>The Valuation Debate: Long Term vs. Short Term (MORGAN STANLEY)

Valuations: The Long-term Debate
• Key Debate: At the outset, we have to state that the P/E metric can be quite flawed when used as a valuation measure for equities. That said, our recent meeting with investors reveals that the biggest debate is about India’s multiple and whether it deserves to trade at a P/E premium to
emerging markets. We break this debate into two parts – what the sustainable premium is for Indian equities, if any, and whether the current market multiple makes the market vulnerable to relative underperformance. First, on the long-term relative multiple, our view is Indian equities deserve to trade at a premium (of around 25-30% versus the historical average of 8%) driven by the factors listed below.

• The demographic dividend vs. demographic sword: India is likely to add around 10 million new workers to its workforce on an annual basis. As the workforce grows, so will the savings and hence the growth rate. This will be the key driver to profit growth, in our view. However, to
employ the accretion in the workforce, India will need to grow at 7% or more (vs. 7.1% over the past decade). This means to us that the country is underinvested and will guzzle capital in the coming years. As India will need to keep importing capital in the medium term (a savings deficiency is a corollary of the high required growth rate), a current account deficit will remain. The implication of this is that India will depend on global capital market cycles unless it shifts funding sources to FDI. The push and pull between a growing working population and India’s capital needs will be key ingredients to the relative multiple. Bottom up, this has implications on the payout ratio, which would need to rise for a sustained premium multiple.

• The political factors vs. capital efficiency: Fiscal deficit is the key manifestation of the political factor, in our view. Public debt and fiscal deficit (read: politics) will drive long-term interest rates or the cost of capital (in the absence of large-scale capital flows). Another aspect of politics is the
democratic system, which works in India’s favor with respect to property rights even as it works against the country in terms of driving capital accumulation and capital efficiency. Whilst the country’s macro is struggling with capital efficiency, bottom-up ROEs continue to score well.
Ultimately for the bottom-up ROE to be sustained, capital efficiency at the macro level will need to improve. Higher capital efficiency will partly offset the need for capital, and vice versa, and hence this becomes a factor with multiplier effects.

• Corporate governance vs. structural liquidity story and capital market infrastructure: This factor drives the quality of earnings and hence equity risk premium. While India’s ROE-focused entrepreneurs provide interesting investment opportunities, problematic episodes with certain
companies have dented investor confidence in the past. The offsetting factor is a side effect of the demographic dividend, which is the structural liquidity story. As domestic savings rise, a younger population will likely take more risk with its savings, causing higher flows into riskier asset classes like equity shares. The flow of savings into equities is supported by a strong capital market infrastructure. The starting point on capital markets is good relative to the physical economy, i.e., the financial economy seems more well developed than the physical economy. Evolution of this capital market infrastructure determines access to stock markets and influences the market’s multiple.

• Earnings cyclicality: Another factor supporting India’s premium multiple is the lower cyclicality of earnings. Investors argue that rising share of global commodity stocks in the market will alter this. First, it has so far not affected the earnings cyclicality due to the offsetting structural
domestic growth story. Second, the share of global commodity stocks has risen from its lows but is still off its decade highs and will probably stay that way in the future given the strong domestic growth.

Valuations: The Short-term Debate
• Key Depart Part 2: On the short-term relative multiple, our view is Indian equities are fairly valued. Whilst returns in 2009 were driven by the rerating of absolute valuations, stock returns in 2010 will likely be driven be earnings growth and hence moderate over 2009. India’s relative returns were driven by superior growth. Indeed, the relative multiple has continued to compress. At the current premium of 20%, we believe relative valuations are around fair levels.

• Absolute valuations: India’s absolute multiples are trading at around the historical average.

• Relative valuations: The relative multiple is well off the highs and has continued to compress during 2009. This multiple is also around historical averages.

• Equity valuations vs. bonds: At the margin, long bonds are appearing more attractively valued versus equities. For equities to beat bonds, earnings growth will have to surprise on the upside. Our base case is that earnings growth will come ahead of the consensus expectations in 2010. In our view, long-term investors can find comfort in the equity risk premium implied in share prices (using our residual income model), which is at fair levels.

• Broad market valuations: The broad market appears distinctly more attractive to us than the narrow market. For one, the multiples are low and, for another, earnings prospects look better. We believe that the broad market will outperform the narrow market in 2010.

• Focus on earnings growth in 2010: Our view is that since market multiples are around fair levels (whether measured absolute, relative vs. EM or relative vs. bonds), equity returns in 2010 will likely be driven by earnings growth rather than change in multiples. The broad market may, however, witness a rise in relative multiples.

To read the full report: INDIA STRATEGY