Credit Suisse:: India Strategy - Sensex should hit 16,000 before touching 21,000.

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India Market Strategy ------------------------------------------------------ Maintain UNDERWEIGHT
Fresh Horses for the Economy


● Under the umbrella of the ‘Indian economy’ there lie 28 states with
wide variation in socio-economic parameters – from urbanisation
and industrialisation to literacy and demographics. We find that
Indian growth since 1991 has been skewed towards a few
‘developed’ states, which pulled away from the rest.
● This is now changing: governance has improved in most underdeveloped
states and worsened in some developed states.
Infrastructure has improved markedly in the former, and some of
these are also resource rich. Thus, credit growth and new project
announcements are now visibly higher in the latter states.
● This balancing of growth is very positive for India’s medium-term
prospects: it helps chances of harvesting the ‘demographic
dividend’, and improves overall productivity. It cannot, however,
offset cyclicality in the economy and the current slowdown.
● Worse, bell-weather sectors (construction, real-estate) are mostly
local to developed regions, making GDP feel worse than it really
is. Market P/E, correlated to GDP growth, is likely to undershoot
fair value. Sensex should hit 16,000 before touching 21,000.
The economic divide
The 28 states and seven union territories that make up India differ
significantly from one another – not just in geography and culture, but
also on several socio-economic parameters. Some states are far more
urbanised and literate than others, enjoy better-than-average
standards of living, and are also ageing faster, with much lower fertility
rates. Conversely, some states lag behind. Even the ‘demographic
dividend’ is localised: half of India’s population below the age of 15
resides in just five under-developed states.
The gap was not always this wide: per capita output in developed
states was only 23% higher than the under-developed states in 1981,
but it was 86% higher in 2008. States that were more industrialised
and urbanised in 1991 benefited more from India’s liberalisation. But
we think the greatest factors for this divergence were less passive:
state governments, which greatly impact growth. The significant
difference in road density for example, which is correlated with per
capita state GDP, is largely due to difference in the lengths of state
highways. Similarly, land reforms and irrigation are state subjects, and
materially impact agricultural productivity. And lastly, law and order,
administrative machinery and civic infrastructure are the hygiene
factors for attracting industrial investment.
Baton passing to the laggards
The growth and output gap between the two halves of the economy
has started to narrow over the past few years: the developed states
have slowed, and the under-developed states have seen a pick up.
This is visible across several metrics such as credit growth, new
project announcements and fixed capital formation. Data also
suggests that the financial crisis affected the developed states more
than the under-developed ones: it seems the so-called resilience of
the Indian economy was largely driven by the hinterland, which had
not benefited from the boom, and was thus largely also immune to the
bust.
Non-cyclical, intrinsic drivers are instead playing a bigger role: 1)
Governance has largely improved in the under-developed states,
while it has deteriorated in several developed states; 2) Partly as a
result of this, there has been a marked improvement in road
infrastructure in the under-developed states. They have also benefited
from the telecom boom – leapfrogging the wired telecom era. 3)
Further, some of the under-developed states are rich in iron ore and
coal, and house a disproportionate share of planned steel and power
expansions. Even without the multiplier effect of such investments,
just their commissioning can drive 9%-plus CAGR growth in these
states over FY11-16.
Strong medium-term but market to undershoot
We believe the shift in location of growth momentum is additive, and
materially strengthens the medium-term growth potential for India:
with a 12% lower industrial ICOR (2004-08), under-developed states
can deliver stronger growth with the same capital.
That said, it does not preclude cyclicality in the overall economy, and
the under-developed states are not yet large enough to offset a
slowdown in the developed states. This will continue to impact the
stock market – GDP growth and market multiples are strongly
correlated. Worse, we believe the slowdown would ‘feel’ worse than
reality, as the economic bell-weather sectors (construction, cement,
real estate) are ‘local’ in developed states. They are an insignificant
3% of the Nifty EPS but by influencing perception of how well the
economy is doing, have a much more significant impact on the
market.
This is likely to be exacerbated by fund flows – we estimate only about
20% of the ETF and 2% of non-ETF FII flows seen in 2010 have
reversed YTD. The market may languish till mid-CY11, falling to
16,000 levels. We would avoid ‘local’ sectors, and be OVERWEIGHT
on the ‘national’ sectors such as autos and private sector banks.