Market valuations should not be a bother at this stage of the bull market

The maximum number of questions I face these days are related to the valuations of the market and the fact that most people are of the opinion that valuations are stretched and thus do not leave too much room for appreciation.

My answer to this is that at the first stage of a bull impulse when most analysts and companies have not recovered from the blow that they have taken from the bear run most of them tend to be conservative on their outlook for growth and at this stage both economic recovery and earnings growth tend to be understated. Looking at valuations today the market P/E is in the region of 20X historic earnings and around 18.5-19X current year expected earnings. The consensus earnings growth estimate for next year stands at around 20% i.e. the markets on one year forward expected earnings are trading at valuations of 15 times 2011E earnings. This is reasonable in the context of the current interest rate environment and growth prospects.

My views on the same are that the economy is just starting to recover and it will gain significant momentum over the next few months and most analysts are underestimating the strength of the economic recovery. Industrial production growth which has averaged 10% over the past two months is likely to average at around 12% for the next six months. As the figures improve the estimates of earnings growth for the next year and somewhat for the current year will also improve. I believe that there is a great possibility that earnings growth for the next financial year will be more near 30% than 20%. In case that possibility fructifies the P/E ratio comes down to around 13.5X one year forward earnings which makes the market actually attractive relative to future growth prospects.

In my view the earnings growth will not only pick up but also sustain at levels of 20-30% for the next few years.

The other key concern is what happens when RBI starts to tighten monetary policy. It is important to then understand what will prompt RBI to tighten, it will be an estimation that growth is stabilizing and improving and that inflation is picking up due to demand pressures. If that is the logic for increasing policy rates then it is actually a bullish signal for the markets rather than a bearish signal. As such i would not be too bothered about monetary tightening at this stage. In any case given the state of liquidity in the system and also the fact that Bank Credit growth on a Year on Year basis is just around 10% as against a deposit growth of 19%, it is highly unlikely that interest rates for consumers and corporates are going to move up in a hurry.

Moreover if one goes and looks at valuations of the markets at the end of 2003 valuations would have looked stretched mainly because growth estimates for the future were understated. In any case in most bull markets the valuations move up and sustain at elevated levels for a prolonged period of time and there is no reason to believe that the same will not happen this time also.

India's V shaped recovery

Now it is clear that the Indian economy is going to see a V shaped recovery and the main contributor to the same will be the inherent strength of the Indian consumer as well as a sharp pick up in investment demand. The income of rural households also is strong mainly due to high foodgrain and crop prices.

I believe that the biggest strength of the Indian economy lies on the strength of the Financial system in which Indian banks today sit on historically high capital adequacy. This has been possible due to strong controls on NPA's, cost control and strong growth in profits. The average capital adequacy of large Indian banks stand at over 15%. This will enable the banks to expand their balance sheets aggressively as the recovery sets in. This is in total contrast to Western economies where large banks are being forced to cut their balance sheets by upto 50% as part of thier bailout packages.

Indian corporates have cut down costs aggressively and raised equity worth over USD 12 billion over the last six months. This will help them expand their business strongly as the recovery sets in. Employment has also started to pick up across services and manufacturing sectors, a total contrast to rising unemployment in the West.

Overall sectors like Financials, Infrastructure and Oil & Gas stocks should do well and lead the rally. Pharma and Technology should continue to do well. Over the next couple of months the markets look like rallying by around 10% from the current levels.

Subsequently I believe next year could be difficult for the markets as they absorb the gains of the current year. Fundementally I believe that next year might be a more subdued 15-20% kind of growth year. However the technical picture looks much more bullish, indicating a move upto around 21000 for the Sensex and 7000 for the NIFTY before any big correction fructifies. I would frankly stick to my fundemental view at this stage.

"In a bull market the game is to buy and hold until you believe that the bull market is near its end"

Don't think of restricting CAPITAL INFLOWS, learn to absorb them

Over the last few days there has been lot of debate going on regarding the moves by some countries in trying to control capital inflows. The top most and largest country to do this at this point of time being Brazil. There has also been debate on this issue in India and a number of policy makers have been openly debating this in public forums. Thankfully, the view of all of them is that there is no sense in putting any sort of artificial barriers or taxes to control capital flows.

India has traditionally been a capital starved country and in the earlier era where there were a large number of restrictions on all kind of capital flows and the country lived in the License Raj the availability of capital for growth was the biggest constraint. As the economy slowly opened up since 1991 we have seen capital flows picking up in India, however they remain extremely low as compared to flows into most other large emerging economies. Traditionally FII flows have dominated in India. Although in terms of FII flows India compares well with most other emerging economies in terms of FDI India has significantly lagged behind. The reasons for this have been several which include limited currency convertibility, Red Tapism in granting approvals for investments, Sector specific FDI restrictions, Poor infrastructure and lack of competitiveness etc.

Even if we look at the composition of the Indian economy today more than 60% comprises Services, 25% manufacturing and 15% agriculture. Strong consumption and sectors where capital requirements were lower dominated the growth in India in the years preceding the last boom of 2003-2007. Due to the scarcity of capital availability the sectors that required lower capital for growth started dominating the Indian GDP thus leading to the current composition which is very different from most emerging economies.

Today we live in a world where liquidity is ample and interest rates are expected to remain low for a prolonged period of time. Credit spreads have also started to come down and are expected to trend lower as there is more conviction in the global economy. Given the fact that the Indian economy is likely to go back to a 8-10% growth trajectory over the next few years a huge amount of capital will flow into India looking at higher returns. As a historically capital starved economy we should welcome this and in fact create absorptive capacity in the economy so that these flows go into productive uses and contribute to the growth in the economy rather than add to inflation.

There is a huge need in India to develop all kind of infrastructure, be it roads, power plants, airports etc. Urban infrastructure in India is in shambles and requires huge investments. It is estimated that investment requirements over the next five years will be upwards of USD 600 billion which is nearly 60% of the current GDP. Under the circumstances the current scenario of ample and low cost global liquidity is a godsend for India. The current savings rate in India is around 35% and the current ICOR (a measure of capital formation) is aorund 4.2 to 4.5. As such the domestic savings rate itself can sustain a growth rate of around 7.5-8%. In order to move up the ladder to a 10% growth we need to get in around USD 80 billion every year on a net basis. The current inflows comprising various capital flows would be in the region of half of this.

It is important that flows come in the form of equity capital and there is need to set up models to provide reasonable returns on these investments in various infrastructure sectors. Capital flows will be of two kinds Risk capital and that looking for fixed returns. It is important for the policy makers to have models to attract both kind of capital.


For models where investors would not like to take a risk beyond the currency risk annuity linked models as were existing earlier in highway projects would attract lot of capital. Given the fact that borrowing costs are extremely low today (even with higher spreads) with LIBOR rates being nearly 0.3%, if the government can come out with models where the risk premium for investing in India is taken care of a large number of global infrastructure funds as well as utility companies might look at putting capital in such models. A reasonable return for them would still be a reasonable cost for India.

The second model is in the form of risk capital where investors can come into projects in form of BOT projects. Here the regulatory regime has to be clear and clarity will need to be there for having lot of relevant data which can be analyzed by potential investors. For example in case of road and port projects traffic projections have to be realistic and in case of Power projects there is need for clarity of long term power tariffs that the utilities can charge etc.


In conclusion I believe that there really should not be any debate on controlling capital flows and the aim should be to channel them into productive asset creation.



Industrial Production growth for September

The IIP growth for the month of September came out to be much higher than expectations at 9.1%. Over the next one year we should see a continuous improvement in these numbers and we should have an average of 10% plus IIP growth for the first 9 months of 2010. The good part is that the growth is well spread out and is across industry segments. GDP growth forecasts for next financial year which currently stand at around 7% should see upgrades over the next few months.

Markets are looking extremely good in the short run and I expect a 8-10% upmove from now on till January 2010.

"Its not whether you are right or wrong that's important, but how much money you make when you are right and how much you lose when you are wrong - S. Druckenmiller"

When Carry Trades start they do not end so fast & Indian Economic Recovery

Over the last few days as the corrections unfolded in the equity markets globally the predictors of doom came out and started talking about the reversal of the US Dollar Carry trade and that the USD was likely to bounce back sharply over the next few weeks and months which will lead to a huge fall in equities and commodities.

My view on the same is that carry trades when they start, do not end so fast. We are just six to seven months into this carry trade and my guess is that given the state of the US Economy and the fact that there is a huge repair required in the balance sheets of financial institutions, the US Government and the US Consumer we are unlikely to see a reversal of the easy liquidity scenario in the US for a long time. Moreover as I wrote in one of my earlier blogs "Bull in the world of two carry trades" we are today in a world where short term interest rates are likely to remain low both in the US and Japan over the next few months and maybe years and as such there is the potential of money flowing through both the currencies. Since both currencies will typically move in opposite direction relative to other world currencies investors who can make the right calls on when to switch currencies can actually make huge returns by investing in equities and commodities.

Moreover if one analyses the history of Yen carry trade, typically such trades go on for years (with obvious short term reversals in between). As such there does not seem to be much logic of talking about an end to carry trades today.

If one logically also analyses the options before investors today, specifically in the Indian context (which is also valid in the global context)

-fixed income in any form is unlikely to make inflation beating returns for investors,

-real estate on the commercial side is on huge oversupply and on the residential side prices are still not where one can look to make strong returns in the near term,

-gold is something that i like however i expect the Indian rupee to keep on appreciating and thus will take away a large part of the upmove in gold prices,

-commodities look good selectively however given the state of a large part of the global economy we are unlikely to see a big upmove from where we already are.

In this context equity stands out as an asset class which is likely to outperform over the next two years atleast. And given the extremely low short term rates in most large economies there is likely to be a huge influx of money into high growth developing economies.



Indian Economic Recovery


The most positive feature of the current results season has been the extremely positive performance by the Indian Financial sector and the fact that the capital adequacy of the banking sector is almost at all time highs and NPA's on an overall basis have come down for most banks. This in a scenario of extremely strong liquidity will lead to a fall in credit costs for consumers and corporates over the next few months. In a previous article "Do not believe the banks when they say interest rates will go up" I had clearly pointed out that bankers who are talking about interest rates moving up over the next few months and not lending are out of sync with reality. We have seen over the last few weeks almost a rate war starting on the home loan front where one of the private banks has reduced rates to 7.5%. Lot of banks have also reduced auto loan rates very significantly with rates for some of the larger cars coming down to as low as 5% and or most others down to 8%.

The order booking of most capital good and construction companies are seeing a very good momentum and Automobile sales have hit the high gear with most companies reporting more than 15-20% growth for October. Numbers will be good for the next six months due to a low base effect of last year. Similarly Cement sector growth continues to be over 12%, steel companies output is growing more than 20% etc. Higher gas production by reliance and start of production of Crude Oil by Cairn is leading to a high growth in Oil & Gas production. Electricity production is also picking up and likely to move up further next year. The services sector is also seeing a pick up of momentum mainly due to higher government spending. Sectors like construction, banking, aviation, tourism, banking and finance, transportation, trade, real estate etc. are also likely to see a sharp pick up which will lead to a pick up in momentum on the services side of the economy( 60% plus of the Indian economy). Consumer spending has also picked up sharply with most consumer durable and non durable companies reporting strong growth numbers.

The only negative is poor farm sector growth in the Kharif crop which should lead to the overall agricultural growth being a negative of around 6% for current year. However this will lead to a low base for next year and we have seen several times in the past that the year following a bad drought is typically a 8-10% agricultural growth year. Industrial production growth is likely to average around 8-10% next year and services sector growth rate should also be around 8-9%. Taking into account all these factors I believe that next year should be a 8-9% growth rate for the Indian economy.



This combined with strong inflow of foreign flows into India and the fact that economic recovery is likely to be rapid sharp corrections due to global events should be only used as buying opportunities in India.

Successful Investing is anticipating the anticipation of others - John Maynard Keynes

BEARS WHO ARE CALLING FOR A MARKET REVERSAL - DREAM ON

We have seen correction unfold in the equity markets over the last few days after the significant run up seen over the preceding few months.

After reaching a level of around 5200 for the Nifty and 17500 for the Sensex the markets have been correcting over the last few days. The reasons for the same are several which include high valuations, some result disappointments, global cues as well as the RBI Monetary Policy which came out a two days back and was taken negatively specifically for the banking and real estate sectors. The overall impact of the RBI policy ex of these two sectors is not much and as such interest rates are not likely to move up any time soon.

I expect that the current correction which has already seen the markets moving down by around 10% from the top should play out over the next few days. As of today the NIFTY has reached a level of around 4800 and the Sensex is at 16200 levels. I do not expect the markets to fall by more than 4-5% from the current levels and as such the bottom of the markets in the current corrective phase should be around 15800-16,000 for the Sensex and 4650- 4700 for the NIFTY.

The market correction has seen bears come out of their (slightly early) winter hibernation and announcing that the upmove is over for now and we are going to see a very deep correction. This will be driven by the reversal of liquidity flow and a US Dollar bounce back. My view on both these issues are as follows -

The Liquidity Tap - The liquidity tap that has been opened by central bankers all over the world is unlikely to be turned off or slowed down any time soon. Comments coming out of all Western central bankers, the Chinese as well as the RBI is that they still believe that the recovery is fragile and they would like to watch for some more time before taking and significant action. Economic numbers out of Western economies are still mixed with alternate bouts of positive and negative data points. some of the improved numbers is segments like Autos and housing in these economies have been driven by incentives and their sustainability after the incentives run out is still doubtful. Credit flow is still muted and the financial sector is not completely out of the woods. As such the logic of reversal of liquidity as a reason for the markets to fall is untenable at this stage.

US Dollar Bounce Back - Given the fact that the US Dollar has continuously been losing value over the last few months it is only natural that there is a bounce back. All bull markets and bear markets have a bounce back associated with them as nothing moves up or down in a straight line. Technically I believe that the US Dollar Index moving below the 78-80 range is extremely negative for the long term direction of the US Dollar. Even fundamentally the US Dollar remains very overowned. As per the comments of Bill Gross a couple of days back, there is a huge over ownership of US Dollars, specially by China. As such any bounce back would be used as an opportunity for investors to exit/diversify their US Dollar holdings. Even taking into account the long term growth prospects of the US economy vis a vis emerging economies there is no way there can be a directional upswing in the value of the USD. As such a short term upswing in the value of the USD should only be used to buy risky assets.

Overall economic performance continues to be healthy and the economic outlook continues to improve. In bull markets dips should be used to buy into rather than sell into and the current correction provides a good opportunity as the fall in the broader markets has been much more severe than the Indices and lot of stocks are coming at good entry level prices.

Another reason why i do not think that we are likely to have a 20% correction at this stage is that the markets had a prolonged period of consolidation between May and August. Even the subsequent upmove in the markets has not been driven by any euphoria or excessive optimism. As such there should not be a severe sell off in the markets as speculative positions are well controlled. Given that the results season is coming to an end this week most of the market reaction to the results will also get over shortly. Under the circumstances my bet would be on a 10 odd percent correction rather than a 15-20% one. I think we will get a bigger correction sometime next year after a much bigger upswing.

“Its important to grab entry points in bull markets as they come with gaps and are normally short lived”

AFTER THE STORM - THE LULL

After a 100% rally from the March bottoms the markets today look to be wanting to pause. The rally from the March bottoms has been fuelled by a variety of factors which includes an unprecedented flow of cheap money into the global monetary system, the bottoming out of economic performance and a sharp uptick in some countries like India ( Industrial Production up by 10.4% in August), China ( GDP up 8.9% in the last quarter) and stabilization in a number of other economies in the West with the downward spiral getting controlled. Infact inflow into emerging market funds have far exceeded the highs of 2007 and the week ended October 21st 2009 saw an inflow of nearly USD 4.4 billion.

While the initial upmove was fuelled by the avoidance of a Catastrophe the subsequent movements have also been driven by cheap money carry trades of the US Dollar and the Japanese Yen. Valuations that had troughed at around 9-10x earnings have now moved up and the Indian markets are trading at around 18-19x earnings. The BSE Sensex EPS for the current financial year is likely to be in the range of 950 and should move to a level of around 1150 for the financial year 2011.

The current results season has generally been one of positive surprises till date with a vast majority of companies from the Automobiles, Banking, Consumer Goods etc that have reported till date have done better than expectations. Capital good companies have been a mixed bag and a large number of mid cap companies have surprised on the positive, specially on the margins front. Low input prices and carry forward of low cost inventory has helped the cause. For the companies that have reported till date there has been an around 5% sales turnover increase and a 25% profit increase. Performance of commodity companies have been subdued, however are likely to pick up going forward. Pharmaceutical companies have also come out with good results.

The strong uptick in margins due to low input costs are unlikely to sustain as input prices which include most metals, oil, chemicals etc have moved up sharply. Although companies will have some pricing power in light of the improving economy the near record margins that most companies have reported for the current quarter are unlikely to sustain.

The telecom sector has taken a hit due to the intense competition and the investigations launched into Spectrum allocation recently should act as a dampener for the sector in the near term. Although there is not much to lose in these companies as far as valuations are concerned, negative news flow will weigh on the stock performances.

Taking all things into account I believe that we are now entering into a phase of the markets where the news flow as far as the performance of the economy is concerned will keep on improving and the overall momentum in the performance of the corporate sector will continue, however the markets will now need to take a pause and adjust the valuations for the move that has already taken place. As such markets with an underlying positive bias will in all probability remain in a range for a slightly prolonged period of time. Whereas the markets have moved up by nearly 100% over the last one year the next one year is unlikely to see a growth of more than 20% from the current levels.

Given the fundamental outlook on earnings I would say that the lower levels of the markets should be at around 12x 2011E earnings which comes to around 13500 for the BSE Sensex and the upper end could be around 20x 2011E earnings which comes to around 22000. The upper and lower bands in my view are extremes and unlikely to be actually seen over the next 12 months.

So under the circumstances the markets will become stock specific and there will be a huge potential to outperform by having the right portfolio mix. Whereas the last one year has been disastrous for active fund managers due to the momentum up move of the markets as well as the fact that any cash in the portfolio became a big drag ( for example a 10% average cash level in the market that goes up 100% drags performance by 10%). It was very difficult to outperform in the last one year. However going forward a few right picks in a range bound market can really make the portfolio outperform.

I am positive on sectors like automobiles, Oil and Gas and Financials on the large cap side. On the mid cap side of the market Sugar, Auto Ancillaries, construction companies as well as alternate energy companies offer opportunities.

The next one year will be where specific strategies by company managements will become important as the last one year was more of a macro period where initially the market meltdown hit companies in a manner where irrespective of the specific strengths of companies all went down and the last 6-8 months have seen a similar upswing. I personally like ranged markets much more than momentum markets as they do not give time for research and analysis. Companies with better growth strategies and high earnings growth would tend to get greater value in more ranged markets. There is a very high likelihood of a 15-20% correction in the first few months of 2010 and that should provide an excellent entry point for investors who have missed out the first wave. Typically correction in a bull market that we have entered now should not be more severe than this.

I do not think that the prediction of the extreme bulls that we will continue to move up with momentum is likely to fructify.

"We are all wrong so many times that it often amazes me that we can have any conviction at all on the direction of things to come. But we must as in this business you are good if you are right six times out of ten. No one's going to be right 9 times out of 10."

POWER IN INDIA WILL GO THE TELECOM WAY - A BIT EARLIER

Circa 2015/2017, some 5-7 years from today a newspaper headline says - The CERC (Electricity regulator) imposes a Rs 1 rupee floor on the rate of traded power. The supply of power in the spot market far exceeds demand. A majority of new merchant power plants operate at below marginal cost. The cost of power in India falls to the lowest in the world due to intense competition.

Sounds unrealistic, not to me. '

Like the price competition which has grasped the Telecom industry around 6-7 years after it was perceived to be a sunrise industry due to increasing competition and new entrants, a similar phenomenon is likely to repeat in the power sector around 5-7 years from today. The reasons for these are obvious,looking at the short term power rates of Rs 10-14 per unit and cost recovery of power plants based on the cost of power generation and the current merchant power rates each and every industrialist today is looking to get into the power sector. CERC has had to impose a cap on short term power rates in order to prevent short term traded power rates going out of hand.

Lets look at some some statistics. India's installed power base today is around 1,50,000 out of which around 80% would be available capacity, as such electricity consumption should be in the region of 1,10,000 MW. The total addition of power capacity over the last 5 years has not been more than 20,000 MW. As against this the power capacity addition over the next 5-7 years would be over 150,000 MW. A broad composition of the same could be -

NTPC -30,000 MW

NHPC 10,000 MW

SEB's 25,000 MW

Reliance Power 20,000 MW

Tata Power 10,000 MW

JSW Energy 10,000 MW

Jindal Steel & Power 10,000 MW

Sterlite Power 10,000 MW

Adani Power 10,000 MW

GMR 10,000 MW

GVK 10,000 MW

Lanco Infra 10,000 MW

Indiabulls Power 6000 MW

Adani Power 10,000 MW

Other smaller players like Torrent Power, CESC, NLC etc. combined 10,000 MW

Wind Power 15,000 MW

And a number of other players who are getting into the game all the time.

(I do not profess to know the exact capacities being added by these companies but this is just a broad illustration)


And so on and so forth. With a huge amount of capacity coming on stream over a period of 2-3 years Merchant power rates are expected to crash. Power availability will go up and cost will come down. This will be extremely positive from the economies point of view. However it runs the risk of exposing the banking sector to high NPA's from this sector as Power Plants are getting Financial Closures very easily these days based on rosy projections of price of power sold and expected profits from the same. The total investment going into setting up power plants by the private sector is likely to be in the region of USD 100 BILLION over the next 5-7 years.
Also given the acute shortage of power in India today with a large part of the country having to go with 6-8 hours of power cuts every day a number of companies are today looking at adding their own captive power plants, this is likely to further add to capacity. It will be difficult for the cost of power production to go below Rs 2 per unit. As such cost recovery will become an issue for a large number of new power plants. Given the huge fixed costs involved in setting up power plants most of these plants will be forced to run on marginal costing just to cover their fixed costs.
As such investing in the power generating sector in India with a view towards a few years into the future is froth with danger. The ROCE for most of these projects is unlikely to go into double digits.

"Sometime your best investments are the ones that you do not make"

Indian Rupee Looks to appreciate big time

As I had written in one of my previous articles titled "Is it time to go underweight on technology" I believe that the Indian Rupee is looking to appreciate significantly over the US dollar over the next few months. It has already appreciated by nearly 5% over the last one month itself.

Over the last few months the India rupee has remained week against the US Dollar and has underperformed most of the other emerging market currencies by a wide margin. The Indian rupee still trades at around Rs 47 to the dollar vis a vis its lows of Rs 39 to the dollar in the first quarter of 2008. As against and appreciation of just around 6-7% of the rupee the Korean Won ahas appreciated by 25% plus in the same time, The Indonesian Rupiah by nearly 30% and the Brazilian Real by nearly 35% etc.

I believe that the Indian rupee which has been reasonably stable in a scenario where the US Dollar has continuously lost value against most currencies and the US Dollar Index is down 15% from its peak of mid March 2009 is set to begin an appreciation cycle which should average 4-5% (at least) per year over the next two years. The reasons why the rupee has not appreciated in the near term despite an inflow of USD 12 billion in portfolio flows since March,continuously falling trade deficit, strong equity fund raising, strong remittances flow etc has largely ( in my view) due to RBI keeping a tight leash on the Rupee due to the pressure on export industries which have been severely hit by the global slowdown. Also given the fact that inflation has been on a negative territory there was no incentive to let the rupee appreciate in order to control inflation.
Going forward given the fact that inflows into India are likely to remain strong and also the fact that inflation is likely to pick up over the next few months there is an increased likelihood that the RBI will let go of the rupee and we will see a steady appreciation. This will also be supported by an overall recovery in the global economy which is already leading to some sort of uptick in exports of traditional labour intensive products.
We have also recently heard of lot of noise coming from the Indian Government as well as RBI on the need to control inflation and the fact that India might be among the first few countries to abandon the easy monetary policy. This is also likely to be a self fulling prophesy for the appreciation of the Rupee as most of the Western Central banks have clearly indicated that they are likely to keep rates low for a prolonged period of time. Just the expectation of rate hike will lead to rupee appreciation.

That was the fundamental view. Even technically the USD has made a very negative pattern against the Rupee both on the weekly and daily charts. Whereas on the daily charts it has made a double top on weekly charts it is on the verge of completing a head and shoulder pattern that should result in the rupee moving to a level of Rs 44.5-45.25 by March 2010.

I believe that the appreciation of the rupee will be positive for the economy as it will reduce inflationary pressures to an extent and also reduce costs of both inputs as well as borrowing for India Inc. However it might hurt some export industries as a fast appreciation of around 10% will be difficult to adjust given that external demand is still pretty week.

"Faith in your own abilities and confidence in your individual methods are essential to success"