Akash Prakash: India in 2008

Earnings have surprised on the upside over the last five years, and look set to continue doing so.

We have all been blessed by an exceptional 2007, as anybody having anything to do with the Indian capital markets has had a banner year. Trading volumes, new issuance and M&As "" all exploded to the upside. The markets were up 50% and we had the benefit of both strong earnings growth and PE expansion. The question obviously becomes as to what will happen in 2008. Can we sustain the run of strong double-digit price appreciation for a sixth year in a row?

On the face of it, it does look difficult as most of the levers for strong equity performance have pretty much fully played themselves out. Ultimately there are only three drivers for equity performance "" the change in the valuation multiple at which the market trades, earnings growth, and (for foreign investors) the strength or weakness of the currency.

As for valuation multiples, it is very hard to make a case for further PE expansion, as the Indian markets have moved from 8-9 times earnings in mid-2003 to somewhat over 20 times March 2009 earnings. No matter which way you cut the numbers, there is no denying the fact that the markets are expensive, in fact, among the most expensive in the world. I am aware of the argument that if you look at the embedded value in certain stocks like Reliance and others, valuations drop. Even if you make these adjustments, valuations drop by only a couple of points, and I for one am not a fan of these embedded values or sum of the part valuation methodology for any and all stocks.

When looking at multiples, one also has to be mindful of the fact that the direction of rates globally is headed down, with India likely to follow the lead of the OECD central banks and eventually cut short rates. A falling interest rate environment is supportive of PE multiples, and should act to support current valuation levels.

To counter-balance the positives from a supportive monetary environment, we have a huge new issuance pipeline, the likes of which I have never seen before. In alone we should have $4-5 billion of issuance. Six power companies alone plan to raise nearly $10 billion (the entire amount raised last year) in the next three months. A friend who runs a large investment bank points out that the bank did 31 equity issues last year and already has signed mandates for 60 deals as of today, and the average size of each deal is higher than last year. Any company executive I meet these days invariably ends the conversation outlining fund-raising plans.

One cannot assume also that we will continue swamping every other market in Asia and once again attract $17-18 billion of new FII flows. The Indian retail investor has woken up and we are seeing that in sustained new equity flows through both mutual funds and the insurance companies; however, even this will not be enough to meet the seemingly insatiable demand from corporate India for growth capital.

Thus, the demand supply equation for equity paper argues for no further PE expansion.

In addition I would argue that as we get closer and closer to the Lok Sabha elections, the political uncertainties will rise and the ability and willingness on the part of this government to move on policy matters diminish. Such an environment will also not boost sentiment or drive up multiples.

Thus, I would argue that the best case is for the market to hold its current valuation levels, and not experience PE compression. The history of markets indicates that it is very difficult to sustain 20-plus multiples for any extended period of time (unless you go into a mania or bubble phase).

Therefore, market returns in 2008 will likely get no support from further multiple expansion; if anything we could see a drag on returns from multiple compression.

As for currency, international investors got a nice 8-10 per cent return (if unhedged) just by being in rupee assets in 2007. The pace and quantum of rupee appreciation this year is very unlikely to match this. So for an international investor this driver of returns is unlikely to contribute meaningfully in 2008.

This now brings us to the last plank of market returns "" earnings growth. Earnings in India have consistently surprised on the upside over the last five years, and seem poised to continue doing so. Having said that, given the current level of corporate earnings, the high ROEs, the huge capex cycle currently under way, ratcheting up of competition across sectors, strong rupee, US recession, rising costs in India, etc. it is difficult to see earnings growing by more than 20-25 per cent for the broad market. While still a very good number, it is a slowdown from the pace of the last few years.

I think the market is likely to follow one of two courses in 2008; either the market will be up/down marginally as we go through some PE compression, and give ourselves some breathing room to digest the huge price run-ups of 2007 and we grow into our multiples. The strong earnings of 20-25 per cent will be largely eaten up by PE compression. While it may be painful in the short term, this PE normalisation will make the market much healthier to continue its long-term bull run and shake off much of the current froth.

India is a great long-term story but maybe a little ahead of itself, would sum up this view.

Alternatively, we could see a huge price run in the initial part of 2008 itself, as the Fed is forced to keep pumping liquidity into the system, which continues to get channelled into the EM asset class. This would be a type of EM mania, and going by the direction of flows into the EM markets since August, India would be a major beneficiary of accelerated flows into the space. In such an environment, valuations temporarily may lose relevance, as we see the sheer weight of money coming into play. This scenario would be like September/October of 2007, but even more fierce. This type of a market move may please the short-term punters and create froth, hysteria and huge short- term returns, but will ultimately end badly and mark the end of the bull phase in India and the entire EM asset class were it to come to pass.

I never thought I would say this, but let us hope for a subdued 2008, the more stable the market the better.