>Are You Ready for Another Lost Decade?

In April 2003 we published an article which posed the question, “Whither the secular Trend of Equities?” This piece laid out the case that the year 2000 was a secular or “long-term” peak for the U.S. stock market. Th e article also forecast that equity prices would experience a wide multi-year trading range as sentiment unwound from the unrealistic assumptions that pushed price earnings ratios and dividend yields to record extremes. Many investors and members
of the fi nancial press are only now recognizing that stock prices have lost ground over the last 10 years, labeling this period as the “Lost Decade.” Not only have equities been unable to make any net progress in that time, but they have actually lost value in purchasing power terms. Given the sharp 2009 rally, one of the strongest on record, it makes sense to re-open the question of whether investors should revert to a buy hold approach or continue to apply the tactical asset
allocation strategy that has worked so well in the last 10 years. Before we address that question, let us fi rst defi ne what we mean by a secular trend.

What is a Secular Trend?
A long-term secular trend is formed when a series of business cycles are linked together establishing extended periods of stock market out- or under-performance. Th ese long-term secular price trends last up to 20 years and sometimes more. Investors need to correctly identify the direction of the prevailing secular trend if they are to successfully protect and grow wealth. Th at is because the tide of a secular bull market lift s all boats as investors are quickly bailed out of their mistakes. Anyone who adopts the buy/hold approach might be a temporary hero but the secular bear proves that the emperor has no clothes. Risky strategies may work in a secular bull market, but only defensive cautious ones will enable you to preserve real purchasing power during a secular bear.

Characteristics of Previous Secular Bear Markets and Where We Are Today
Secular bear markets are characterized by several factors. Th e most important is a complete reversal in psychology from the euphoria and over confi dence of the previous secular bull, to one of total disgust with equities by the time the bear has run its course. Unfortunately this is not an overnight process, but requires prices to experience a huge drop over an extended period. Th e large decline is obviously discouraging as investors see their wealth being slowly eroded. However, it is the extended duration of the drop in real purchasing power that slowly eats away at the confidence of even the most optimistic investors. Experience has shown that in order to correct the structural distortions built up in the previous secular bull, it was normal for the economy to undergo between four and six recessions before the bear is finally laid to rest.

We’ll examine the psychological aspects fi rst by considering valuation, not as a fundamental measure, but as one of sentiment. Arguably the most popular long-term measure of stock market valuation is the price investors are willing to pay for corporate earnings. Why at one time are fearful investors only willing to pay $6.64 for $1 of earnings, (i.e. 1982 Secular Bottom) while at another time investors are eager to pay $44.20 for that same $1 of earnings (i.e. 2000 Secular Peak)? Th e answer lies in the extremes of confi dence or lack thereof only seen at major secular turning points.

Take a moment to look at the Shiller P/E series at the bottom of Chart 3*. Th e key turning points are summarized in Table 1. Notice that at the beginning of secular bear markets the average P/E ratio is 31.5; in contrast the average at the end of these periods is 6.95. Th e current (October 2009) Shiller P/E reading is 18.77. We may have traveled a long way from the 2000 historic overvaluation peak (P/E 44) but clearly there is a long way to go to reach truly undervalued levels once again.

Does Inflation Have an Effect on the Secular Trend?
Th e long-term trend of commodity prices appears to have an enormous eff ect on the direction of the secular trend of stock prices adjusted for the CPI. Th is relationship is shown quite clearly in Chart 6. Th e series in the upper panel represents stock prices defl ated by the CPI since 1871 and industrial commodity prices prior to that date. The secular bear markets since 1850 have been fl agged with the dashed red arrows. It is fairly evident that all of them have been associated with a background of rising commodity prices. Th e relationship is not an exact tick by tick correlation but the chart clearly demonstrates that a sustained trend of rising commodity prices sooner or later results in the demise of equities. Th ere was one exception to this relationship and that developed in the 1929-32 bear market where commodities and equities both fell due to the collapsing economy. Aft er that, sharply rising commodities resulted in a trading range for equities until 1949. By the same token, the solid green arrows show that a sustained trend of falling or stable commodity prices is positive for equities as all six secular bulls developed under such an environment. Th is point is also underscored by the opening decade of the last century. It has been labeled a secular bear, but real equity prices were initially quite stable as they were able to shrug off the gentle rise in commodities. Only when commodity prices accelerated to the upside a few years later did stock prices adjusted for infl ation sell off sharply.

To read the full report: ANOTHER LOST DECADE

>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

>TATA TEA (KOTAK SECURITIES)

■ Confluence of positive factors. Our positive stance on Tata Tea (TT) is reinforced after a recent interaction with management and our channel checks at a Wal-mart store in US (on Eight O Clock coffee). Three factors aiding TT are (1) Tetley UK is operating at its highest EBITDA levels—a perfect cash cow, (2) good growth in EOC providing mix improvement and (3) input cost inflation and price increases (possible due to rational competition from Unilever) is likely helping TT post EBITDA growth. Reiterate BUY.

■ Tetley’s UK black tea business is a perfect cash cow
Tata Tea reported modest volumes (Tetley black tea volumes have likely declined) growth in
1HFY10. In a recent interaction, management indicated that Tetley’s UK operations are posting the highest-ever EBITDA at a percentage level—indicating that TT is utilizing the UK black tea business as a perfect cash cow to raise resources which can seed growth in other opportunistic areas and markets. The 100 bps volume market share loss (yoy to 28.7% in 2QFY10) in UK market seems to indicate this. We agree with this strategy; however, we note that successful identification of investible businesses is imperative for gainful deployment of resources raised from the UK black tea operations.

We believe the company’s strategy of focusing on new markets and new initiatives in tea (aggressive push of herbal and green tea) is paying off well. We believe the initial success of integration of various recent acquisitions is visible. Black tea accounts for about 70% of Tetley’s UK operations, while the rest is accounted by other value added tea including red tea, green tea etc. The management intends to reduce the contribution of black tea to 50% from the current 70% over the next three to four years.

■ Contrary to conventional wisdom, input cost inflation is a boon for TT
Higher tea prices combined with rational competition from Unilever globally and HUL in India are likely aiding TT in effecting judicious price increases to cover the inflation in tea commodity prices (EBITDA margins were maintained at ~12% for 1HFY10 even as TT effected a 16% price increase at consolidated level). We recall that at the analyst meet in June 2009, the management had indicated that it plans to focus on value sales and profitability in FY2010E, even at the cost of volumes. In FY2010-11E, we expect TT to post 10% and 15% EBITDA growth on the back of input-cost-inflation-led price increases.

To read the full report: TATA TEA

>VOLTAS (ANAND RATHI)

■ Business environment improves; concerns continue. Voltas is seeing a gradual improvement in businesses especially in the UCP segment and the domestic EMPS segment as well as some parts of the EPS segment. But the international EMPS business is still a concern due to lack of order inflows from international markets in the last few quarters. We thus maintain our Sell rating.

■ EMPS segment the key. As growth in UCP and EPS segments (except textiles), along with domestic EMPS, is picking up, only the international EMPS segment is a concern: slack order inflows even with crude at over US$70/barrel. Voltas’ order backlog has declined for five consecutive quarters now. The current order backlog is Rs43.6bn, down 22% yoy. It includes a Rs7bn order, currently suspended.

Still awaiting international orders; maintain Sell

■ Margin outlook stable. We expect the EBITDA margin to expand 146bps in FY10, to 8%, and thereafter to be stable on account of higher margins in the UCP and EPS segments.

■ Change in estimates. We raise our earnings estimate on account of the better margin profile of the EPS and UCP segments, consolidation of Rohini Industrial and assumption of better order
inflows due to higher crude oil prices.

■ Valuation. Our new target price of Rs169 (Rs129 earlier) is at 15x one-year-forward estimated earnings (Dec ’11).

To read the full report: VOLTAS

>INFOSYS TECHNOLOGIES (RBS)

■ Increasing traction from new engagement models underpins long-term targets
Infosys showcased its thrust on new engagement models, where output/pricing are not directly co-related to manpower. The company aims to earn a third of its revenues from these models in five to seven years (vs 5-7% currently, ex-Finacle). It has closed about a 100 such deals in FY10 ytd of TCV of US$165m. Discussions are on for 150 more projects worth US$528m. Growth from these models is significantly higher- bookings and revenues are up 75% and 50%, respectively, vs a 4% yoy decline in overall revenues in 1HFY10. Apart from customers' demand for outcome-based pricing, a key driver is to side-step rate card negotiations, typical of time and material based contracts.

■ New operating model to drive productivity, while client-partner role focuses on mining
Infosys has increased the minimum number of years an employee needs to put in technical roles to eight (typically six earlier). While this is in line with clients' insistence on experienced technical staff, it also increases the average billability of an employee by about two years. A larger span of control of 1:3:9 (from 1:2.4.5 earlier) also helps spread overhead costs wider. Infosys plans to increase its sales headcount by 30% in FY10, particularly to deepen large client relationships through dedicated client-partner roles.

■ Near-term outlook unchanged; valuations price in growth expectations, in our view
Management reiterated its near-term demand outlook given in October 2009. It does not expect the usual budget flush to play out in December 2009, as clients are still strictly monitoring spending levels. While most 2010 budgets are likely to be finalised in time, recent interactions with clients indicate budgets will likely be flattish yoy. Infosys expects discretionary expenses to be curtailed. We maintain about 20% growth for FY11F is already built into current valuations and that this would be difficult to surpass.

To read the full report: INFOSYS TECHNOLOGIES