Investing in a deserving Economy

Current growth rates and market levels are sustainable. But invest systematically, and resist the hype.

India is on its way to a 10% growth rate if it modernizes and streamlines infrastructure and reduces social inequalities. The continued feel-good factors in the economy are echoed by estimations of the Reserve Bank of India and other agencies, modestly estimating GDP growth 8% to 8.5%. The Finance Minister feels more can be attained and aims for a growth rate of over 10%. But to realize, that we need to remove infrastructure bottlenecks by investing more in power, roads, railways, ports, airports, parks and so on. To this end, the government has more than doubled its allocation for infrastructure from $200 billion in the 10th plan to $450 billion in the 11th plan.

As India strives to keep up the momentum, is should be cautious of global factors, including fears of a US slowdown. Such an eventuality would put the brakes on the IT, textiles, and gems and Jewelry sectors. Also, the contagion of the sub-prime fiasco was stemmed by the interest rate cut by the US central bank (the “Fed”), but the threat could re-erupt. For now, the market is optimistic, and there’s talk of another Fed rate cut. If it happens, it would result in an inflow of funds to economies like ours, with higher interest rates. That would help the infrastructure sector.

Based on actual corporate earnings for the first half of 2007-08, we expect Sensex earnings to grow at 25% in FY 07- 08 at Rs 900 and at 20% over FY 08-09 at Rs 1,080. Thus at 20,000 levels, the market is trading at 22 times the current year’s earnings and 18.5 times estimated earnings for FY08-09. Isthat stretched? With 22% compounded growth in earnings over a two year period, and returns ratios at a healthy 20%, current valuations appear to be sustainable. Also, the Chinese market which competes for liquidity with India currently trades at 40 times earnings. In fact, it could go even higher, if nothing untoward happens in our shaky political and social spheres.

Financing projects is no longer an issue, with buoyant capital markets providing the means. A crucial factor, however, is execution of large projects. Order books continue to fill up rapidly. We believe that the financial risk is still low and nowhere near the levels of the mid-1990s.

Three engines of growth robust domestic consumption aided by a young demographic profile, large investments to crank up our creaking infrastructure, and exports led mainly by out sourcing in the IT, ITeS, and pharmaceutical duties have helped India become one of the world’s fastest growing economies. Companies are living up to market highs. The order books of companies related to infrastructure are robust, with some firms having revenue visibility of 2-3 years. Growing corporate clout and confidence is reflected in the fact that Indian firms have acquired companies abroad. Corporate returns ratios like ROCE and ROE are high, and many companies have de-leveraged their balance sheets. Given multiple engines of growth valuation seem quite in order.

So far as stock selection is concerned, we follow two strategies — theme selection and sector rotation. If the theme identified is Indian capital expenditure, then you identify sub-sectors within that sector. Sector rotation is when you take a call interest rates are likely to move downward, and you reallocate your portfolio towards interest rate sensitive stocks. Once the theme is identified, we look at competitive intensity in the industry and the pricing power players enjoy.

Quantitatively, we look at EBIDTA margins, financial leverage, ratios, asset turnover ratios, working capital management and return on equity. Then we look at valuations. Along with price earnings ratio, we also place emphasis on PEG (price/earnings to the company in relation to its competitors). We also look at the fair value using DCF (direct cash flow) method, and compare it with Enterprise Value. If we feel the stock is undervalued, we see whether it is liquid. Lastly, we see what kind of institutional coverage it has, the less the coverage, the more the potential to appreciate. Then we decide whether to buy.

At recent dizzy market levels, there is a strong urge to quickly capitalize on each fall and rise. But the advice to retail investors is: do not try to time the market. And, although this may sound repetitive, invest through a mutual fund’s systematic investment Plan (SIP) and focus on the underlying corporate earnings. Don’t be taken in by hype.