Bull rampage: Will it continue? - Views on News from Equitymaster

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Bull rampage: Will it continue?

Apr 29, 2004

Indian indices emerged as one of the best performing in FY04 and attracted a great amount of Foreign Institutional Investors (FIIs) interest. Now, with annual results from India Inc. in full bloom and most of the companies dishing out robust performances, a dilemma concerning most investors would be, 'Is this performance likely to continue in FY05 and if so, what would be the stock markets' reaction to this?' Let us try and find out. Over the last five years, while real GDP grew at a CAGR of nearly 6%, the BSE-Sensex fell by around 18% each year (on a point to point basis) for four years leading to the year FY03. Thus, while the economy continued to grow, investors remained skeptical about the growth in stock markets and largely stayed away from them. This led to the stock prices languishing at lower levels and remaining largely undervalued.

Investors, with a little help from FIIs, woke up to this fact in early FY04 and as a result returned to the stock markets with a flourish. While strong demand growth and improved productivity helped, the fact that the stock prices seemed undervalued on account of four years of battering, also rekindled investors' hopes. The buying frenzy, which ensued, culminated into a huge 84% appreciation in the benchmark index Sensex, even touching the all-important 6,000 levels for a brief period of time. Now that the stock markets have gained in a substantial way, let us try and answer the dilemma we discussed earlier.

It is common knowledge that stock prices are nothing but pointers to future growth prospects of a company. Therefore, looking at a stock price and the current earnings of the company, we can have a fair idea of what the markets are expecting the company to deliver in terms of profits 2-3 years from now. So in trying to arrive at a rough estimate of where the indices would be one year hence, we would see how prices stack up against the current earnings of companies.

Hence, having looked at the basic metric, P/E (price to earnings ratio), we believe that most of the stocks appear fairly valued from a short term perspective as investors are expecting the companies to repeat their FY04 performance or even better it, which according to us seems to be unlikely.

If we consider the top down approach, then for the markets to scale further heights, the robust growth in GDP should continue in the future as well. However, we would like to point out that the record growth in FY04 was made possible largely due to a sharp revival in the agricultural sector, where output improved on account of normal monsoons. The poor output the year before further amplified the effect. With growth in the sector, aggregating to 3% or thereabouts in the decade before FY04, expecting the same to grow in the region of 8% on a continuous basis appears unrealistic.

With not much incremental demand coming from rural populace on account of lackluster agriculture growth and limited government infrastructure owing to high fiscal deficit, the industrial sector also is likely to grow at current rates of around 5%-6%. Therefore, even if the services sector grows at 8%-9%, it does not need a rocket scientist to tell that 8%-9% GDP growth is unlikely, when 50% of the economy is expected to grow much below 8%. Thus with the GDP not expected to repeat its stellar performance of FY04, the impact will be felt on corporate earnings, which will be unable to meet investor expectations, thus causing a downward pressure on prices.

Thus, while the top-down approach clearly points to a subdued FY05, we believe there are certain companies and sectors, which might appear overvalued from a near term perspective, but have very good prospects from a long term point of view. These are the ones having sound management and business models that can sustain consistently high growth rates. Once again the key words are 'long term' and 'strong fundamentals'.

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