The BSE Sensex reached the coveted 21,000 mark a couple of weeks back. It was indeed a vindication of the India growth story. However, if the next few trading sessions were any indication, it looks like the growth story has begun to sputter up a bit. Not only has the index given up Mount 21,000 but even 20,000 has been taken back.
Some experts call this a normal correction. A small pause in the long journey of still higher highs. Do we belong to the same school of thought? Well, if one is talking really long term, then even we tend to agree. The elephant that is the Indian economy has finally woken up from its slumber and is really galloping ahead full steam. Without a great deal of reforms, it can easily chug along at 6%-7% per annum for quite some years to come. And if reforms do happen, then a sustainable double digit growth does look well within reach.
But can we say something similar about the near to medium term outlook of Indian stocks? Maybe not.
Let us try and examine why we are a tad pessimistic. Our first concern is with respect to valuations. Since the lows of March 2009, the P/E of the Sensex has more than doubled. It has turned from an attractive looking P/E of 11x to more than 22x times currently. A P/E of such a magnitude does not sit lightly on the shoulders of Indian markets. It is at the higher end of what the markets normally trade at. Hence, any significant upmove in P/E from the current levels does look a little difficult.
Thus, in view of the higher than normal P/E, any contribution towards taking the stocks still higher will have to come from the growth in earnings of India Inc.
And how does the scenario look like on this front? Again, not very encouraging according to us. You see, earnings look best when there is an environment of low inflation. During such times, companies get to spend less on wages and other costs and hence, a greater pie of the revenues is accrued to the shareholders. However, when inflation is high, wages and other outlays account for a major chunk of the company’s topline and net profit margins tend to take a hit.
It is common knowledge that inflation is currently ruling at way above historical trends. As if this were not enough, measures by economies across the world, especially the US has ensured that prices of industrial commodities start hotting up as well. Since India is a commodity dependent country, the same is likely to have an impact on Indian companies.
Thus, with both valuations as well as profit margins not looking in very great shape from a near to medium term perspective, it can be argued that it would be a stretch to assume returns are going to look anything like the one in the recent past. Investors expecting the same could be in for a disappointment. However, any further weakness in the developed economies or a significant correction in Indian equities or maybe both, can once again present a good opportunity to invest in the long term India growth story.