>REVISITING THE ROAD TO 50K (MORGAN STANLEY)

• Implied long term returns seem attractive: One way of looking at market valuations is to find out the number of years it could take the market to reach a certain level. In our base case, using our residual income model, the BSE Sensex (used as a market proxy) could take about nine years to breach 50,000 from its current level. If the assumptions are made optimistic, the period to 50K shrinks to seven years. When we last did this exercise in January 2007, we had estimated the road to 50K to be around 13 years. To that extent, Indian equities are distinctly cheaper than they were in early 2007 (index level was around 14,000). Even in our bear case, investors may still go home with double-digit long-term returns, something which they could have not have expected for most of the past three to four years save for the period starting November 2008.

• Critical success factors: The critical success factors for returns and hence the period to reach 50K include some obvious ones such as GDP growth, interest rates, the inflation rate, and the success of India’s infrastructure roll-out and fiscal consolidation. A less obvious but increasingly accepted factor is global risk appetite, which has a bearing on the expected rate of return and hence the actual rate of return. Some of the least obvious factors include the pace at which Indian companies globalize, the rate of wage increases, the investment rate, the estimated asset life in the books of accounts, and capital structure alterations.

• Short-term volatility an opportunity: The short-term outlook is mired by excessive volatility that the market is going through as it grapples with the pace of growth recovery versus the prospects of Central Bank tightening both at home and abroad. Other factors such as equity supply, monsoons, and crude oil will also influence share prices. Indeed, the market is pricing in almost all the growth recovery that we are forecasting in the coming six months.

• 12-month and 10-year outlook both look rewarding: However, we see more growth in F2011 and that is not in the price. More importantly, for long-term investors, our residual income model suggests that the market is delivering an equity risk premium of 6%. Put another way, the market is likely to deliver a long-term annual return of 13% same as the 10-year trailing return. This is based on an assumption that earnings will grow at 15%. If instead earnings compound annually at say 19%, the returns could be around 18% compounded annually for the next 10 years. Versus long bonds, equities appear to be at fair value. A bit more than half the index value is ascribed to future growth, which is more or less in line with history, whereas growth is likely to be better in the coming 15 years compared to the trailing 15 years (industrial growth averaged 7%, GDP growth averaged 6.9%, and BSE Sensex earnings CAGR was 13.9%).

• Sensex target a tad higher: Our Sensex target for June 2010 is 17,600 (600 points higher than our previous June 2010 target as we adjust F2009 earnings for actual numbers). The bull case implies upside of 41% from current levels, while we think the market is unlikely to go below
its post election result day level in our bear case. Key catalysts could be reforms and infrastructure spending, although investors should be prepared for heightened volatility, which could make trading a less-rewarding strategy compared with “buy on dips and hold”.

To see full report: INDIA STRATEGY