BACK TO THE PAST? If the Indian economy recovers

If the Indian economy recovers as fast as the stock market expects, the growth would be different from that seen in the past. The old champions may not necessarily thrive in the new economic paradigm that's emerging on the horizon

LOOKING at the price charts of most companies, investors seem to be in a catch-up mode. This is evident in the stock price trajectory of most stocks, which saw a sharp spike in the past few days. In many cases, the stock prices have nearly doubled in a matter of few trading sessions. It's a kind of emotion that grips a commuter when he/she loses a train or bus by a fraction of a second. When we see a bus/train departing in front of our eyes, we rush towards to it without caring about the risks involved. What if you hurt yourself badly in the process? But who cares?
    The stock prices are being bid higher and higher in the hope that underlying earnings growth will justify the high prices sooner or later. But what do investors fear losing? Are the future rewards as promising as they were during the heydays of the bull-run? Between FY2003-FY2008, corporate earnings in India grew at over 20% year-on-year for an ETIG sample of 20 leading companies. The list includes India Inc's top names such as Reliance Industries, HDFC, Tata Steel, ACC, BHEL, Tata Motors, Grasim, Hero Honda, ITC, HDFC Bank and State Bank of India. The growth in dividend payouts was even more generous at nearly 22% yearon-year during the period. Not surprisingly, the price-to-earning multiples reached historic highs in 2008.
    Those days seem to be back. Most frontline stocks, especially in cyclical sectors, are now at their 52-week highs or better still their valuations, measured by various ratios such as price-to-earning multiples or price-to-book value among others are not far from the highs of 2008.
    With valuations come expectations. And higher the valuations, greater is investor expectation from that particular stock. To justify the elevated valuations, corporate earnings have to grow at the rate of over 20% year-on year for at least the next two years. Companies also have to improve the quality of earning i.e. the profit growth has to be accompanied with an equally rapid rise in cash flows and dividends payouts.
    This will require a repeat of the India's economic performance seen in the last bull-run, when the economy grew consistently at over 9% for three consecutive years. What's more, the economic growth was qualitatively different than seen previously. For the first time in many years, economic growth was largely led by high double-digit growth in domestic capital formation. The investment demand was fuelled by a benign combination of low inflation, lower interest rate and ample liquidity in the global financial system. The process was aided by a rapid rise in national saving rate, declining fiscal deficit and rising corporate profitability. This induced an unprecedented demand for capital goods, commercial vehicles, cement, metals, real estate and financial services. As most of these industries are dominated by a handful of companies, the growth was fully captured by leading firms in the respective sectors. Not surprisingly, companies from these sectors showed strong top line and bottom line growth and were at the forefront of the last rally.
    Similar set of companies are once again leading the bull charge. This is evident
from the accompanying chart, which details the relative performance of various sectors during the first five months of the current calendar year.
    But there's no guarantee that India's economic growth will again be led by investment demand? The first factor to contend with is the base effect. Last time, the growth in investment demand began from a low base, thereby pushing up the rate of growth. Now, India Inc is sitting on a huge pile of capex. To match the historical growth, companies will need to further scale up their investment plans. But this looks daunting in the changed economic and financial environment. India's fiscal deficit is on a rising trajectory and its financing will crowd out the space for private sector investment. On the demand side, while the consumers in India are facing an income squeeze, those in major developed economies especially USA are forced to save at a time when employment opportunities have dried up. The latter process, which is called deleveraging, has just begun and will take many years to complete.
    If the Indian policymakers try to circumvent the problem caused by a slump in global demand by stimulating domestic demand, it will have its own consequences. This will first necessitate a reversal of past trends, which saw growth in private final consumption expenditure (PFCE) lagging behind GDP growth. In FY 2003, PFCE accounted for 69% of India's GDP. It declined to a little over 51% during the March 2009 quarter. If the government attempts to reverse the trend through various policy measures, it will lower the country's savings and investment rate. This, in turn, will lower the investment demand in favour of consumer goods and create new winners and losers in India Inc. The hardest hit will be companies in cyclical sectors such as capital goods, metals and financial services. The relative gainers would be companies that supply goods and services to consumers, especially FMCG and pharma companies.
    If economic growth does recover in India, it would be a different than what we have seen in the past. And to gain, investors will have to offload baggage of the past and look at the future afresh.
    krishna.kant@timesgroup.com 

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