Greater risks, slower rewards

India was the best performing emerging market in the three months to August. And the Sensex hit a four-month high at 5298 last week. Surprisingly resilient, given that in June this year, just as the new government took over, Morgan Stanley had cut India's weightage for the Asia Pacific model portfolio from 5.9 to 2.9 per cent.

Brokerages rewrote strategies, doing an about-turn on Sensex targets, earlier pegged at 6000-7000 levels.

Corporate India has since then turned in an exceptional performance for the first quarter of FY05, but there have been no upgrades.

In fact, a month ago, JP Morgan's Adrian Mowat downgraded India from 'overweight' to 'neutral' on the ground that fears of higher interest rates would hold the market back. And ABN Amro Asia Securities calls for 'underweight India'.

There is good reason for the gloom. With the monsoons not quite normal, oil prices soaring, uncertainty on the US recovery, mayhem in the domestic bond markets, and inflation crossing 8 per cent, the past four months have left strategists stupefied.

To add to their woes, the rupee decided to get into the act, reversing its course. No prizes for guessing what the new buzzword on the street is. Caution with a capital C.

Tough times lie ahead, and timelines for making money in the markets are now being stretched to at least a year. The risks are not fully priced in.

Outside influence:While it may appear that India is relatively insulated from global factors in that the export to GDP ratio is just 12 per cent, there is a bigger correlation, especially for commodities. Interestingly, from a market perspective, about 47 per cent of India's market cap is influenced by international factors; of course the bulk of it is accounted for by oil and gas and petrochemicals, followed by software. And FIIs continue to be big players in our market currently, accounting for more than a third of the free float.

Pressure on profits: The splendid numbers that the corporate sector put out for Q1 seem in the distant past. It's slowdown in the earnings that is being talked about, given that the high base effect will catch up sooner rather than later and that higher raw material costs are bound to pressure margins.

The next two quarters will tell whether companies are able to command pricing power and pass on higher costs in the face of rising competition.

Since most firms have spruced up their balance-sheets and are sweating their assets to the full, there is little room to prune costs further.

Says Ajay Srinivasan, managing director, Prudential Corporation Asia, "The second quarter is likely to see Asian GDP growth peak. Most Asian economies are likely to see a decline in the rate of growth hereon, as the slowdown in external sector growth overshadows domestic demand," adding that "the rise in long-term oil prices creates an important risk in the region."

Observes Arup Raha, head of research at JP Morgan India: "Either the second quarter or the third quarter could be the peak of the cycle and we would, therefore, remain defensive in our stock picks."

Raha feels that the latest data on industrial growth notwithstanding - up 7.3 per cent y-o-y in June - industrial production growth, which is strongly correlated with earnings growth, seems close to peaking.

An ABN Amro study notes that the anticipated slowing in domestic and global economies and rising interest rates will impact volume growth, pricing and costs, which in turn will hurt earnings.

Overall, it expects top-line growth to slow and margins to fall for several sectors. Manish Chokhani, director, Enam Securities, contends that it is becoming difficult to forecast earnings because there is little visibility on the discount rate or long-bond yields. "How long do I discount for and at what rate?' he asks, adding that the movement of the rupee will determine interest rates and, in turn, earnings. He is clear that there is long-term inflation in commodities and, therefore, one has to be invested in fully-integrated resources companies and firms which have pricing power.

S Naganath, chief investment officer, DSP Merrill Lynch, is not so worried. "Earnings growth will continue to remain in the 15-17 per cent trajectory, he maintains, adding that the capex cycle is turning and more importantly, it is based on demand in both domestic and overseas markets.

Besides, he feels consumer demand is yet to be derailed.

No garage sale: The sweet spot which the emerging markets and India found themselves in two years ago, when liquidity was abundant and valuations were compelling, is gone.

For sure, there's no firesale. India's markets may appear inexpensive relative to history, but are about 33 per cent higher than their lowest trailing P/E in the past 10 years.

Chokhani points out that while the forward P/E for the Sensex may be 12, at a disaggregated level, or in terms of specific stocks, the P/Es are far higher.

Tech bellwether Infosys, for instance, trades at 24x forward earnings while Bhel trades at 14x. Moreover, there is not much of a cushion, if things were to go wrong," he cautions.

ABN Amro's strategy paper says valuations on a one-year forward P/E seem reasonable, but if earnings come under risk, these could be misleading.

Mowat feels that if confidence in the US economy improves or oil prices moderate, markets such as Taiwan and Korea are likely to outperform India.

For August, India slipped to the third position after being the best performer in the quarter, as FII redirected some of their flows into those markets. Srinivasan is slightly more optimistic.

"In terms of valuation, India, while not particularly cheap when compared with the rest of the region, is still reasonably valued relative to its history and its growth potential," he says.

That should ensure that the downside is protected. Says Sandeep Dasgupta, chief executive, Deutsche Asset Management, "there is enough liquidity so that the Sensex should find support at 4900 levels." Dasgupta says there is enough money waiting on the sidelines - including that of hedge funds and

India-dedicated funds - that will flow in once there is some clarity. Naganath actually foresees a strong upmove in the markets towards the end of the year, saying the Sensex could get closer to the 6000 mark since some of the negatives such as oil have already been priced in.

With the myth that bond funds protect capital being shattered, retail investors appear to be turning to equity.

"We are seeing better inflows in September, says Dasgupa. Adds Chokhani, "Equities are better than bonds for sure and we might as well play for the big move which could happen in 18-24 months".

Play defensive: So what are fund managers staying with? Good old technology, of course: pricing is stable and demand is good and the rupee is now depreciating, though valuations are not exactly compelling.

Capital goods, engineering, power and utilities are still in style. Not surprising since orderbooks are bulging and the capex cycle is finally turning, though valuations are not undemanding.

Cement could continue to have a good run for some more time and pharma is still in. It's, however, time to pare exposure to automobiles, CVs in particular.

With fuel prices up and freight rates stagnant, demand could flag. Competition in two-wheelers could dent margins.

Banks can also be given the miss; weaker treasury gains have been priced in but slower growth has not. Consumer staples in general are yet to find favour as are oil and gas stocks.

And surprisingly no one's too bullish on steel either; the commodity cycle too may just be peaking. However, telecom is still on the buy list.

Mid-cap mania
The rally in mid-caps has been spectacular, though it must be mentioned that many of these stocks are very illiquid.

While there is value in many of them, according to Chokhani, the valuation gap between the large- and mid-caps is now closing. There are, of course, stocks to be discovered, and in a growing economy, many of these companies could do well.

Looking ahead: In the long run, the markets look good. Naganath points out that investor money is moving to absolute return strategies and the Indian markets are an attractive destination given that its economy is one of the fastest growing in the region.

The recent spate of IPOs, too, have created enormous interest in India. "If the market cap moves to around $400 billion, the increased weighting alone will ensure an inflow of $3-4 billion a year," he says. Adds Chokhani, "the $30 billion that the FIIs have brought in are here purely because the economy is growing at 6.5 per cent."

After several years, capacities in Indian industry are set to expand. And, as Naganath observes, this time around, the footprint of operations for companies is much larger.

Moreover, with companies sitting on cash, projects are being funded more through equity and internal accruals and low-cost debt.

Having tightened their belts in the last couple of years, it should not be too difficult for the corporate sector to combat a slowdown.

As Srinivasan puts it, "given the greater influence of the local economy on India's corporate profitability and its relatively lower dependence on the external world, India is in a sense a contra play."