Sensex @ new high ? What to expect going forward

Recently people of the country have shown great maturity and have delivered a very important and clear electoral mandate away from populism towards development. The stock market has joined the party with all key indices trading at all time highs. Now that the dream mandate has come, specific question in minds of stock market participants are whether they should book profit or reshuffle their portfolio?

Before giving any prediction, we must give our basic philosophy of the market- ‘art is not in predicting the market but in preparing’. And our firm view is that we are in a bull market, and there is no doubt in our mind. This ongoing rally is not comparable with other rallies in recent past like 2009-10, 2012 or 2013.Those who were pullback rallies in a bear market but the current rally is a distinct bull market rally. So, its characteristics would be completely different.

There is a classical theory that bull markets are born on pessimism and if we recall the situation during July –August 2013, a period when pessimism was at its peak with high volatility in INR and fear of Fed tapering. So, the birth of this new bull market perfectly coincided with a deep pessimistic environment. It is also said that bull market builds during atmosphere of skepticism. And during last 6-8 months, there were good amount of skepticism. Who will win the poll, who will hold the PM chair, who will be finance minister, how the policy correction will happen etc.etc. Also talks are happening like interest rate will move up in US and that will imply fall in equity across globe. This really provides a classic skeptic atmosphere for a nascent bull market to grow.

On a more fundamental level as we had repeatedly said in the past, there were four major ills in our economy - Fiscal Deficit, Current Account Deficit, Inflation and slow GDP growth. Out of the four, two have clearly subsided and so provides excellent base for this current Bull Run. Also last August, we had released a long term chart of Sensex and the pattern was clearly indicating end of bear market that had started in Jan 2008. You can recall the weekly outlook of last week of September 2013. We had said very clearly, the stocks are trading close to their lower end of valuation band and that buying equity here implies close to 0% chance of losing money. That was a classical point to get into equity market as equity with near zero risk is a rare investing opportunity. Our being bullish was also based upon our interpretation of Indian corporate earning cycle. We were and still are anticipating earning upgrade for Indian corporate. Recent, 4QFY14 earnings reflected double-digit PAT growth after three consecutive quarters of muted growth; even sales growth came at decent 13%. Net Profit margin improved from 10% to 10.7%, however it is still below its long term average. EBITDA margin of Sensex increased from 20.5% to 22.5%. Thus, it clearly shows a bottoming out pattern. Also as all parameters like sales growth, PAT growth, EBITDA Margin etc are below their long-term average and so indicates large upside possibility. Remember similar upside took place during bull market of 20032-2007. Sensex PAT growth during 2002-2008 was 21% on an annualized basis. However during the correction period of 2008-2013, Sensex EPS has grown by just 8% and now the consensus suggests Sensex EPS growth of 16%+ over next three years. 

On macro basis, discussion on policy paralysis is already over and there is some growth related buzz across the Industry. The order book of engineering and construction companies that had declined to Rs1433bn by middle of 2013 has grown to back to Rs1990bn. Of course, a major fear is possible reversal of FII inflow. There is no denying the fact that large part of the current bull run has happened due to aggressive buying by FII’s and any talk of possible reversal whenever that may happens will surely be a cause of concern. FII’s over last 12 months have bought equities in India to the tune of 1.1% of total market capitalization of Indian equities. Previously, correction was seen after buying of 1.2% of market cap. At present, FII’s are overweight India by 2.5% as per the MSCI benchmark. Though in recent past such overweight level by FII’s has resulted in market declines but this level is below longer term average.

Also and most importantly, we are modeling rise in return on equity for Indian corporate. Slowing economy of 2009-2013 saw steep decline in reported ROE’s of Indian companies. But with new stable government at centre and also considering recent speeches by new PM that the solutions of all social and economic problems are development only assures us of correctness of our ROE rise assumption.  RoE improvement would be on hand because of margin improvement and assets turnover improvement.  A number of corporate had been waiting to restructure their balance sheet in last two years but poor liquidity environment had denied them the opportunity. Now with positive outlook and improved liquidity lots of asset sale will happen resulting in higher asset turnover in aggregate for Indian corporate. Also margin improvement will take place on account of reduced cost inflation and reduced financing cost.

Now, we come to our forecast in terms of market levels. As we have said in the past, we calculate market range in terms of P/E range of 13.5-19.5 with fair value at middle point that is P/E of 16.5. If you recall, Sensex never breached our lower bound forecast levels in 2011, 2012 and 2013. And also Sensex always touched our fair value forecast for each of these years. Our estimate of lower bound as Sensex 15548 in 2012 and Sensex 17700 in 2013 was adequately followed by the market. Sensex, usually never goes below 13.5X baring some large uncertain happening like 2008 crash, similarly upper bound for Sensex stays at 19.5x. Though, some time it goes above this point, like 2008 beginning but retraces back very fast.  Now, our Sensex EPS estimate for FY15E is at 1490 and accordingly our fair value estimate is 24597 and upper bound estimate is 29069. Also one must keep in mind that there is high probability of Sensex EPS upgrade and so high chance of upward revision in Sensex estimate. During FY07, the profits of listing companies in India were 7% of GDP, now it is just 4% of GDP and so a turnaround in economy will have disproportionately high impact on Indian corporate profits.

Now, the question arises that when the market has achieved its fair value, should we exit?  Our answer is no, characteristics of a bull market is completely different from the characteristics of a bear market.  During the bear phase, market moves between the lower boundary to fair value like in 2010, 2011, 2012, and 2013 in our case.  While in a bull market, market moves between the Fair value to upper boundary like in 2004, 2005, 2006, and 2007. Currently, we are in early bull market  and the chances of dipping of 5% below fair value is there of course, but in all probabilities market from here on will be trading primarily between fair value and upper boundary and will keep forming higher top and higher bottom.

Now in terms of preparation, the most important question is, what one should do? My first advice is- one should not sell, if one is holding equity portfolio. Second, if we need to sell, sell those stocks where return on capital employed (ROCE) is very low and chances of any improvement over next 2-3 years are also very less. Third and most importantly, you must add/double your investment in equity through our model funds or mutual funds. Say, someone has 5% of his networth employed in equities as of now, then he should ideally deploy further 5% of his networth into equities. And in terms of how one should deploy money into equities- we would recommend using systematic investment plan that is spreading equal installments over say next 6 months. We surely see some kind of correction in 3rd and 4th quarter of this year because extents of EPS changes are still not very clear. Also just now, it is not clear, which set of pocket in market will take leadership in 2015 and onward. And market in latter half of the year will go in some kind of consolidation to clearly assess winners of 2015 and ahead. But instead of worrying about that correction, one should plan to use that for further investment purpose. 

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