Taiwan	12.80	7440	21970	5049
Philippines	0.50	255	416	482
Indonesia	1.60	2125	-1732	975
Brazil	11.00	679	2485	-560
India	6.00	8771	10985	2836
Thailand	1.60	74	2977	1643
Total	52.70	31592	38385	5161
India's share in flows		27.8	28.6	55
Source: Morgan Stanley Research, Bloomberg, www.ise.org, SEBI, CEIC. Note: Data upto May

Market experts are confident of the interest of foreign investors in emerging economies, especially India and China. They reason saying that current global economic growth is mainly fuelled by rising consumerism in India and China, whose GDP growth in excess of 7 per cent is one of the highest in the world and they outperform even their Asian peers.

Says Rohra, "As long as India and China post such robust growth, they will continue to attract more funds as compared to other emerging economies."

However, there could be India specific risk related to fund flows. Market players see the end of participatory notes, if it happens, as one of the major risk as over 50 per cent of FII inflows is through this route.

In early September, one of the suggestions put forward by the Tarapore committee on fuller capital account convertibility was that fresh issue of PNs should be disallowed and existing PNs be phased out in a year. Even the RBI and Sebi are concerned about PNs and their ownership.

However, at present, the finance ministry has decided to maintain a status quo on the same. But if this is done, then market players fear that this might have catastrophic impact on the market and will leave the investors bleeding.

Participatory notes are derivative instruments issued by foreign security houses to entities which want to invest in Indian stocks but do not want to register here.

RISK 5"� Japanese growth
Indian markets face a big threat from the Japanese market, which is growing rapidly and is cheaper in terms of valuations despite the size of the $6 trillion economy being 8 times that of the Indian economy.

In this scenario, FII flows could get diverted. The world's second largest economy, is witnessing robust growth after a decade of stagnation. After growth rates of 2.3 per cent and 1.7 per cent in 2003 and 2004, the Japanese economy grew a robust 3.2 per cent in fiscal year 2005.

Consequently, for the first time in six years, it ended its zero interest rate regime in July this year and hiked the rate to 0.25 per cent. Japan's industrial production rebounded to a record in August and the production index rose to a new high. Consumer prices went up 0.3 percent last month signalling a buoyant economy.

RISK 6-- Other risks
Besides this, market participants list some external factors such as the global political scenario, fear of terrorism, volatility of oil and commodity prices and internal factors such as the rising current account deficit, uneven distribution of rains and lagging political reforms affecting our markets.