Valuations Are High But Stocks Are Headed Higher, Ridham Desai To BloombergQuint
At a time when Indian outsourcers are facing the brunt of tougher visa norms in the U.S., Ridham Desai of Morgan Stanley believes that it’s the technology stocks that could well turn out to be the dark horse for Indian markets. The India equity head of research and managing director at the global investment bank told BloombergQuint that higher capital spending by American corporates will more than compensate for the visa hurdle that Indian I.T. companies have been facing lately.
While the “structural story is still bad”, there could be a surprise waiting, he said on the sidelines of the Morgan Stanley 19th India Summit.
Benchmark Indian equities, already at record levels, are set to head even higher, said Desai. Indian stocks are one of the biggest gainers of “secular global bull run” that’s underway, he added.
Here are some of other key takeaways from Desai’s conversation with BloombergQuint.
- Nifty could triple over the next five years
- There will be enough corrections en route for people to invest
- Consumer, infrastructure and financial sectors will drive growth
- Prefer private banks over public sector lenders
- GST will cause some short-term pain, for small and medium enterprises
Here’s the entire conversation with Desai.
Here are edited excerpts from the conversation.
Late-Stage Bull Market
Are conversations more about the short-term which is full of uncertainties, both domestic and global, or are people really talking about the long-term? Because your report talks about the next three-five years and the picture is looking fabulous?
Uncertainty is part and parcel of life, irrespective of time frame. Nobody should have this view that uncertainty reduces in the longer term. Actually, they increase. As time expands, uncertainties expand. The backdrop here is that we are sitting in a global equity bull market. Lets’s not mistake that. We characterise this as a late-stage bull market. Growth everywhere is improving including India.
Bonds Vs Equities
In your note Ridham Vs Rhythm you said don’t look at PE multiples because valuations will not determine what happens to the markets. Would you like to elaborate?
The challenge is that valuations for market calls play a role only at the extremes. So, it is very easy if the market is trading at 5-6 times book to say it is overvalued. At some point, it will correct itself. If it is trading at 2 times book, it is easy to say, buy it. Take a bit of pain in the near-term but eventually come out good. Now, we are right in the middle of that range, around 3.2-3.3 times book. I use price-to-book multiples because earnings actually are depressed. PE is misleading. If you want to use PE then you have to normalise earnings. If you normalise earnings, PE ratios also sit in the middle of the range. India is actually at the lower end of its range versus U.S. equities which is considered the bellwether equity market of the world. Compared to emerging markets, it looks a little rich, but India has a superior growth and return on capital (RoC) than emerging markets. Compared to bonds, stocks are more attractive. The bond multiple is about 15 times. Yield is 6 percent. Equity multiple is 17 times.
Valuations High, Stocks Headed Higher?
So, you would naturally go and buy equities?
Equities certainly look more attractive than bonds. Choosing between a 10-year bond and Indian equities as an asset class, I would buy equities. That said, the mid caps and small caps do look a bit stretched on valuations. Valuations are in no-man’s land. Not at levels at which I can pound the table and say stocks are cheap, buy them.
Earnings Recovery Likely?
For the last three years, you’ve started off the year with a belief that earnings would probably grow 15-20 percent and typically then we are back to revising it downwards. What gives you the confidence that this year will be different?
Actually, I said the same thing last year and I went wrong. So you have to take my view also with a pinch of salt but we have seen a fair bit of assimilation of factors. I think consumption is on a recovery path because of the enormous work done on inflation both by the government and the central bank, real wages are turning positive which is boosting consumption growth. We have seen fair bit of repair work on infrastructure, infrastructure spending percentage as a part of GDP is about to hit a new high. We have seen a recovery in exports thanks to the general recovery globally. So three out of the four pillars that drive the economy are actually on a recovery path. The only thing that’s missing here is private capex, which I reckon as a consequence of these three factors and therefore, pricing neutralisation rate will also turn in about 12-15 months. So now you could say that the economy is now firing on three out of four cylinders and the fourth cylinder is about to start. So, it is a good backdrop for earnings recovery.
You look at earnings itself, margins for corporate India are just coming out of all-time lows. Revenue growth has started recovering three quarters ago. So it’s not that earnings are falling anymore, they have actually started recovering. So, that increases our confidence that earnings could be turning and we could be at the start of a new earnings cycle. You cite the example of analysts having over-estimated earnings for the last 7 years prior to that in the preceding 5 years they under-estimated earnings. So, in 2004, consensus estimates were at 15 percent but the market delivered 13 percent. So, we have gotten used to analysts missing estimates at some point in time. The market is not oblivious to this by the way. On the aggregate the market is a damn smart animal and it gets things right 8 out of the 10 times. It does go wrong 2 out of 10 times and those are when valuations reach extreme levels and the sentiment becomes either too exuberant or too depressed but on most other occasions the market has a good working sense of what is happening. Ultimately it is the aggregate view of all the people involved, there’s real money at play, not people like me who only have a view. I may have real money at play but definitely not when I am on television.
So, the market does have a contribution to understanding what’s happening and it’s not oblivious to the change in earnings cycle which is why you are seeing some buoyancy in stock prices which has been going on for a while. The market took a temporarily dim view on demonetisation but quickly came back, because it realised that demonetisation was not going to be that damaging for earnings. It took a while for the sell-side consensus view or the buy-side consensus view to change.
Triggers For A Correction?
Even if there’s a small disruption that happens due to GST or a small global scare, do you think that the decline gets limited to just 5-10 percent?
If you go back to the 2003-2008 market which was a bull market, the index had a stellar rise in the first few months. We peaked out somewhere in January 2004, when the market went sideways. Then the May 2004 election results happened. A lot of people think that the election results caused the market to fall but actually in the preceding week emerging markets had already corrected, India was holding on for the election results and then it corrected. Then in the correction, we fell 25 percent. People have forgotten that, we went down 25 percent in a raging bull market. A lot of people became so skeptical that they sold and went away.
From there again the market went up, we had 20 percent corrections on a regular basis, 3-4 of them. So 20 percent corrections I don’t think are out of reality, we had one in December. So, those can happen but right now I can’t see the triggers in place for such a steep correction.
What is it that you think drives earnings growth? The question is from a thematic and sectoral perspective.
There are only 10 sectors and you can break them down in a regular fashion.
My view is that discretionary consumption will be at the forefront. The other one will be financials, and infrastructure will be the third player. This does not mean that these are the sectors you buy because the answers will be different if the question is which sectors to buy. But I think these could be the big drivers of growth in the coming years.
I see fundamental changes happening on the household balance sheet. Households are more enabled to borrow money. So they will advance some of their future consumption. I think consumption will surprise on the upside. Especially discretionary consumption, which is what you do when you borrow money, which includes housing, household effects, clothing, kitchen appliances, host of things. Now banks and non-banks are willing to lend even to do a hair transplant, to buy a rock-show ticket. These are all in the nature of discretionary consumption for India. For India, everything that is non-food and clothing in discretionary. So there is a fair bid that could happen there. As a consequence, financials will grow because loan growth will drive financial earnings.
But they are not cheap?
See cheap and expensive is a function of future cash flows, not what the multiples are. So, you may say public sector banks look cheap and private sector banks don’t but actually it is the other way round because private sector banks are the ones which have better return on capital and better growth prospects. Public sector banks are constrained for capital and therefore struggle to grow and struggle to improve their ROE’s from their current single digit levels. So, I would argue, that is a function of future cash flows.
Where is the dark horse in this? Are you betting on a dog, are you betting on a dark horse?
We have been overweight on technology. We have added to that and it has been going down. So, may be that’s the dark horse. Because, the market is very pessimistic. I see U.S. capex turning. And, therefore, some demand in the enterprise sector will come back. The structural story is still bad. But there could be a bit of a trade there, which could surprise us. It has not worked out but let’s see if it works out in the second half.