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India’s valuation premium over other emerging markets is
increasingly at risk, in our view. A relatively higher ROE
coupled with a long history of excess returns over COE (cost of
equity) has been one of the key reasons why India has
consistently commanded a large premium to its EM peers. A
worsening competitive environment, falling productivity gains,
large balance-sheet expansion and deterioration in cyclical
outlook for some sectors have dragged India’s ROE. A
coincident and protracted rise in COE is driving down the
excess return gap as well. Sustenance of India’s large
valuation premium will depend on a synchronous upswing in
sectors linked to the domestic capital formation cycle, coupled
with a softening in global commodity prices.
ROE – under pressure: In contrast to the FY04-08 boom phase,
overall ROE for the IIFL universe of 140 companies (aggregate market
cap of US$990bn, or 67% of India’s total market cap) has declined by
4pps in FY11. Across multiple industries, rising competitive intensity is
driving down operating margins even as a sharp deceleration in capital
formation has negatively affected profitability of sectors linked to the
investment cycle. Asset turnover ratios are down on account of large
equity dilutions, rising cash balances and high CWIP. A spike in the
costs of factors of production (particularly land and labour) and
productivity loss arising from poor infrastructure are gradually eating
into returns available for equity investors. Of the 17 sectors in our
coverage, 13 have seen a decline in their ROE. Big offshore
acquisitions such as Corus and Zain, with much lower profit margins
than their parents’ respective domestic businesses, have been an
additional drag on ROEs. We see no let-up in these downward
pressures in the next 12 months, given the deceleration in GDP
growth, rising fuel and feed costs, and rising borrowing costs.
Cost of equity – on the rise: For most of the past decade, India’s
10-year gilt yield—the risk-free reference rate for calculating cost of
equity—has moved in a tight range of 6-8%. We worry that long
bond yields will break out of this range and stay higher for longer.
The sustained build-up in inflationary pressures driven by a number
of structural factors and potential worsening of the twin deficits will
keep the central bank’s monetary policy on a tight leash; the
sovereign yield curve will steepen as yields harden at the longer end.
The consequent reduction in the excess return gap (ROE-COE) will
have a negative bearing on equity valuations. During the FY04-08
boom phase, ROE-COE for our coverage universe averaged about
8pps and was the key factor for valuation expansion. This gap has
narrowed to 2.5pps.
India’s valuation premium – sustainability in doubt: IIFL’s
coverage universe is currently trading at an FY11 price/book multiple
of 2.8x vs FY11 RoE of 16.5%. In contrast, emerging markets in
aggregate trade at price/book multiple of 2x vs RoE of 15%. Over
the past seven years, India has traded at 80% valuation premium,
justified by its 4–5pps higher ROE. This ROE gap, though, has more
than halved currently. The continued contraction in the comparative
excess return gap is an added worry. The risk to our hypothesis of
relative valuation de-rating of India would be a sudden or sustained
fall in global commodity prices (larger commodity-centric EMs will be
hit much more) and a sustained growth turnaround in capital
formation.
On a sector-wise basis, ROE trends have been as follows:
1. ROEs of Financials, Utilities, FMCG and Pharma have been
reasonably stable through the last eight years;
2. ROE of Autos, after dropping to a third of its FY04-08 average in
FY09, has shot past its pre-crisis average, while current ROE of
the Media sector is well above the FY04-08 average;
3. ROEs of Technology, Energy, and Capital Goods are down by
almost a third to a sixth (4-10pps) in FY11 relative to the FY04-
08 average; and
4. ROEs of Cement, Telecom, Construction, Real Estate and Metals
have collapsed to about half of their FY04-08 average.
While economic growth momentum in FY11 recovered to pre-crisis
levels, the composition of growth materially changed. The cyclical
momentum across domestic sectors is decidedly mixed; in most
cases, it is much worse compared to the last phase of high growth.
In contrast, during the pre-crisis period, almost all sectors performed
very well.
We have highlighted a detailed sector-wise analysis later in this
report; however, here are some generic reasons for the downdraft in
ROE:
1. Worsening competitive environment: Across sectors and
product segments, the competitive environment has substantially
intensified vs the previous high-growth phase. Telecom is a wellknown
example: EBITDA margins of the sector leader, Bharti, are
down from 42% in FY08 to 36% currently (only for the domestic
business, excluding Zain). Another example is the Construction
sector, where companies have bid and continue to bid for
projects at unviable prices. In Autos, demand growth has been
robust and profitability has held up despite escalating
competition—but high ROEs are vulnerable to a slowdown in
demand as pricing power will wane quickly.
In some other sectors, waning pricing power has come at a time
of sudden and sharp spikes in a number of cost items—an added
drag on ROE. FY11 EBITDA margin for the IIFL universe was
more than 200bps lower than the FY04-08 average, despite the
sharp economic recovery from the FY09 cyclical low.
2. Business cycle shift due to macro, global factors:
Accelerated growth in capital formation was the biggest driver for
GDP expansion during FY04-08—50% of the incremental growth
during this period came from an increase in gross fixed-capital
formation. A number of sectors linked to that chain—
Construction, for instance—did exceptionally well. This has
changed over the last couple of years; the growth momentum
has shifted to consumption, led by rising wages and rural
incomes, while faltering policy-making and poor execution have
acted as big drags on the business cycle of sectors linked to the
capex chain. Demand growth in Cement, for example, has fallen
below expectations, and with large capacities coming on stream,
operating margins and ROEs have come under stress. For global
sectors like Metals, the last growth phase coincided with a
supercycle and extraordinary expansion in margins and ROEs;
while product prices have risen, there has been a severe cost
push as well eroding operating margins.
3. Limited scope for further productivity gains, poor
infrastructure: Cost of almost every factor of production,
particularly land and labour, has risen sharply in the past 3-4
years. Apart from rising rigidity in labour markets, rising share of
offshore wages on a consolidated basis and a spike in wages of
PSU staff (consequent to the Sixth Pay Commission) has further
pushed up labour costs as a proportion of sales. Any material
productivity increases from hereon hinge on a big improvement
in the quality of infrastructure—which in turn depend on
improvement in execution and the policy environment. And these
things take time.
4. Large international acquisitions: A few large-caps have seen
substantial balance-sheet expansion due to big overseas
acquisitions after FY07. The acquisition of Corus by Tata Steel,
JLR by Tata Motors, Novelis by Hindalco, RE Power by Suzlon and
Zain by Bharti are some examples of large acquisitions that have
resulted in large equity dilutions or weighed down consolidated
margins. Granted, some of these acquisitions have done very
well as managements have successfully turned them around, but
in aggregate, acquisitions have adversely affected ROE. Tata
Motors’s ROE post its JLR acquisition is flattered by accounting
policy changes on amortisation of R&D costs in JLR (but for this
change, FY11 ROE would be lower by 21pps). Tata Steel’s FY09
ROE was bolstered by one-off inventory gains (and higher
carried-forward inventory costs had a depressive impact on FY10
profitability) and a 19% decline in shareholders’ funds, mainly on
account of changes in actuarial valuations on Corus’s pension
liabilities and goodwill impairment.
5. Changing balance-sheet composition, falling asset
turnover: Over the last five years (FY06-11), shareholders’
funds for our non-Financials universe rose by 3x, but EBITDA
rose by a lower multiple of 2.6x; thus, EBITDA growth has not
kept pace with the rise in networth. Our Dupont analysis of ROE
shows that EBITDA margins for our universe are down by more
than 200bps for reasons enumerated earlier. Asset turnover has
also trended markedly lower over this period, partly on account
of higher share of CWIP and investments as a proportion of total
assets, and this has been the biggest drag on the ROE of our
universe.
Cost of Equity: Higher for longer
Over the past decade, India’s 10-year gilt yield—the risk-free
reference rate for calculating cost of equity—has moved in a tight
range of 6-8%. AAA bond yields have averaged about 130bps higher
during this period. We worry that long bond yields will break out of
this range in the near future and stay higher for longer, driven by
high inflation, high deficits and tight monetary policy. The yield curve
has rarely been as flat as it is today, with the gap between 10-year
and 3-month yields at 30bps (against the long-term average of
150bps), and we believe that the steepening of the curve this time
will be led by a rise in yields at the long end. We estimate that 10-
year gilt yields will be 100-150bps higher in the coming year, as
compared to the FY04-08 period; cost of equity will concomitantly go
up. It is well-known that an increase in excess return gap (ROE-COE)
drives valuation expansion (conversely, a reduction thereof drives a
valuation contraction). Rising COE will dent the excess return gap.
Inflation to remain high in the medium term: WPI inflation
averaged 9.5% in FY11, the highest in over a decade, while core
inflation at 6% was the highest in six years. With adjustment to
higher international crude oil prices yet to happen, inflation is
unlikely to moderate in the near term. Further, some of the drivers
of inflation are demand-driven and will persist unless growth
moderates. The large liquidity injection in the rural areas from the
government’s social sector programmes such as those under NREGA
(National Rural Employment Guarantee Act) and higher credit flow to
rural India is driving the structural uptrend in food inflation, in
addition to fuelling wage pressures in unskilled labour. There is now
growing evidence that double-digit wage inflation in both skilled and
unskilled labour is becoming the norm and if not matched by
productivity growth (which, in turn, is constrained by poor
infrastructure) will result in inflationary pressures persisting in the
medium term.
Consequently, barring a collapse in commodity prices (like in 2008-
09), we think inflation will remain elevated in the medium term and
average higher than in the recent past. Thus, while WPI Inflation
averaged 5.4% during the last decade, it is likely to average 100-
150bps higher (6.5~7%) over the couple of years.
Monetary policy to remain tight, flat yield curve suggests
long-bond yields will move up: Given the underlying inflationary
pressures, part of which is demand-led, monetary policy will remain
tight over the next few quarters. While we expect RBI to stop policy
tightening after another 75bps of rate hikes (taking repo rate to
8%), the easing cycle is unlikely to begin immediately. Furthermore,
with RBI committed to keeping liquidity tight (LAF will operate in
deficit mode) to ensure monetary policy transmission, the pressure
on rates will remain on the upside. The yield curve has already
flattened, with the gap between 10-year gilt and 3-month T-bill
under 30bps. With the policy rate likely to be raised by a further
75bps and easing some time away, we expect the yield curve to shift
upwards, with both short-term and long-bond yields rising another
50-75bps over the next couple of quarters. With the 10-year gilt
yield already rising to 8.4%, there is a real risk of it moving to over
9%—which in the past decade happened for a few weeks, at the
height of the global financial crisis. Thus, as against an average of
6.9% during FY04-08, the 10-year gilt yield is likely to average 8-
9%, or 100-150bps higher over the next couple of years.
Government borrowings will remain an overhang: A high and
slowly declining fiscal deficit implies that aggregate government
borrowings (Centre + State) will remain an overhang on domestic
liquidity, with consequent upward pressure on long-term interest
rates, in our view. We estimate that even by FY14, aggregate (centre
+ states) fiscal deficit, at ~6-6.5% of GDP, will be ~150-200bps
above the FY08 low of 4.6%. Aggregate government borrowing will
rise to 6% of GDP in FY12 from 5.5% of GDP in FY11, owing to the
higher fiscal deficit (largely due to higher subsidies and absence of
3G/BWA auctions). As a result, even by FY14, aggregate government
borrowings will likely remain over 4% of GDP, as against ~3% of GDP
during FY05-08.
Further, in contrast to FY03-08, when domestic liquidity improved as
a result of RBI intervention in FX markets (induced by low current
account deficit and the consequent large BoP surplus), the next
couple of years will be marked by high current account deficits and
consequent modest BoP surpluses leading to negligible/modest RBI
intervention.
As a result, in contrast to the need for issuing MSS bonds during
FY03-08 to suck out excess liquidity from the system, RBI will have
to conduct net OMO purchases of government securities to
accommodate government borrowing. Already in the last three
years, RBI has conducted net OMO bond purchases of ~3% of GDP.
Uncertainty over timing and quantum of OMOs will thus keep longbond
yields under pressure.
Equity risk premium: our calculations suggest 6%
Cost of equity (COE) = risk-free return + equity risk premium.
Theoretically, equity risk premium (ERP) is defined as the additional
return that an equity investor seeks over and above the risk-free
return for taking the extra risk. There are many methods to calculate
ERP. One simple method is to equate ERP to the difference between
compounded returns over a long period between equities and riskfree
assets; the assumption here is that equity investors were
satisfied historically with that extra return and they will remain so in
the future as well. The difference in tax treatment also needs to be
factored in while calculating ERP. Long-term capital gains on listed
shares are fully tax-exempt in India, while income earned on bonds
is subject to 30% tax, though the tax treatment could vary across
market participants. India does not have a long history of fully deregulated
debt markets. Given that limitation and the large volatility
seen both in debt and equity markets in the past two decades, we
have attempted to compute ERP by taking averages across multiple
time periods (both with and without tax differentials) since the
beginning of liberalisation in 1991. Detailed calculations are given in
the table below. The ERP so computed comes out at 6.0%, and we
believe this is a reasonable representation of the risk premium that
long-term equity investors would target for.
In March 2011, Tata Steel (AAA-rated for domestic debt) raised
Rs15bn through a perpetual bond with semi-annual coupon at a yield
of 11.8%, which at that point represented a spread of 3.8% over the
10-year gilt yield. In April 2011, Tata Power raised US$450m
through dollar-denominated perpetual bonds (maturing in 60 years)
at a yield of 8.5%, almost 5pps higher than 30-year US Treasury. In
the above backdrop, ERP of 6% looks reasonable as well.
Note, however, that ERP can fluctuate violently in the near term and
could significantly deviate from long-term averages. One recent
example was the big collapse in ERPs in 2007, driving a big bubble in
equities globally, followed by an equally sharp spike in ERPs in 2008,
driving a big correction in equity values. Figure 24, a chart of
earnings yield gap (inverse of PE minus 10-year gilt yield), a proxy
for ERP, for Nifty corroborates this point.
Excess return gap set to further fall
During the FY04-08 boom phase, ROE-COE for our coverage universe
averaged ~8pps and in FY11, this gap declined to 3pps. Given our
hypothesis that ROEs will stagnate at current levels while COE is set
to rise further, the excess return gap is set to shrink further.
Valuation premium – sustainability in doubt
IIFL’s coverage universe currently trades at an FY11 price/book
multiple of 2.8x, vs FY11 ROE of 16.5%. In contrast, emerging
markets in aggregate trade at 2010 price/book multiple of 2x, vs
ROE of 15%. Over the last seven years, the Indian market has
traded at a premium of ~80% to EM peers on price-to-book basis, as
compared to peak-trough ROE differential of 1-7pps. With the
continuing decline in excess return gap, we believe that India’s
premium valuations will likely come under pressure.
It is true that there is a cyclical component that is driving up ROEs in
commodity-centric EMs, while this is having a mixed impact on ROEs
of Indian companies. It is equally true that during the last boom
phase of FY04-08, commodity prices too sharply rallied, but ROEs of
the IIFL universe held up very well, as the domestic cycle across
sectors was on a synchronous upswing. We attribute a large part of
the ROE decline to the shift in growth components of the domestic
economy and the change in cyclical outlook for some of the domestic
sectors for reasons enumerated in earlier in the report.
Relative to EM universe, India’s ROE premium has narrowed from an
average of ~5pps during FY04-08 to 2pps currently, as India’s ROE
remains below the long-term average and EM ROEs have improved
to their long-term average from the decline during the financial
crisis. Yet another factor to note is that India’s COE is rising and that
is acting as a drag on excess return gap, thereby reducing the
relative attractiveness vs other emerging markets.
There are two key risks to our hypothesis: 1) any sudden or
sustained fall in global commodity prices, especially oil, will drive
down ROEs of larger commodity-centric EMs much faster than India;
2) a big policy push to re-accelerate the investment cycle that
ushers in a turnaround in business cycle of some of the domestic
sectors that have been badly hit, although this will take time to play
out.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
India’s valuation premium over other emerging markets is
increasingly at risk, in our view. A relatively higher ROE
coupled with a long history of excess returns over COE (cost of
equity) has been one of the key reasons why India has
consistently commanded a large premium to its EM peers. A
worsening competitive environment, falling productivity gains,
large balance-sheet expansion and deterioration in cyclical
outlook for some sectors have dragged India’s ROE. A
coincident and protracted rise in COE is driving down the
excess return gap as well. Sustenance of India’s large
valuation premium will depend on a synchronous upswing in
sectors linked to the domestic capital formation cycle, coupled
with a softening in global commodity prices.
ROE – under pressure: In contrast to the FY04-08 boom phase,
overall ROE for the IIFL universe of 140 companies (aggregate market
cap of US$990bn, or 67% of India’s total market cap) has declined by
4pps in FY11. Across multiple industries, rising competitive intensity is
driving down operating margins even as a sharp deceleration in capital
formation has negatively affected profitability of sectors linked to the
investment cycle. Asset turnover ratios are down on account of large
equity dilutions, rising cash balances and high CWIP. A spike in the
costs of factors of production (particularly land and labour) and
productivity loss arising from poor infrastructure are gradually eating
into returns available for equity investors. Of the 17 sectors in our
coverage, 13 have seen a decline in their ROE. Big offshore
acquisitions such as Corus and Zain, with much lower profit margins
than their parents’ respective domestic businesses, have been an
additional drag on ROEs. We see no let-up in these downward
pressures in the next 12 months, given the deceleration in GDP
growth, rising fuel and feed costs, and rising borrowing costs.
Cost of equity – on the rise: For most of the past decade, India’s
10-year gilt yield—the risk-free reference rate for calculating cost of
equity—has moved in a tight range of 6-8%. We worry that long
bond yields will break out of this range and stay higher for longer.
The sustained build-up in inflationary pressures driven by a number
of structural factors and potential worsening of the twin deficits will
keep the central bank’s monetary policy on a tight leash; the
sovereign yield curve will steepen as yields harden at the longer end.
The consequent reduction in the excess return gap (ROE-COE) will
have a negative bearing on equity valuations. During the FY04-08
boom phase, ROE-COE for our coverage universe averaged about
8pps and was the key factor for valuation expansion. This gap has
narrowed to 2.5pps.
India’s valuation premium – sustainability in doubt: IIFL’s
coverage universe is currently trading at an FY11 price/book multiple
of 2.8x vs FY11 RoE of 16.5%. In contrast, emerging markets in
aggregate trade at price/book multiple of 2x vs RoE of 15%. Over
the past seven years, India has traded at 80% valuation premium,
justified by its 4–5pps higher ROE. This ROE gap, though, has more
than halved currently. The continued contraction in the comparative
excess return gap is an added worry. The risk to our hypothesis of
relative valuation de-rating of India would be a sudden or sustained
fall in global commodity prices (larger commodity-centric EMs will be
hit much more) and a sustained growth turnaround in capital
formation.
On a sector-wise basis, ROE trends have been as follows:
1. ROEs of Financials, Utilities, FMCG and Pharma have been
reasonably stable through the last eight years;
2. ROE of Autos, after dropping to a third of its FY04-08 average in
FY09, has shot past its pre-crisis average, while current ROE of
the Media sector is well above the FY04-08 average;
3. ROEs of Technology, Energy, and Capital Goods are down by
almost a third to a sixth (4-10pps) in FY11 relative to the FY04-
08 average; and
4. ROEs of Cement, Telecom, Construction, Real Estate and Metals
have collapsed to about half of their FY04-08 average.
While economic growth momentum in FY11 recovered to pre-crisis
levels, the composition of growth materially changed. The cyclical
momentum across domestic sectors is decidedly mixed; in most
cases, it is much worse compared to the last phase of high growth.
In contrast, during the pre-crisis period, almost all sectors performed
very well.
We have highlighted a detailed sector-wise analysis later in this
report; however, here are some generic reasons for the downdraft in
ROE:
1. Worsening competitive environment: Across sectors and
product segments, the competitive environment has substantially
intensified vs the previous high-growth phase. Telecom is a wellknown
example: EBITDA margins of the sector leader, Bharti, are
down from 42% in FY08 to 36% currently (only for the domestic
business, excluding Zain). Another example is the Construction
sector, where companies have bid and continue to bid for
projects at unviable prices. In Autos, demand growth has been
robust and profitability has held up despite escalating
competition—but high ROEs are vulnerable to a slowdown in
demand as pricing power will wane quickly.
In some other sectors, waning pricing power has come at a time
of sudden and sharp spikes in a number of cost items—an added
drag on ROE. FY11 EBITDA margin for the IIFL universe was
more than 200bps lower than the FY04-08 average, despite the
sharp economic recovery from the FY09 cyclical low.
2. Business cycle shift due to macro, global factors:
Accelerated growth in capital formation was the biggest driver for
GDP expansion during FY04-08—50% of the incremental growth
during this period came from an increase in gross fixed-capital
formation. A number of sectors linked to that chain—
Construction, for instance—did exceptionally well. This has
changed over the last couple of years; the growth momentum
has shifted to consumption, led by rising wages and rural
incomes, while faltering policy-making and poor execution have
acted as big drags on the business cycle of sectors linked to the
capex chain. Demand growth in Cement, for example, has fallen
below expectations, and with large capacities coming on stream,
operating margins and ROEs have come under stress. For global
sectors like Metals, the last growth phase coincided with a
supercycle and extraordinary expansion in margins and ROEs;
while product prices have risen, there has been a severe cost
push as well eroding operating margins.
3. Limited scope for further productivity gains, poor
infrastructure: Cost of almost every factor of production,
particularly land and labour, has risen sharply in the past 3-4
years. Apart from rising rigidity in labour markets, rising share of
offshore wages on a consolidated basis and a spike in wages of
PSU staff (consequent to the Sixth Pay Commission) has further
pushed up labour costs as a proportion of sales. Any material
productivity increases from hereon hinge on a big improvement
in the quality of infrastructure—which in turn depend on
improvement in execution and the policy environment. And these
things take time.
4. Large international acquisitions: A few large-caps have seen
substantial balance-sheet expansion due to big overseas
acquisitions after FY07. The acquisition of Corus by Tata Steel,
JLR by Tata Motors, Novelis by Hindalco, RE Power by Suzlon and
Zain by Bharti are some examples of large acquisitions that have
resulted in large equity dilutions or weighed down consolidated
margins. Granted, some of these acquisitions have done very
well as managements have successfully turned them around, but
in aggregate, acquisitions have adversely affected ROE. Tata
Motors’s ROE post its JLR acquisition is flattered by accounting
policy changes on amortisation of R&D costs in JLR (but for this
change, FY11 ROE would be lower by 21pps). Tata Steel’s FY09
ROE was bolstered by one-off inventory gains (and higher
carried-forward inventory costs had a depressive impact on FY10
profitability) and a 19% decline in shareholders’ funds, mainly on
account of changes in actuarial valuations on Corus’s pension
liabilities and goodwill impairment.
5. Changing balance-sheet composition, falling asset
turnover: Over the last five years (FY06-11), shareholders’
funds for our non-Financials universe rose by 3x, but EBITDA
rose by a lower multiple of 2.6x; thus, EBITDA growth has not
kept pace with the rise in networth. Our Dupont analysis of ROE
shows that EBITDA margins for our universe are down by more
than 200bps for reasons enumerated earlier. Asset turnover has
also trended markedly lower over this period, partly on account
of higher share of CWIP and investments as a proportion of total
assets, and this has been the biggest drag on the ROE of our
universe.
Cost of Equity: Higher for longer
Over the past decade, India’s 10-year gilt yield—the risk-free
reference rate for calculating cost of equity—has moved in a tight
range of 6-8%. AAA bond yields have averaged about 130bps higher
during this period. We worry that long bond yields will break out of
this range in the near future and stay higher for longer, driven by
high inflation, high deficits and tight monetary policy. The yield curve
has rarely been as flat as it is today, with the gap between 10-year
and 3-month yields at 30bps (against the long-term average of
150bps), and we believe that the steepening of the curve this time
will be led by a rise in yields at the long end. We estimate that 10-
year gilt yields will be 100-150bps higher in the coming year, as
compared to the FY04-08 period; cost of equity will concomitantly go
up. It is well-known that an increase in excess return gap (ROE-COE)
drives valuation expansion (conversely, a reduction thereof drives a
valuation contraction). Rising COE will dent the excess return gap.
Inflation to remain high in the medium term: WPI inflation
averaged 9.5% in FY11, the highest in over a decade, while core
inflation at 6% was the highest in six years. With adjustment to
higher international crude oil prices yet to happen, inflation is
unlikely to moderate in the near term. Further, some of the drivers
of inflation are demand-driven and will persist unless growth
moderates. The large liquidity injection in the rural areas from the
government’s social sector programmes such as those under NREGA
(National Rural Employment Guarantee Act) and higher credit flow to
rural India is driving the structural uptrend in food inflation, in
addition to fuelling wage pressures in unskilled labour. There is now
growing evidence that double-digit wage inflation in both skilled and
unskilled labour is becoming the norm and if not matched by
productivity growth (which, in turn, is constrained by poor
infrastructure) will result in inflationary pressures persisting in the
medium term.
Consequently, barring a collapse in commodity prices (like in 2008-
09), we think inflation will remain elevated in the medium term and
average higher than in the recent past. Thus, while WPI Inflation
averaged 5.4% during the last decade, it is likely to average 100-
150bps higher (6.5~7%) over the couple of years.
Monetary policy to remain tight, flat yield curve suggests
long-bond yields will move up: Given the underlying inflationary
pressures, part of which is demand-led, monetary policy will remain
tight over the next few quarters. While we expect RBI to stop policy
tightening after another 75bps of rate hikes (taking repo rate to
8%), the easing cycle is unlikely to begin immediately. Furthermore,
with RBI committed to keeping liquidity tight (LAF will operate in
deficit mode) to ensure monetary policy transmission, the pressure
on rates will remain on the upside. The yield curve has already
flattened, with the gap between 10-year gilt and 3-month T-bill
under 30bps. With the policy rate likely to be raised by a further
75bps and easing some time away, we expect the yield curve to shift
upwards, with both short-term and long-bond yields rising another
50-75bps over the next couple of quarters. With the 10-year gilt
yield already rising to 8.4%, there is a real risk of it moving to over
9%—which in the past decade happened for a few weeks, at the
height of the global financial crisis. Thus, as against an average of
6.9% during FY04-08, the 10-year gilt yield is likely to average 8-
9%, or 100-150bps higher over the next couple of years.
Government borrowings will remain an overhang: A high and
slowly declining fiscal deficit implies that aggregate government
borrowings (Centre + State) will remain an overhang on domestic
liquidity, with consequent upward pressure on long-term interest
rates, in our view. We estimate that even by FY14, aggregate (centre
+ states) fiscal deficit, at ~6-6.5% of GDP, will be ~150-200bps
above the FY08 low of 4.6%. Aggregate government borrowing will
rise to 6% of GDP in FY12 from 5.5% of GDP in FY11, owing to the
higher fiscal deficit (largely due to higher subsidies and absence of
3G/BWA auctions). As a result, even by FY14, aggregate government
borrowings will likely remain over 4% of GDP, as against ~3% of GDP
during FY05-08.
Further, in contrast to FY03-08, when domestic liquidity improved as
a result of RBI intervention in FX markets (induced by low current
account deficit and the consequent large BoP surplus), the next
couple of years will be marked by high current account deficits and
consequent modest BoP surpluses leading to negligible/modest RBI
intervention.
As a result, in contrast to the need for issuing MSS bonds during
FY03-08 to suck out excess liquidity from the system, RBI will have
to conduct net OMO purchases of government securities to
accommodate government borrowing. Already in the last three
years, RBI has conducted net OMO bond purchases of ~3% of GDP.
Uncertainty over timing and quantum of OMOs will thus keep longbond
yields under pressure.
Equity risk premium: our calculations suggest 6%
Cost of equity (COE) = risk-free return + equity risk premium.
Theoretically, equity risk premium (ERP) is defined as the additional
return that an equity investor seeks over and above the risk-free
return for taking the extra risk. There are many methods to calculate
ERP. One simple method is to equate ERP to the difference between
compounded returns over a long period between equities and riskfree
assets; the assumption here is that equity investors were
satisfied historically with that extra return and they will remain so in
the future as well. The difference in tax treatment also needs to be
factored in while calculating ERP. Long-term capital gains on listed
shares are fully tax-exempt in India, while income earned on bonds
is subject to 30% tax, though the tax treatment could vary across
market participants. India does not have a long history of fully deregulated
debt markets. Given that limitation and the large volatility
seen both in debt and equity markets in the past two decades, we
have attempted to compute ERP by taking averages across multiple
time periods (both with and without tax differentials) since the
beginning of liberalisation in 1991. Detailed calculations are given in
the table below. The ERP so computed comes out at 6.0%, and we
believe this is a reasonable representation of the risk premium that
long-term equity investors would target for.
In March 2011, Tata Steel (AAA-rated for domestic debt) raised
Rs15bn through a perpetual bond with semi-annual coupon at a yield
of 11.8%, which at that point represented a spread of 3.8% over the
10-year gilt yield. In April 2011, Tata Power raised US$450m
through dollar-denominated perpetual bonds (maturing in 60 years)
at a yield of 8.5%, almost 5pps higher than 30-year US Treasury. In
the above backdrop, ERP of 6% looks reasonable as well.
Note, however, that ERP can fluctuate violently in the near term and
could significantly deviate from long-term averages. One recent
example was the big collapse in ERPs in 2007, driving a big bubble in
equities globally, followed by an equally sharp spike in ERPs in 2008,
driving a big correction in equity values. Figure 24, a chart of
earnings yield gap (inverse of PE minus 10-year gilt yield), a proxy
for ERP, for Nifty corroborates this point.
Excess return gap set to further fall
During the FY04-08 boom phase, ROE-COE for our coverage universe
averaged ~8pps and in FY11, this gap declined to 3pps. Given our
hypothesis that ROEs will stagnate at current levels while COE is set
to rise further, the excess return gap is set to shrink further.
Valuation premium – sustainability in doubt
IIFL’s coverage universe currently trades at an FY11 price/book
multiple of 2.8x, vs FY11 ROE of 16.5%. In contrast, emerging
markets in aggregate trade at 2010 price/book multiple of 2x, vs
ROE of 15%. Over the last seven years, the Indian market has
traded at a premium of ~80% to EM peers on price-to-book basis, as
compared to peak-trough ROE differential of 1-7pps. With the
continuing decline in excess return gap, we believe that India’s
premium valuations will likely come under pressure.
It is true that there is a cyclical component that is driving up ROEs in
commodity-centric EMs, while this is having a mixed impact on ROEs
of Indian companies. It is equally true that during the last boom
phase of FY04-08, commodity prices too sharply rallied, but ROEs of
the IIFL universe held up very well, as the domestic cycle across
sectors was on a synchronous upswing. We attribute a large part of
the ROE decline to the shift in growth components of the domestic
economy and the change in cyclical outlook for some of the domestic
sectors for reasons enumerated in earlier in the report.
Relative to EM universe, India’s ROE premium has narrowed from an
average of ~5pps during FY04-08 to 2pps currently, as India’s ROE
remains below the long-term average and EM ROEs have improved
to their long-term average from the decline during the financial
crisis. Yet another factor to note is that India’s COE is rising and that
is acting as a drag on excess return gap, thereby reducing the
relative attractiveness vs other emerging markets.
There are two key risks to our hypothesis: 1) any sudden or
sustained fall in global commodity prices, especially oil, will drive
down ROEs of larger commodity-centric EMs much faster than India;
2) a big policy push to re-accelerate the investment cycle that
ushers in a turnaround in business cycle of some of the domestic
sectors that have been badly hit, although this will take time to play
out.
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