Earnings won't grow 20% in FY09: Shankar Sharma

Q: The other big problem for the equity market has been that bond yields have soured to 9.5% and more interest rate hikes could be on their way. How much of a problem is that for equities according to you and how do you map interest rates going forward?

Sharma: Without getting too much of the minutiae of where interest rates are headed, the fact is that the benign cycle got over sometime middle of last year in terms of liquidity and low interest rates and with government finances being in the kind of peril situation that they are in you can absolutely be very clear on one thing that rates are not going to come down in a hurry and that by itself means PE multiples will compress because they are completely inversely related.

So the best case that will happen is the numbers are pretty much where they are supposed to be but the market actually pays a lot lower multiples for the same earnings. That possibly is one scenario. I place only 20% reliance on that scenario. Our sense is that the markets firstly will pay lower multiples, and secondly the numbers themselves will be lower. We put out a piece of research in January or February in which we had said that anybody looking at 20% growth in FY09 has got to be smoking something really strong and clearly anybody who still holds out hope that the markets earnings will rise 20% this year they are still on that same dope.

If this markets numbers are going to be very disappointing; people have been disappointed or at least so, a tad disappointed by Infosys. But at least there are visible bad numbers or visible moderately bad numbers for a lot of companies forecasting - let's say Rs 10 earnings, they could end up with Rs 2 earnings or minus Rs 10 earnings. That's the situation one can foresee for a number of companies out there in the next 12-months time. So forget these earnings estimates, forget analyst talks - they don't really know anything about the reality on the street. They will always be behind the curve; the market has told you enough about what's in store; globally situation is going from bad to worse. So it's a lethal cocktail whichever way you look at it. So you have to just play out these overs and hope that you don't lose anymore wickets - that's a best hope you can have as an equity investor.

Q: Give us a quick word on that emerging market bond spread point that you have mentioned and what correlation it has with FII flows, could you just elaborate on that and what your expectations are of outflows from FIIs, even from here for the rest of the year?

Kumar: What has happened is that in the last three-four years, you have seen incrementally greater share of foreign ownership in the market as a result of incremental inflows. So the aggregate foreign ownership in the market versus five years back at about 11%; that is at the peak - went up to about 20%. So during this period of pretty high flows, we have attracted much greater share of flows coming into Asia versus our market capitalization. So what we have seen-especially since the time that the hedge fund flows through P-Note became a large percentage of the overall foreign inflows-that there has been a pretty strong correlation between these risk appetite indicators and net foreign inflows.

Q: You spoke about fairly alarming levels a few months back and we are not very far away from those levels, what kind of multiples do you see this market bottoming out because there was an optimistic view earlier that if you will not sing to those 10 kind of PE multiples where we have sung to sometimes in past bear markets, do you see that possibility looming ahead later this year?

Sharma: Rest everything be equal, the fact that we are more or less doubled in terms of interest rates right from the lows of this decade that clearly crimps the overall PE multiple for the market - forget earnings growth, forget India story, forgetting GDP growth; forget everything else - just interest rates have gone up very sharply that will crimp PE multiples. This level of interest rates and inflation although real interest rate is actually low; that is obviously because inflation has become very high and that is not necessarily a good way to reduce real interest rates-the fact is that the last time we were enjoying these kind of interest rates, our multiples used to be in the range of between eight and twelve times, which was in the second half of the 1990s. The only thing that used to skew the PE multiple band was the IT pack that used to typically traded between 40 and 60 times earnings consistently over three-four years and then topped out at 200 times earnings in 2000.

So by and large, old economy used to trade around those multiples and there is nothing to say that why those multiples cannot return especially if numbers are going to be disappointing. The fact is that the tightening measures will have a lagged effect, the numbers won't look bad immediately, order books won't like decline or start to hurt immediately but on a lagged basis couple of quarters out you will see the effect of the tightening cycle in India that began about nine months back and has gathered pace in the last six months.

That is the way we see this thing panning out, we do not think that you are anywhere close to the situation improving and on the other side the bad news is that the corporate sectors numbers have still not started to turn sour. So that does not make for a very happy situation. There is one more angle to our thesis that we held through the beginning of this year and late last year that emerging markets as a story are probably over for the next year or two years because that is the market that has made the most money. So when things sour globally for equities - that is where the maximum pain will be felt.

This year US has -if you can call it that the rock star of market-not fallen as much as Emerging Markets (EMs) have. Nasdaq has been absolutely stellar performer relatively speaking. That is enough indication of the fact that wherever there has been a bear market for the last seven-eight years, which has been US technology you will see a catch up rally there at least on a relative basis. Wherever maximum money has been made markets like India, China even Brazil has been hurt very badly lately. That is where the maximum money will be taken out, just as capital goods and banks in India have been hurt the most, IT has not been hurt, pharma has not been hurt - so it has been exactly the same theme on a global basis that markets that have not done well have actually outperformed this bear market. Markets that went up four-five times have been crushed in this bear market. So EMs overall will hurt a lot more than the US will, because that is where growth expectations have been very high and that when they disappoint will hurt a lot more than a market where people have very low expectations, which is the US.

Q: How are you mapping the macros because while people keep talking about earnings growth still being 15%-17%, the macros seem to be breaking down with every passing week, Index of Industrial Production (IIP) numbers weak, most of the other government balance sheet, inflation all of them have worsen considerably, do you think it is just a matter of time before they catch up with corporate earnings or can the disconnect remain for a long time you feel?

Kumar: One of the facts is that earnings revisions are actually a lagging indicator of the market which basically to put it in other way that markets react well before the actual downgrades in earnings come through. That could be for variety of reasons. So yes, I think the current consensus earnings forecast that you have out there for FY09 at about 18%-20%; that definitely has some risk. It can go down but at the same time if you look sector by sector, company by company there is definitely capability within the top companies to still deliver 14%-15% compounded growth rate over the next couple of years even though the macro challenges that you have mentioned are extremely severe. One other thing to note is that in India the monetary tightening started two years back in Q1 of 2006 - that is when the mortgage growth and overall credit growth was 35%-40%. In that sense, the Central Bank has already been tightening; this last round of tightening that has given the maximum grief to the market is primarily because of reaction to the headline inflation numbers. I think that can definitely have some downward impact on growth and bring down some of the earnings forecast, which are out there. But I do definitely believe that once you look sector by sector, there is still definitely possibility to get 14%-15% compounded growth in earnings over the next two years.

Q: This one view in the market, which is that considerable price destruction, has happened already you should now start accumulating stocks because value has emerged? You would refrain from doing that even at these levels of 13,000-odd?

Sharma: You can find value- we do have a pretty reasonable list of companies, which are below 10-times earnings and even 7-times or 8-times earnings. But remember a lot of these companies are smallish companies and smallcaps by and large - you never buy at the beginnings or at the foothills of a bear market. You buy them when you are on the other side of the bear market, which is that you climb to the top or conversely to the bottom of the bear market and then they begin rallying. So it's too early to still go out there and start to be aggressive buyers of smallcap names because that's where you will find the sub-10 multiple situations. Remember when liquidity tightens, they are the companies that get deprived most of cash in growth capital and therefore their numbers become more at risk because those companies require good equity markets to supply capital to them. For a large company, which has internal generation, they don't require good markets of growth. But small companies always require capital for growth and if capital doesn't come then the numbers they are forecasting themselves are put to risk.

So yes, there is value but smallcaps, midcaps will hurt a bit more and probably a lot more then from where they are just now before they become really cheap. It's till too early to say that the midcaps have bottomed out or the smallcaps have bottomed out. We in any case are not big believers in midcaps as investment themes. By and large you will lose more money on a five-year basis in them than you will make and wherever you make money, whether you can exit in the size that you want to exit and that's quite as a matter together as many fund managers now realise it's one thing to have NAVs linked to all these midcap stock prices but you try and sell 2,000 shares and stocks are tanking 20%. That's a real problem.

So whether the gains can be captured, taken home, paid out of dividends it's a big question mark. So by and large there is value but there is no real rush to get all your money to work just yet.

Q: What's your own feeling? We are 6-months through with this pain - do you think it's one of those classic bear markets which people are not admitting to yet and prices will get really cheap and screamingly cheap before this market bottoms out as has happened in prior bear markets?

Kumar: One of the things that I do believe in is that the prior bear markets would have extended for a much longer period of time over the last decade or so. You have seen such evolution of information and capital flows - at what speed it kind of flows and absorbs information that any dislocation slash bear market can get absorbed at a very rapid pace and that is what we have seen in terms of reaction that we have had in our stock prices. So it need not be that if the previous correction lasted and remained low for two-years that we have got to be at that again. My own belief is that we are fundamentally at some kind of a value level for the overall market itself obviously within that you will have spaces which have collapsed much more and there could be greater value.

So you could always see 5-10% further decline from around 13,000 on the Sensex, which would be an extremely attractive level fundamentally. So even if you have 5-10% declines from there for people with investment perspectives of 6-months and beyond, I think there are opportunities to pick up good companies, solid companies with good cash flows and attractive valuations. Obviously it needs to be done in a kind of a phased manner so that one does not get caught up in the volatility side of things.

Q: What do you think, is there only max 5%-10% downside to this market or much more than that?

Sharma: Let us hope it is just 5%-10% - that is what my heart tells me. But my mind tells me that it is probably twice that number that still has to be traversed. So be that as it may, you have to pick the least-worse options and that is what our strategy has been in this entire year. Buy the ones where you are going to lose the least money. So that is a strategy that we think will still be relevant through next few months; do not be too brave in this market.