Over the past few weeks, markets have almost exclusively obsessed over one thing – the upcoming General Elections. Frankly, we are nauseated by the way every discussion at work or a conversation at social gathering quickly derails into one about politics.
The amount of bandwidth invested in analyzing vote-shares and swings, possible alliance math, voter turnout ratios, opinion polls and psephologists’ views is understandably huge. But what’s disconcerting is the growing opinion that this election result will have binary consequences- it will either set us on to a multi-year bull run or else descend the economy and markets into an irreparable chaos.
As always, we feel that the truth lies somewhere in the middle.
It’s a worthwhile exercise to look at diverse high-frequency indicators as a sort of a dashboard for the economy. In most developed countries one would get an aggregate Lead Economic Indicator, or LEI, index with some predictive power for economic health but in India we don’t have that luxury. The idea of the dashboard is to look for signs of improvement or growth that can point towards a stabilizing economy with a few green shoots.
We can look at a representative panel which will show that some indicators are improving; some are getting less bad while others continue to deteriorate. Electricity generation is clearly improving and so is consumer inflation while corporate margins are stabilizing and steel production growth is getting less bad. Commercial vehicle sales and same store sales growth for urban consumption proxies continue to deteriorate.
We understand the limitations of this approach – one, these are at best co-incident and not leading indicators and two, they may not be fully representative of the entire economy but nonetheless are good starting points to understand the emerging contours of growth. When growth gets concentrated in only a few sectors, as was the case in India for past few years, money rushes into these small oases causing what investors call an earnings re-rating.
This narrow funneling of the market also shows in concentrated outperformance of stocks – of the Nifty 50 stocks, only 30% (i.e. 15 stocks) outperformed the overall benchmark in 2013 down from almost 60% of them outperforming the benchmark in 2009 and a decadal average of about 50%.
The economy we feel is in the process of gradually bottoming out but growth is neither going to roar back nor be even-paced across various sub-sectors.
This obviously has investing implications, specifically for the erstwhile darlings that have been beneficiaries of a significant re-rating in a growth scarce environment. Some leading stocks in the Consumer Staples (FMCG) sector have reported remarkably steady operating profit growth, in the range of 18-20% over the past few years, however, the high valuations ascribed to these stocks are not independent of growth opportunities available elsewhere. When growth was plentiful as in 2009, investors accorded these stocks a forward Price-Earnings Ratio (PE) of about 20 times but in growth scarce periods like in 2013, a similar earnings profile was worth its weight in gold with a PE of 30 times or higher.
We stumbled across an interesting parallel in the world of cricket.
When India scored less than 100 runs in a Test innings, Rahul Dravid’s contribution to the total was almost 20%. One can easily imagine this run-scarce scenario - generally on testing overseas pitches where one man stands up to the challenge.
As run-getting gets easier, say for instance when India makes between 300 to 400 runs in a Test innings, Dravid’s contribution falls to about 11% of the team total - these are most likely dry and flat wickets at home where other batsmen hog the limelight. It’s not that Dravid does poorly in these run-fests but the conditions are better suited to a different batting style. Something similar plays out with Hindustan Unilever (HUL) as well. In a tough environment, where the market is trading at a PE of 12-13 times, HUL commands a multiple of over 28 times. As money-making gets easier with market PE normalizing to 15-16x, HUL loses some of its relative sheen.
At the bottom of the last growth cycle in 2002, the top 10 holdings of foreign institutional investors, or FIIs, accounted for almost two-thirds of their overall holdings in the country. As the economy recovered or growth broadened, by the end of 2007, the top 10 stocks contributed just over 35% of their holdings. For the typical FII, India went on from being a 20 stocks market to a 100 stocks market. In the recent past, this concentration has been inching up again with the top 10 holdings accounting for almost 50% of overall ownership by middle of 2013. If the slow broadening of growth thesis pans out, the universe of investible stocks will go up again.
A word of caution is due here.
In the recent pre-election rally, investors have bid up a lot of stocks and sectors that may not see any fundamental recovery in the foreseeable future, notwithstanding any election outcome. That the MSCI Small Cap Index already trades at a hefty 20% PE premium (versus a 20% historical discount) to the MSCI India Index is a bit perplexing to us. So while putting on that India macro improvement trade, one might have to adopt a nuanced approach and yes, over time, the trade is likely to work irrespective of the election outcome.
This article has been contributed by Amay Hattangadi and Swanand Kelkar of Morgan Stanley Investment Management.
