The Hindu Business Line : Who's pumped up about the market, and who isn't

AS THE market continues to scale new peaks, expert views on current valuations and the direction in which the market is headed are becoming increasingly diverse. The divergence between prominent foreign institutional investors (FIIs) and domestic fund managers is pronounced, with the former somewhat unconvinced that the rally will endure.

The rally, that has taken the Sensex well past the 8,000 mark, appears to have perplexed several foreign brokerages. They had turned cautious on the Indian stock market even when the Sensex was at 6500 levels and, not surprisingly, their concern has now heightened.

The FIIs have been the prime drivers of the rally over the past there months as they have invested close to $4.5 billion. As the buzz of caution has been heard from the big names in the FII ranks, it is quite likely that the inflows have materialised from the new entrants into the Indian market. About 130 have registered with SEBI so far this year.

Though no one is sure how long the liquidity-driven rally of the past few months will sustain, the likes of UBS, HSBC and Morgan Stanley have all crunched enough numbers on return on equity and price-to-book-value — the relationship between market value and the underlying book value of a company's assets — to back their bearish view that the market is overvalued.

But these views are strongly contested by domestic fund managers and brokerage houses. According to them, the current valuations are not too high; equities are fairly valued and will continue to deliver attractive returns for the long-term investor, although not of the order witnessed over the past two years.

We take a closer look at these views to discover the rationale behind the two divergent takes on the market. Meanwhile, the accompanying story examines what such views mean for investing in equities.

Why FIIs are cautious

A rapidly growing economy, a superior return on equity (ROE) vis-à-vis other markets in the region, low volatility in ROE, a strong financial system, low gearing and a robust corporate performance are a few reasons why the Indian stock market, along with that of Korea and Taiwan, has been courted aggressively by the FIIs since 2003. But their outlook for the Indian market has turned cautious.

Morgan Stanley, for instance, believes that the downside risk of investing in India is now magnified, as corporate fundamentals are likely to take a turn for the worse. In a June report, the outfit argued that with companies on investment mode, the high ROE, which makes India the "darling of investors", would decline to lower levels, as the cost of expansion (higher interest and depreciation costs, expanded equity base) strains earnings.

As companies step up their capital spending, they are also likely to lower their dividend payouts, making them less attractive.

A poorer quality of earnings due to a high share of non-operating income, poor breadth of earnings and concentration of performance in the materials sector, peaking of operating margins and rising interest rates are the other factors that it perceives would have an adverse impact on earnings.

HSBC Global Research, on the other hand, does not paint as gloomy a picture. It believes that the fundamentals of Corporate India are intact but that valuations are stretched. At the time of the report, the Sensex was at 6800 levels. The valuations, it argued, factored in a sustained improvement in India's growth rate, which increased the downside risks. It did not see a substantial upside either, as FIIs had exhausted most of their options in large-cap stocks.

UBS Investment Research is underweight on the Indian stock market, as it scores poorly on the relative valuation. In a report issued in August, the outfit estimated the Indian market to be the second most overvalued market, after Australia. According to UBS, historically, three of the four most overvalued markets tend to underperform over the next twelve months. The positives that make India a preferred destination for investors, such as low volatility in ROE and low gearing, it says, are priced in.

Same market, different spin

Domestic fund managers and brokerages, on the other hand, disagree with their international counterparts, both on the extent of correction and on the sustainability of the current valuation levels. In their view, the market may perhaps go through a consolidation phase before moving up again.

The latest views do acknowledge the possibility of pressure in the market over the near-term. According to Franklin Templeton Mutual Fund's latest market outlook, near-term dampeners include a decline in commodity prices, fiscal deficit and the impact of rising interest rates. The fund house is, however, optimistic about the market direction over the medium to long term.

Most fund managers also contest the notion that the current valuations are steep. Kotak Mutual Fund, in its latest equity market outlook, asserts that while the indices trade at all-time highs, valuations of specific stocks are not expensive. Mr Sandesh Kirkire, its Chief Executive Officer (CEO), believes that there is tremendous opportunity in the mid-cap space, with several companies on a faster growth trajectory than their large-cap counterparts.

Mr S. Naganath, Chief Investment Officer and President, DSP-ML Mutual, too, believes that the current valuations, at 14.5 times forward earnings, are not unduly stretched.

In a note published on the Web site of HDFC Mutual Fund recently, Mr Prashant Jain, CIO, HDFC Mutual Fund, says an annual profit growth of 15 per cent over the next five years is possible, even if we factor in a slowdown in earnings growth on the back of cost pressures on inputs, low incremental cost savings and costs of expansion.

Based on this aspect, valuations, at 14-15 times forward, do not look expensive. According to his calculations, even if the Sensex were to be accorded a much lower price-earnings multiple of 11, the index would advance to 11500 by March 2010, on the strength of its earnings growth. This conservative estimate would mean an annual return of 7-8 per cent.

Moreover, although India may be richly valued relative to peers, Mr Prashant Jain believes that India deserves a higher valuation because of its higher economic growth rate, low leverage and low dependence on exports.

According to Mr Sandip Sabharwal, Head of Equity, SBI Mutual Fund, foreign brokerages tend to view India as expensive on the basis of its high price-to-book value. He argues that India, being a service-driven economy, is not heavy on assets. It would, therefore, tend to have a higher price- to-book value when compared to other manufacturing-centric economies in Asia.

Besides, although Indian stocks look expensive on a price-to-book basis, they look less so on a price-to-earnings metric. This only shows that Indian companies have become more efficient in utilising their assets. The divergence in views is significant, as the inflows from FIIs have outpaced those of domestic funds by a factor of three over the past year; the differential gets larger if one considers the bull market from April 2003.

Though their inflows pale in comparison to the FIIs, domestic funds have invested heavily and early in mid-cap and small-cap stocks and benefited by the manifold rise in prices. This suggests that they are taking a broader view of the market than the FIIs, who, appear focussed on the large-cap space .

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