Morgan Stanley (MS), in a recently released report titled “China and India: New Tigers of Asia, Part 3”, argues that India’s growth will accelerate to a sustainable 9-10 per cent by 2013-15, after delivering an average growth of 7.3 per cent over the past decade. Chetan Ahya, the author of the report, bases his case on the combined impact of demographics, globalisation and structural reform. His argument is basically that the interplay between the above-mentioned three factors will lead to a virtuous cycle of income growth, job creation, higher savings and investment, ultimately leading to higher GDP growth. He makes the point that by the time India hits its peak growth trajectory in 2013-15, it will have overtaken China to become the fastest-growing large economy in the world. The Indian media predictably lapped up the report, and one got the sense that it was seen as one more independent confirmation of the inevitability of India’s rise to economic greatness. The MS report is one more in a series of bullish publications about India and its projected future growth prospects. Many in India seem to take our growth for granted, and there is a sense of “we have arrived” developing among many in the intelligentsia.
As a good counter to these optimistic, forward-looking projections, two recent articles by T N Ninan in Business Standard and Ajay Shah in The Financial Express make the counterpoint of how we cannot take rapid structural growth for granted. Both the articles detail the many challenges we face in realising this growth potential. From poor fiscal discipline to corruption and the rise of oligarchies to the lack of institutional capacity and a drift in political leadership, all are constraints on realising our potential. Both also make the point that there have been many other countries in both Asia and Latin America which were similarly poised in the eyes of the world to deliver strong economic growth, but which ultimately could not do so. It is easy to extrapolate current trends into the future, and while the bulls will dismiss many of the constraints highlighted as being typical of where we are in our growth and political maturity cycle, and wax eloquent about the quality of our entrepreneurship and the aspiration among the young, is the case really as open and shut as many of the bulls seem to imply?
I think every investor in the Indian equity markets today has to make up her mind as to where she stands on this debate. Will the Indian economy deliver a decade plus of 8-9 per cent growth or not? For the reality is that the markets are clearly priced as if they will. I think there is very little case to buy India today, at current valuations, unless you make this fundamental long-term growth assumption. Most of the quality companies in India are already priced for strong future growth, with analysts already using 2012 or 2013 earnings to justify current prices. To make double-digit returns, you obviously need earnings to continue compounding much beyond the next two-to-three years. In the last 12 months, the huge FII inflows have also been attracted by the perceived predictability and stability of India’s growth, the case on which these institutions argue for higher allocations towards India is based on this perceived long-term growth trajectory. The desperation on the part of MNCs to set up base, so visible in recent times, is also linked to this fundamental growth assumption. The India growth story is seen as being China of 10 years ago, but far more investable, with much better quality companies. For any investor today who has doubts on the sustainability of an 8-9 per cent growth trajectory, she should be selling and getting out of the markets. For any growth disappointment is bound to lead to earnings downgrades, a reversal in capital flows and a valuation multiple de-rating as numbers disappoint.
Given how important this view on long-term growth is to one’s investment stance, it is quite remarkable how little debate one sees on this issue among investors. Most just seem to extrapolate the current growth acceleration into the future, without much appreciation of the constraints and weight of economic history. India may still deliver, and hopefully will, but it is by no means a sure thing.
The other interesting angle is the historically poor linkage between strong economic growth and equity market returns. Thus, even if India were to deliver a decade of 8-9 per cent economic growth, that by no means guarantees strong equity market returns. There are many instances, the most famous being China, where strong GDP growth has had absolutely no correlation with market returns. In fact, in some cross-market studies, there is even a negative correlation.
For there to be a linkage, the companies and sectors comprising the listed market must be able to convert the GDP growth into earnings per share (EPS) growth, which is a product of margins and equity dilution. If margins are at a cyclical peak, they will mean revert, and this will lead to earnings lagging the macro nominal GDP numbers and breaking the linkage. Likewise, if companies do not exercise capital discipline and dilute excessively, we may see robust earnings but very poor EPS growth. This is a common problem in high-growth emerging markets, growth inevitably leads to a deluge of capital issuance, disrupting capital efficiency ratios and EPS projections. The second factor is the ability of the market to hold its valuation multiple. Very often a period of strong economic growth does not translate into market performance, despite earnings delivering, as the market having already priced in growth has to face the headwind of multiple compression which drags down equity returns.
The Indian markets have historically had a decent record in converting economic growth into corporate earnings, with a very strong correlation between earnings growth and the nominal IIP (source : Morgan Stanley). Profit share of GDP in India currently also does not seem to be out of sync with past history. Indian valuations, while not cheap, do not seem to be at levels that would lead to significant multiple compression over the coming years. Thus in India’s case, strong growth will hopefully continue to drive market returns, as has been the case over the last decade (trailing 10-year CAGR in returns is 14 per cent).
However, once again I am surprised as to how little debate there is on this issue among investors. Everyone just seems to automatically assume the linkage between economic growth and market performance, despite broad cross-country evidence to the contrary.
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In a world of low nominal GDP growth and poor growth visibility, India is trading like a growth stock, attracting strong capital inflows due to the visibility of its growth potential. We are among the most expensive markets in the world due to investors believing that we will deliver a decade of sustained 8-9 per cent GDP growth, and this growth will drive corporate earnings and ultimately market performance. Both these assumptions, secular GDP growth and the linkage between growth and equity returns are being implicitly assumed by the market as being a sure thing, as they have been delivered in the past decade. However, the weight of history suggests that neither can be assumed simply on the basis of extrapolation, there is a non-trivial probability of these assumptions not coming to pass. Any failure to deliver on the above will lead to a serious loss of capital.
The author is the fund manager and chief executive officer of Amansa Capital