Many factors will contribute to push profit share to GDP which includes a recovery in consumption, real wages are turning, exports are picking up, and government infrastructure is at an all-time high.
It can’t get bigger than this for investors and traders. Morgan Stanley predicts Nifty to triple in next 5 years to hit Mount 30K while in the short term, it sees Sensex hitting 34000 by June 2018.
“If you remember between 2003-2007 Nifty earnings compounded at 39 percent and the index was up 7-fold, we expect earnings to compound by 20 percent in the next 5 years which could take the index towards 30,000. These are very modest estimates,” Ridham Desai, MD, Morgan Stanley said in an interview with CNBC-TV18 on the sidelines of 19th India Summit.
One big reason behind the estimates is profit share to GDP is close to all-time low, and we should not forget that it is just a cyclical number and it tends to recover.
Many factors will contribute to push profit share to GDP which includes a recovery in consumption, real wages are turning, exports are picking up, and government infrastructure is at an all-time high. The only missing piece is private capex, but that should also recover by next year.
“We are in the midst of a cyclical recovery in the economy which is good for earnings. The market will not go up in a straight line but it is safe to assume that it is a well-entrenched bull market, and there is considerable more upside for the long-term investor,” said Desai.
For somebody who is looking for a 3-6 months perspective, there will be a lot of problems as valuations look stretch, but that should not worry long term investor.
“Valuation are not my concern, although it looks stretched in the small and midcap space. PE multiples will look loft at current levels because earnings look depressed. But, if we normalise earnings, PE multiple may not look that rich. Therefore, I look at price to book, India close to its long-term averages,” said Desai.
He further added that if we look India relative to US markets, its valuations are just off the 2008 lows which tells us how rich the valuation are. But, relative to emerging markets, the valuations are above average which is justified because of India’s superior growth and rising return on equity (ROEs).
What will take the rally higher?
One sector which will take the rally is financials, followed by consumption stocks.
“It looks like investors will underestimate consumption in the country and the reason is the fundamental change which is happening in the households psychology. There is cultural shift which is happening as more and more people in their 20s are borrowing money which advances demand in a meaningful way,” said Desai.
The per capital income is also going higher which should also fuel demand for non-food consumption. In the financials, Morgan Stanley expects a lot of disruptions which could come from technology or regulations.
But, it looks like the state-owned banks will lose market share and hence they are more trading plays and not investment plays.
“We like NBFCs because there is a disparity in valuations as some of them have turned quite attractive and have fallen to 2x book, while others trade at 6x book,” said Desai.
GST Could Be Trigger For Market To Correct:
In the short term, goods & services tax (GST) could trigger some correction in the market, said Desai. Why?
Morgan Stanley did a survey of micro and small manufacturing and Services Company recently which showed that almost half of firms survey said that they are not prepared for GST launch on July 1.
In fact, 90 percent of them have expressed a desire for training. Hence, there is a possibility that when GST get launched, we face some amount of disruption on growth.
“The market could react negatively to this and if this gets combined with a global event then you could get a drawdown on Nifty in the range of 5-10 percent,” said Desai. This is not the time to short this market.
Below is the verbatim transcript of the interview.
Latha: I have a summary of your recently written note and this is looking very bullish. You expect earnings to compound at 20 percent over the next five years and Nifty to triple within five years, 30,000 index?
A: Yes, let us put it into context, between 2003 and 2007, Nifty earnings compounded at 39 percent and the index was up 7-fold. So this is relatively modest in that context. We did that in four years, in five years we triple. The context here again is that the profit share to gross domestic product (GDP) is at close to all-time lows. So profits have fallen off and it is a cyclical number. It tends to recover.
I think the factors have been set up for a recovery. Consumption looks like it is on a recovery path thanks to the enormous work done on inflation, so, real wages are turning. Therefore you will start seeing some recovery in jobs. Exports, which were lagging and which were a big drag for two years running, have recovered as well. Government infrastructure capex is doing quite well. It is about to hit all-time highs. So three out of the four legs which drive the economy are in place. The fourth and the only missing leg is private capex but as a consequence of these three, as utilisation rates climb next 12 months, we think capex will also recover next year.
So I think we are in the midst of a cyclical recovery in the economy, which is good for earnings. It is not going to go up in a straight line, there are various things that will happen over the next several quarters, but I think it is fair to assume that this is a well-entrenched bull market and therefore there is considerable more upside for a long-term investor.
For somebody who is looking at it from a three-six months perspective, I can give you a lot of problems that the market is going to face, but we can come back later in this discussion to that.
Latha: Valuation wise even with giving a very rich growth in the current year, we will still be about 18 times. We are at very tall valuations and some of the fast moving consumer goods (FMCG), the favourite sectors that everyone likes, we are at 40-60 times some of the good earnings numbers. If you take an HDFC Bank, we are already at 4 times, if it is RBL, it will be 5-6 times.
A: Valuations are not my concern. I think they are little bit stretched in the midcap space, smallcap space, so, that is a concern there, but let us look at valuations and actually valuations can be looked at in different ways. I look at it relative to India's own history. You sight P/E multiples but remember earnings are depressed so P/E multiples invariably are going to look a little richer because the earnings are below normal. If you normalise earnings then P/E multiple may not be as rich as it looks right now.
Therefore, I look at it in terms of price to book which doesn't deal with cyclicality in earnings and on price to book India is at about close to its long-term average. So it is not cheap in the conventional sense, but it is also not rich. These are not levels at which you can make a market call on valuations. Valuations are useful only at extreme levels; when they are too low or too high, otherwise you have to use other things like sentiment, growth and other things to judge where the market is heading.
Then again if you look at India relative to US multiples, which is the bellwether market of the world, India's valuations are just off the 2008 lows; it tells you how rich the US markets are. So, again, everything is in the context of relative positioning so valuations do not have an absolute context. So relative to the US, India is okay. Relative to emerging markets (EMs), yes, the valuations are above average and that is justified by India's superior growth and rising return on equity (RoE) versus EM. I think EM has got more structural problems, so India's valuation premium is sustained versus bonds.
Look at the 10-year bond, 10-year bond is offering you 15 times earnings, 6.6 percent, equities are 17 times and 10-year bond only gives you a coupon for ten years. Equity coupon continues beyond that and the equity coupon is a growing one, the 10-year bond is a static coupon which one will you buy; the 10-year at 15 times or the equities at 17 times? So if you are a long-term investor - that is where I think you want to be.
As I said midcaps, smallcaps, I think there is a little bit of a stretch there because there is an earnings recovery coming and as you can go back in time; we tend to underestimate both, recession in earnings as well as recovery in earnings. So the off repeated comment, especially I have seen it on your channel as well, is that for the last seven years, analysts have started the year with 15-17 percent earnings growth and ended the year with nothing.
It is quite possible that we continue to start at 15-17 percent but we end differently from the last five-seven years. I will again give you history, in 2004 analysts started with 15 percent, ended the year at 30 percent. So the reverse is possible if the growth cycle is turned.
Latha: I was going to ask you does this feel like 2003-2004 and you kind of partly answered it.
A: It feels more like 2004, not 2003. In 2003, the index multiple was 2.1 times book and the P/E multiple was 10. It was a very juicy level, very different from today. In 2004, we were somewhere around 3 times book and 17-18 times earnings and all through 2004-2005 everybody kept complaining that valuations are rich and the market kept going up, but we did get big corrections along the way. So it is not like a linear straight line move that you are going to see even now.
Nimesh: If this scenario plays out of a 20 percent CAGR growth and whatever we see of from 2003 to 2008, similar scenario plays out, this time what will lead this rally because every bull market has got different legs and different sectors taking the market higher?
A: I think financials only look like the place to be and consumer discretionary is the other place. Let me just talk about discretionary consumption first and then I will come to financials. So, I think we are going to underestimate consumption in this country and the reason for this is fundamental change that is happening in the household psychology.
There is a cultural shift that is happening. My father never borrowed money, I have never borrowed money, but everybody who is 20-30 something in the world in India is now looking to borrow money. There is a big way in which people have changed their mindset versus norms. What does borrowing money do? It advances demand, so, we will underestimate consumption in a meaningful way because if we look at nominal GDP growth as a guide to consumption, I think consumption will be ahead of it.
There is a second thing that is happening in consumption, is we are approaching a j-curve in the per capita income. So, if you look at India’s consumption basket, 60 percent of it is food. However, now from here on, when the consumption basket grows another 10 percent, 6 percent will not be food because that is only that much food you can consume. So, the remaining 40 percent will grow at 10 percent which is 25 percent. So, a lot of non-food consumption will grow quite rapidly as a consequence of these two factors. So, I think we will underestimate discretionary consumption and therefore I think that is a sector to back for the medium-term.
As a consequence of household leveraging, I think there is going to be a big boom in retail loans and therefore financials will also do quite well. In the financial sector however, there is a lot of disruption that is likely to happen and that is coming from technology, it is coming from regulations. So, those things will create some difficultly in picking the right stocks. However, one narrative I think is quite clear is that the state-owned banks will lose market share. So, sitting at 70 percent, I think they are likely to give up 10-30 percent.
Latha: So none of them on your list?
A: No, none of them on our list. You could trade in them but I don’t think you should invest in them. The trading rallies can be quite powerful as we have seen over the past few months, but then they will probably give up performance as their valuations get full and the structural factors start impeding them.
I don’t think the government is in any hurry to put meaningful capital to work there, so, they are starved of capital and I think they will lose share to the privates and to the non-financials.
Latha: You spoke about government investment also being fairly rich. None of your stocks reflect that. We don’t have the Larsen’s in your list, or the ABB’s or all those various road construction companies?
A: There is a technical issue because our industrials coverage is in transition. So, right now we don’t have industrial stocks in coverage but we will soon have them.
Nimesh: To take your call on financials forward, I think recently your team upgraded the NBFCs, the likes of M&M Finance and Shriram Transport. Without talking about individual stocks, broadly what is the sense on the NBFCs and why you like that space.
A: So, there is a disparity in valuations. Some of them I think have turned quite attractive and have fallen to 2 times book. There are others that trade at 6 times book and I think in a bull market if you are looking for one year returns, there is always opportunity for you to switch from one side to the other side and the other side plays catch up and then you give up on one side which is expensive. So, that is exactly what we are doing as well.
Anuj: You spoke about this being a 2004 kind of scenario. Let me be a devil's advocate, let me be a bears advocate. We heard all this argument in 2008 as well that there is enough liquidity and the market is just going to keep moving and we saw what happened after that. Do you think there is a bit of a risk right now that with so much complacency around, you look at the volatility index both in US and in India, it is at historic lows. Do, you think there is a bit of a risk that we could have a significant correction from hereon?
A: You are shifting the debate from medium term to the short term. In the short run there are factors to worry about. Clearly depressed volatility is a reflection of market sentiment which is quite rich. As I said at the outset, when you are making a call on the market, when valuations are middling the only tools you have is your assessment of the growth cycle and where sentiment is.
I do think that sentiment is quite rich. I am looking for this trigger which will cause the market to correct. I think the trigger actually could be GST. We just completed a comprehensive survey of India's micro and small manufacturing and services companies. These are not your typical listed entities. Listed entities all get classified as large companies. India has 9 million firms, we are talking about the tail end of these firms. So, that is 99 percent of India's enterprise universe. Our survey shows that almost half of these guys are not prepared for GST launch on July 1 2017. In fact 90 percent of them have expressed desire for training and we are about less than a month away.
So, there is a possibility that as GST gets launched on July 1, we face some amount of disruption in terms of growth.
The market can react to this in two ways. One is, market can say that this is fine, we know this is temporary, GST is a great long term reform and this disruption will go away in a quarter or two and therefore let us move on. So, nothing happens, except that the VIX index climbs up, but the index actually doesn't do anything much. However if this is combined with a global event because a large part of India's bull market at the moment is also driven by global factors. It is not just local thing which is happening. We have to remember that Europe, US, Japan, emerging markets all of them are going up. So, if there is a global event of some sort which I can't actually predict here and it gets combined with some disruption on GST, then you could get a draw down on the Nifty which could be in the 5-10 percent zone.
So, I don't think we can rule that out. I think for somebody who is trying to trade this market and who is not looking at it from a 3-5 year perspective, they can wait on the side lines. It is not yet time to short the market I think. Shorting the market may be a little bit too risky because the timeframe is really shrinked there.
However it may not be a bad thing to just wait on the side lines. We got a great moment in December. The only problem for retail investors is that when that moment comes they will not feel like investing.
Nobody was wanting to put money to work in December. We were discussing on December 2 I think, that demonetisation would be forgotten in a couple of months and now is the time for people to put money to work. However that is always the most difficult moment to put money to work.
GST is very different from demonetisation. I classify demonetisation as an unknown unknown. GST is a known unknown.
Latha: Won't every one think that way, that if this did not give you a dip even for demonetisation, will this really give you a dip in GST? So, even this dip are you anticipating?
A: There was a serious dip in demonetisation. We had 1300-1400 point dip in the Nifty and it looked very bleak in December and growth forecast was being cut and people got quite concerned. We may not get a similar type of thing on GST because of the difference that GST is a known unknown. GST is uncertainty.
I contrast risk and uncertainty in this fashion which is, risk is something that can be quantified. Uncertainty is something that cannot be quantified. I am struggling to quantify GST, both in upside as well as downside term.
Imagine the lift that GST is going to provide to corporate profitability over the next 3-4 years. However if you ask me to quantify what will be the inventory gains, what will be the warehousing cost gains, what will be the freight cost gain, what will be the input credit cost gains, I have no idea. I cannot even start with a number. So, that is the problem with GST, that it falls into the bucket of uncertainty.
So, if it is combined with a global event then I think you could get a bit of a draw down in the Nifty. So, that is for people with 3-4 months view, it may pay to be on the side lines for a while especially in mid and small caps because that is where the risk is greater than large caps.
We saw last week for example or the week before, when there was a little bit of a correction, how mid and small caps corrected. That was bid. Even today there is a bid on the screen, that is liquidity right? However that bid can go away if markets get a bit nervous about these impending events.
Nimesh: How should one participate in this market now given that the opportunities are quite limited?
A: I don't agree with that. Why are we saying opportunities are limited?
Latha: Given the valuations.
A: I will tell you why opportunities appear limited, it is because most of us tend to get anchored to the winners of the past 3-4 years. A lot of those winners trade at valuations which do not warrant further investments. However if you start shifting your attention to host of companies and stocks that have actually not participated, I think there is enough juice in this market.
So, I don't think the opportunities are limited, certainly not. It is reflected in our recent upgrades. There are NBFCs that trade at 2 times book. People don't want to buy those stocks because they are worried that they trade at 2 times book and not 6 times book.
You have to shift your attention when the valuation risks are as disparate as 2 and 6.
Latha: You have a 24000 bear case. Why? What might lead to that?
A: There are two purposes served by index targets. One is to highlight the range of outcomes which could be enormous over a 12 month period, in fact on any timeframe. So, the range is pretty wide and usually it is wide because a lot of unknowns are there which we cannot actually foresee. The second is that targets actually provide some semblance of discipline. They are not to be viewed as levels at which I think the index is going to go but more as levels which instil some discipline about how I think about the market. Those are the purposes that index targets serve.
There are things that can go wrong. Things could go wrong with GST implementation, things could go wrong with India's macro, demand may not recover as we are forecasting and things could go wrong globally. So, there are enough things that could go wrong and which could cause the market to go down.
We are attaching a 20 percent probability to 24000 scenario which is not a irrelevant probability but it is on the lower side compared to our base case and bull case.
Also we have rolled our index targets. So, now we have a new target for June 2018, which is 34000, which says that there is likely 10 percent upside to the index and this is very much in contrast to where I was in December when I was far more bullish with a much bigger upside to the market.
So, I do think that returns are likely moderating over the next few months.
Anuj: Last time we invited your pharma and real estate analysts, these were two sectors where you had contra longs. Real estate has worked beautifully for you, pharma has not. Thoughts on these two spaces?
A: We have given up on pharma since then. So, we are underweight on pharma. There are structural problems there which don't go away very easily. I think the valuations are still rich.In contrast we actually like IT where also there are structural problems but the valuations are more attractive. So, between pharma and IT my preference to IT shifted at the start of the year. So, we made that shift actually. However even IT has not worked out. Both pharma and IT have gone down. Pharma has probably gone down a bit more than IT but even IT is down. So, it has not worked out, I am waiting for it to turn. Let us see how much it tests my patience and if I give up. However for now I think IT represents good valuation risk. Those who are a bit more technically minded, I could highlight the fact that the correlation between IT sector and the index are running at two standard deviation below average and in negative territory. It means that if the market goes down IT could likely go up. So, it provides you a good hedge if you don't have other means of hedging yourself against risk. However I have to admit that neither of them have actually worked quite well for us.