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6,000? What next?

Nov 11, 2004

It's that time for the Indian stock markets when Indian investors are once again waiting for the Sensex to breach the coveted 6,000 mark. The Sensex closed just short of this level in yesterday's trade and in all probabilities, it would, once again, achieve this mark. This 'magical' figure was reached in early January this year and soon then, bears took over the reins of the Indian indices as the bulls were pushed into the back seat for the first half of the current year. However, now, that the bulls are back with a vengeance and with the indices once again near their highs, we again look at the prospects of India Inc. and consequently the stock markets.To begin with, in early January this year when the Sensex had touched the 6,000 mark, the index valuation was over 17x its trailing 12 months earnings. Considering that the bottomline of companies, forming a part of the indices, has grown at a CAGR of 17%-18% over the last 8 years and the index valuations for the indices have also hovered in the region of about 16x-17x on an average, the brakes on the Indian stock market rally in early part of the year did not come as a surprise.

Coming back to the current scenario, there is once again an all round optimism on the bourses. The Sensex valuation is close to 15x its trailing 12-months earnings. Strong corporate earnings growth (15% YoY sales growth and 24% YoY PAT growth in 1HFY05 of top 200 companies), reasonably attractive valuations (approx. 10x-11x FY06E earnings) and improving management quality in terms of transparency are amongst the few positives that have created an air of optimism amongst not only domestic investors but also amongst the FII community towards India.

Further, if one looks at the expected GDP growth for the Indian economy over the next couple of years and compares it to the growth rates of other economies, India is clearly amongst the fastest growing economies in the world. India in recent years, has taken some good steps in terms of policy announcements for infrastructure development and also considering the reforms process currently underway in the country, the climate looks conducive for growth.

However, amidst the positives present, it is also important that investors do not lose sight of some key negatives that may shadow the growth prospects of India Inc. going forward. And amongst the bigger concerns are strong global crude oil prices and rising interest rates.

It is important to note here that as per estimates, every US$ 5 per barrel rise in oil prices retards India's GDP growth by 0.5% and increases inflation by about 1.4%. However, the impact of high oil prices has not been reflected aptly in the inflation figure, which has cooled off from its highs of 8.3% in August 2004 to the current levels of about 7%. This is because the Indian government had, until now, been adopting various measures to prevent the passing on of the effect of the rise in global prices to Indian consumers. However, with the government having bit the bullet finally, hiking petroleum product prices in the region of about 6%-9%, it's impact will soon start to reflect on consumer prices leading to higher inflation.

Further, with interest rates on the rise, it would affect the valuation of stocks. The rise in the interest rates raises the expectations of the markets participants, which demand better returns commensurate with the increased returns on bonds. Moreover, while in a low interest rate regime, corporates are able to increase profitability by reducing their interest expenses, in a rising interest rate scenario, since interest expenses rise, profitability takes a hit. That apart, when one calculates the inherent value of a company by the cash flow discounting model, there is a two-fold impact. One, there is a reduction in the cash flows due to lower profitability, second, there is a higher discounting rate due to higher interest rate regime. This leads to a relatively lower intrinsic value of the company. Due to this, there may be a change in asset allocation among equities and debt, which could favour the latter.

To conclude, while we are certain that India Inc. (on a broader scale) will continue to perform well in the medium to long-term, it is time to sit back and re-look at stock specific fundamentals and valuations, especially which have outperformed the benchmark indices by huge margins and make sure if their current valuations justify their growth prospects. We believe that considering the various positives working in favour of Indian equities, it would not be wise to stay out of Indian equities at the current juncture. However, the need of the hour is to follow a stock specific and staggered investment approach.

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