Morgan Stanley - India Strategy

Morgan Stanley in their India Strategy Report say,

Conclusion: Indian equity valuations appear tolerable at 16.5x F2008E earnings (BSE Sensex measured using Morgan Stanley estimates). However, we see four key issues with the multiple: (i) rising long rates; (ii) the global multiple and India’s relative position; (iii) the low valuation dispersion across sectors and stocks; and (iv) earnings revisions. In this context, valuations still appear vulnerable.

What’s New: The higher level of long-term interest rates seems to be pointing to a further decline in the market’s P/E multiple. There is little argument that Indian equities warrant a premium to the rest of the world – the key question is quite what level of premium is justified. Pertinently, India remains susceptible to a decline in relative P/E if the world falters. In our view, investors could also suffer because the dispersion of
valuation multiples across stocks and sectors is too low – reflecting a view that the narrowing of the gap in fundamentals across stocks is permanent. As fundamentals revert to mean, the dispersion of valuation multiples may increase. Finally, the biggest
problem is with the denominator of the P/E multiple. We think earnings are at risk from the prospects of slowing economic growth. Earnings revisions have already turned down in recent weeks.

Ultimately the Earnings Outlook Is a Bigger Issue
We think the key issue with the P/E ratio is with the denominator – i.e. earnings. Earnings could be in a bubble, as suggested by the big increase in their share of total output. Profits to GDP have surged from around 2% at the start of the decade to an estimated 6% in F2007. True, the starting point may have been low, especially with respect to companies in cyclical sectors, but the current level may not be sustainable
either. Earnings have benefited from a sweet macro backdrop of low rates and thus a positive financial leverage effect and rising capacity utilization owing to depressed capex and high growth. Several of these areas are under the scanner – rates are rising and eroding the positive financial leverage effect, growth could be slowing in response to higher inflation and capex is already at an all-time high.

On our residual income model, if we assume that the market expects a 14% long-term return from the BSE Sensex constituents (which equates to an equity risk premium of
around 6%, given that long bonds are around the 8% mark), the mid-term annual earnings growth from these companies (i.e. from F2010 onwards) needs to be around 17%. This is not impossible for the BSE Sensex constituents, but also not a given, in our view. We think the next two years’ growth will probably be lower than the consensus is expecting for the reasons discussed earlier. The consensus is forecasting 15% growth in earnings in the coming two years for the BSE Sensex constituents on aggregate. However, more than half the aggregate earnings for the BSE Sensex come from just five companies. Incidentally, earnings revisions have already turned down, and this could be an early indicator for lower multiples