Stock Prices Are Set For Cheer In The New Year, Says Morgan Stanley’s Ridham Desai
“If you pay the right price, you make money,”said Morgan Stanley’s Ridham Desai, as Indian equities enter a new year.
There may be a lot of variables affecting the stock market, but the prices—far better than they were eighteen months ago—will bring cheer to Indian equities as we enter a new year.
That’s according to Ridham Desai, managing director and India equity strategist at Morgan Stanley, who believes valuations are much more lucrative than they were last year.
There is always uncertainty, sometime good or bad. But if you pay the right price, you make money.Ridham Desai, Managing Director And India Equity Strategist, Morgan Stanley.
Indian equities currently face uncertainty from a number of sources—the U.S. Federal Reserve’s rate hike, the upcoming election year, growing trade tensions between U.S. and China and a liquidity crunch in India’s credit system stemming from infrastructure lender IL&FS’s defaults on payments. The benchmark S&P BSE Sensex, which gained more than 27 percent in calendar year 2017, has gained only 2.45 percent in 2018.
“Last year when midcaps and smallcaps were on a tear and ended the year up 60 percent, quite clearly in the start of this year, we were cautious on midcaps because we didn’t feel the price was right,” Desai told BloombergQuint. “Now, all that is adjusted.”
The overall market is currently at a price to book value of 2.8 times. That’s lower than the average of around 3.2-3.2 percent over the last 25 years, Desai said. “While it could fall lower if any of the uncertainties go horribly wrong, it's less probable given the country’s macroeconomic strength.”
Watch the entire conversation here:
Here are the edited excerpts of the conversation:
Do you think market will bring cheer in new year?
I think it will.
Are the factors set for it?
Factors are not set, prices are set. There has been so much damage to prices. In stock market, you make money only when you buy cheap. Otherwise, you don’t get money. It doesn’t matter what the factors around it are. There is always uncertainty, sometime good or bad. But if you pay the right price, you make money. It is hard to say whether the price is right. But it looks better than what it was in past 18 months or so. Especially, last year when midcaps and small caps where on a tear and ended the year up 60 percent, quite clearly in the start of this year, we were cautious on midcaps because we didn’t feel the price was right. Now, all that is adjusted. There are few issues with macro. Frankly, it is hard to predict in what shape and form they take. Given little bit of time, things will settle down and it will get better. If you have bought stocks with right price, then you will eventually make money.
Even the valuations are right, can the valuations become better if trade wars on global front, Fed and elections don’t play as per plan?
They can. The market is, right now, 2.8 times to book. Most people quote multiples of price to earnings but that assumes that earnings are at trend level. When earnings are off trend, as they are right now and they are way below trend... we were in earnings recession which lasted longer. I was continuously telling earnings will turn but they are still not turning, at least not on headline basis. We are not being able to call the earnings cycle. PE becomes less useful in trying to judge where valuations are. Price to book is at 2.8. So, the average for the market going back 25 years is about 3.1-3.2. So, it is below average. There have been four occasions where the market has traded 2.2 times book in last 25 years. You got that opportunity in 2003, 2008. We didn’t get there in 2013 but we were close, and in 90s. Every you went there, and you bought the market, you made money with three-year view. So, this market trades between 2.2-4.5 times book. We are at 2.8. We are not at 3.6. 3.6 will make you much closer to 4.5. 2.8 makes you little closer to 2.2. So, can it drop to 2.2 and make a fifth type of 2.2 occasion? It can.
I don’t see the circumstances around it right now. If you look at four previous occasions, each of them had crises around it. We are not in crisis situation. We are in a tough micro environment, globally and to some extent locally. Less locally, more globally. It doesn’t suggest to me that we are about to go down another 15 percent. The likelihood is that we may have created a bottom. There are things which can go wrong. I can start counting them and they can go horribly wrong in next six months and we may even test that low. For example, the electorate in country decides that I want a fragmented coalition government. The trade war with China starts getting worse. The Fed continue to raise its rates because labor markets in America are tight. And/or we get in inflation scare globally because the Fed backs off. And growth in India falters. That are the circumstances through which we get there. We attach a probability to it, may be 30 or 35 percent. It is good price to engage.
Bear thesis seems to be hinging more on labor market being tight and Fed itself underestimating the pace at which it will hike rates. Should such a scenario occur how bad it could be for emerging markets and India in particular?
Emerging markets have already taken the pain. If the Fed has underestimated inflation and has to hike at a faster pace, I dare say that U.S. markets will take a bigger knock than EMs here on. It looks conventionally bad for EMs but because of the damage the EMs have taken - if you look at relative performance and relative valuation, then it is somewhere lower and not higher - so, the U.S. market are demanding the multiples and not the EM markets. They are not trading at demanding multiples. If the Fed is got wrong, then we have to be more weary about SPX than MSMI index. But absolute returns could be bad everywhere. Policy errors are poorly tolerated by markets. So, if you are painting a policy error situation then, markets will not treat it well, at least not in short run on a 3-6 months’ time scale.
What if 2 of the 3 states don’t go to majority party coming in December? Is that a scare telling on markets?
The market will certainly look closely at election results in December. If market starts believing that it is sending a signal that we are heading for a fragmented government in 2019 because there is no clear direction, compare and contrast with 2013 December, when the same states give very clear directions of where the country wanted to head, and the country headed to that direction and there was no gap. This time if that signal doesn’t come, then I am sure the Nifty will start wobbling again. Depending on how much the market gets nervous and prices in, we will get reaction post elections in 2019.The often-repeated examples of market behavior are 2004 and 2009. But I like 1996 and 1998. In 1996, India voted in most fragmented coalition government ever. The lead party has 40 seats in the house. It was 240 people supporting it from outside. Sensex, the day later, was down 2 percent. Compare that to 2004 where the Sensex fell 17 percent. It tells that it is important to know what is in the price rather than what the elections results would be.
If the market starts believing there is coalition government, the bulk of pricing in would have taken place by April of next year and the reaction to actual result may be fairly muted.Unlike the last 30 years, this is the first time that market is heading into elections with likelihood that it gets government which is less strong than the exiting government. Every single government in last 30 years was coalition government. So, market had a hope that we will get a majority government. Now, you have one. So, the chances are you could slip from a majority to more minority government. That is probability which the market will have to bake in. If you look at history of last 30 years, historically the markets have approached elections with tinge of optimism and that tinge of optimism may be missing this time around.We are analyzing single factors. Market is complex adaptive system. So many things go in. One factor may not show up in price behavior. It is hard to separate things like election reaction, liquidity, Fed.
There is always uncertainty, sometime good or bad. But if you pay the right price, you make money.
When I said a lot of bad news in the price, I didn’t mean the state election results. I meant the current state of news. I don’t think market has truly anticipated December elections. There is bit of confusion. There is a consensus view. I will challenge that consensus view because I think it makes no sense in standing there with consensus. That is probably in price. Something which happens different from consensus, then market will get effected by it.
There is disagreement between the Finance Ministry and RBI. There’s a meeting on Nov. 19th, but do you reckon that this has the power to derail the party if things don’t turn out to be favorable?
The word I use is debate. It may morph into a disagreement or agreement. The government statement is very clear that we are debating issues. There are few issues on table. It may be with respect to FCRA deposit issue or RBIs reserves and how you treat them or PCA for SOE banks. There is RBI and government’s position. It doesn’t require any intelligence to guess whose position is what. It is good that it is in open. It speaks well of this country. That we can openly discuss this and government and leading institution which defines the country’s institutional framework can disagree and debate in open. Hopefully, this debate gets settled. I am not worried that it will become a crisis.
Market also seems to be less worried. On the day of news, the market was pretty stoic. It wasn’t panicking. The market’s judgment was right. There have been debates within the election commission and government, Supreme Court and the government. So, it is not unnatural in democracy for institution to debate with executive. This happens all the time. This are good things. Some of these debates gets settled by court judgments which then the government decides that it is not right thing and then you enact a new law. You get legislatures to enact a new law or sometimes they accept the court judgement and say this is new law.
It has taken a form more aggressive than just in initial discussion, in my mind. If it morphs into disagreement which results in something which markets don’t want right now. What will be its impact on markets?
It will be bad. If the debate becomes a disagreement which then provokes Section 7 then that’s not good news. The markets will not like it, at least not in short run. In medium term, we don’t know. There are people who believe that it will threaten India’s institutional framework. It think it’s a loose opinion. I don’t think it will threaten India’s institutional framework. But the markets will not like it which is very obvious. We already know the markets reaction from that morning. Even if you give hint that you will disagree and provoke Section 7, then I am not going to like it. Not just stock markets, but bong markets currency, everything will be in pain.
How do you read into the NBFC crisis? Do you believe that this is one more cycle wherein this is spat of large 50 odd companies in particular sector, where the sector gets dismantle but runs into rough weather and then few companies would bite the dust and few stronger one will emerge? How will you categorize what has happen over the last 60 days?
What will you characterize for 2008 for the U.S. banking sector? How many banks blew up? Not a single NBFC blown up yet. I don’t think it is crisis. There is confidence issue which is around the default of IL&FS, the proposed change in leadership at Yes Bank. Simultaneous events which have triggered the confidence issue because there are inter bank exposures. Suddenly there is a withdrawal in market place and reluctance to lend money. There is ability, but no willingness to lend. The ability to lend is enhanced in last 30 days. The amount of liquidity that come into market is unprecedented. The government has cut its borrowing programs by Ra 70,000 crores. The RBI effectively completed two OMOs totaling to over Rs 75,000 crores. SBI is in market place like last year buying paper worth Rs 45,000 crores. There is a relaxation on lending NBFCs by RBI. If you add this number, it is Rs 2 lakh crores. That is unprecedented liquidity response to a currently brief spell of unwillingness to lend. This will fade away and the confidence comes back into system. It hinges on growth.
Having said that, will there be a change the way NBFC functions? There is clear lesson out of this. Regulation will get tighter. The growth rate which the NBFCs were reporting will slow down. The competition for banks with deposit franchise will lessen. They will grab more share. NBFC balance sheet will look less skewed in terms of asset-liability mismatch. There will be few changes. The stock market has quickly priced in. It is smart, and it is not waiting for all these things to come to us. So, the share prices on an average of NBFCs are down 50 percent. Some are down even more, a few are down even less where the market believe that business model is okay. So, the market is priced in. Whatever we are saying is going to happen. Safe for a crisis. I don’t think crisis is priced in but all other things, growth slow down, adjustment in balance sheet, couple of months before liquidity starts coming back, it is already in the price. Sit back, make a reassessment, adjust your growth rates lower and judge whether the prices are adequate or not.
From cycle perspective, from last 6-8 months, we have been pounding the table on corporate banks in which we think that’s the path forward. Corporate banks have taken lot of pain in last 5-7 years. The NPA cycle peaked a while back. Provisioning is now peaking. The profit growth in private banks, both in private sector and public sector will be enormous over the next two years. Most of them trade at one-time book. They are not really demanding any price. The returns will come there. You made lot of money in NBFCs and now it is time for corporate banks to give you the returns.
Would the wider market also viewed from that funnel, retail and non-retail or industrials?
I would not distinguish on that pattern. We will see robust retail loan growth. I don’t see that slowing down. But the growth recovery in industrial loans may be sharper. But that doesn’t mean retail loan growth may not be there. I will hesitate to distinguish in that way.
I will distinguish on basis of deposit franchises. People with ability to raise deposits, infrastructures to raise deposits, either banks will do better than non-bank finance companies which have dependence on wholesale funding. Wholesale funding will be little bit more expensive as the rate cycle has turned. There will be some compression of names. Those who have very good asset models are able to extract higher yields from markets may find themselves protected. The market is smart, and it has figured it out. If you do the performance of NBFCs in descending order, you know exactly which NBFC has got better asset yield, slightly better liability franchise and the worst as well. Market has not led to anything for us to guess.
For non-financials, in next 12 months, do you think because of the price that the sectors might be trading at, that industrials and capex driven sectors might make a comeback as compared to discretionary and consumers?
Discretionary may do quite well. I worry about consumer staples. On a relative basis, they have reported phenomenal growth over last few years. On a relative basis, that growth may slow down because rest of them will start accelerating. Discretionary consumption which is cyclical consumption is priced to do well. For industrials, we are overweight for that sector. We are very bullish going forward in next 12 months on pick up and private capex. Government capes is already doing well. So, capex cycle looks like it is poised for recovery. The recovery will be more visible post elections. There is a little bit of time where it will start reemerging in the headline. The government capex is already showing up. The industrials companies do both. So, you don’t have to wait for private capex cycle to come.
There has been fundamental change in country’s finances and how they were run. Pre-2014 - I am making a very broad statement here so don’t go into the granularity - the government at the center collected taxes together with the states. Tax collection was spread out and was not centralized. Expenditure was largely centralized. You had a planning commission which kind of decide where to spend. This was PM Modi’s biggest grievance. His dismantle the planning commission as he felt that they did not fully comprehend the priorities at the individual state level. In India, the states are not uniformly developed. Their priorities are different. For example, UP need better roads, Gujrat needs educational institutions. You can’t have same priorities for states. That he found missing at the center. We were a centrally planned economy in terms of expenditure, but tax collection was decentralized.
Post 2014, the finance commission and GST has changed it. Tax collection now in this country is centralized. The central government collects all taxes and then it farms it out to states. Finance commission ensure that the ratio of distribution has gone up substantially from the 40s to the 60s. Now, the expenditure is decentralized. Each state is running its own expenditure program. Maharashtra thinks infrastructure is big thing and starts spending on infrastructure. UP does something else. There is unique state-level opportunity which is emerged which is driving the revenues and earnings of industrial companies. So, there is a big thematic shift. I am making a broad statement. But from a centralized expenditure, decentralized tax regime we have gone to centralized tax and decentralized expenditure regime.
There can be state catering companies which might benefit in meaningful way even if sector might not go up in same way.
It is possible to do it that way. The importance of national industrial companies become less relevant compared to the past.
What is your view on export-oriented sectors? Let’s start off with IT.
The sector was not moving, and we turned over weight. We have gone underweight. The valuations are now fuller. The relative growth opportunity shifted home. This is the same thing of staples versus discretionary. In consumption space, I will prefer discretionary to staples because the relative growth is shifted in favor of discretionary. It is not staple growth is running over and turning negative. It just means that discretionary grow faster.
I will make that comparison for IT versus industrials, though not comparable. The relative growth has shifted in favor of industrials. IT has done history. The valuations looks lot fuller. If oil prices are going to remain soft than they have over the past few months, then the currency pressure will wain a bit. That tail wind also goes away. We may go into when the IT is s relatively less strong sector.
What about pharma?
Pharma is more idiosyncratic. It is more bottom up, company specific. Each company has got its own cycle. Domestic pharma looks good. The U.S. Pharma business is little bit less predictable and more dependent on regulatory factors. You need to analyze it bottom up. I rarely make a top-down call on pharma.
What’s your view on autos as a theme? It got derailed in 2018.
There have been a couple of soft months. The festive season has been a lacked luster one. Within auto space, the companies which cater to rural market, like tractor and two wheelers, will do better than cars for the next few months. Somebody who is looking at trade should prefer tractors and two wheelers over cars. That is because the rural economy will gather more momentum. The rural economy struggled for while because there was a big adjustment happening to wage growth coming out of massive wage growth in 2011 and 2014 where wage growth was compounding at 20 percent because of the manner in which MNREGA has been rolled out. That wage growth collapsed. By 2016, it became negative. So, it was lot of pain in rural economy. That pain has now subsided.
Direct Benefit Transfer has been a massive success. This year we are analyzing at Rs 2 lakh crores. We have done Rs 1 lakh crores. It will give huge amount of tailwind to rural consumption as cash going directly to accounts. Hitherto, government distributed subsidies in kind. So, the government decided you need cheaper price, so I will give you cheap price. Now, government is saying I will give you cash and you decide. The poor section will say I will buy rice. Somebody may say I want to educate my kids or repair my house.
So, suddenly there will be shift in consumption pattern. The power to take decision has shifted away. Government should not be the entity deciding on behalf of individuals or families. Some families may take wrong decision and spend on alcohol. It is bound to happen and will come in news saying DBT is failure because people are spending money on alcohol. Supreme Court has said in the wisdom that just because 0.2 percent of system is failing on Aadhaar why should the other 99.8 percent not receive the benefits. That’s the same case with Aadhaar and DBT. This changes rural consumption in coming 3-4 years.
I am bullish on rural consumption. In auto space, you differentiate in that fashion if you are making a relative call. But I am constructive on overall autos. It fits the discretion of consumer cyclical consumption versus staples.
Do you think there is high probability of we doing well because earnings might finally make a comeback in next 6-12 months?
I’ll end on an optimistic note. We will be lot higher than we are today. Baked on that view, the country will elect a majority government and not get political upheaval. Baked into that is the trade war will not morphs into crises for world growth. And the Fed will not make mistakes. This are very tall assumptions but unfortunately, I have to make few assumptions. Unless I make those assumptions, I don’t get there. So, we will be higher than we are today.