Indian stock market has likely hit bottom

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Levi Folk, Financial Post

India’s stock market appears attractively priced and represents a long term buying opportunity according to research I conducted recently for Excel Funds Management Inc.

Looking at economic fundamentals and valuations leads me to the believe the Indian market is being priced similar to past market corrections, yet the fundamentals are much more attractive today.

In April, 2007, in this column I argued that India’s economy was overheating and the stock market was richly priced and at risk for a correction. We are now past that point, and India’s stock market appears attractively valued.

India’s market was cheaper in July than at any time over the past four years, according to market price-to-earnings ratios (P/E) from MSCI Barra. The trailing P/E on the MSCI India Index was that low in November, 2004, before a rise in the market by a factor of approximately 3.7.

As the market rose, investors justified higher valuations for India’s stock market based on the high growth potential for the economy and the stock market.

Since then, inflation has spiked higher and interest rates and banks’ reserve requirements have been raised to combat that inflation, which is largely a factor of higher food and oil prices.

Inflation and interest rates have dented India’s growth outlook, but not by as much as the market downturn would suggest. GDP growth estimates have been lowered for 2008 from last year by up to 1.5%, to roughly 7% to 8% GDP growth. One would expect an associated earnings slowdown, but consensus forecasts are for earnings to come off the boil rather than crash as in previous episodes.

The previous two market corrections in 1997 and from 2001 to 2002 were associated with major economic and earnings slowdowns in India. In 1997-1998, during the Asian currency crisis, GDP growth in India slowed to 4%. Similarly, from 2000-2002 when the global technology bubble burst, GDP growth slowed again to 4% at the start of the crisis and remained below trend for the duration. On both these occasions, earnings growth turned negative.

The story is quite different today. The economy is slowing but to a much higher level of growth. The reasons for the slowdown are quite different today as well. In 1998 and 2001, for example, export growth fell heavily and was an important factor in India’s widespread economic slowdown. Today, India is much better insulated from trade and hot money flows. The current issue for India is not one of too weak growth but of overheating.

The Reserve Bank of India has hiked interest rates to 9% following a series of increases in reserve requirements for banks to arrest rising inflation. Inflation spiked higher to more than 12% at an annualized rate in July, and the RBI needs to aggressively tackle this problem. This is a problem of overheating and too strong growth in India.

Under the current scenario, the economy will slow to below its potential rate of output in order for inflation to recede. The IMF is forecasting 8% growth for India’s economy in 2008. This rate of growth is consistent with slowing but still positive rates of earnings growth. Consensus estimates are for 17% growth in Sensex earnings for fiscal year 2008 and 20.5% growth in fiscal year 2009.

Current valuations are attractive given current rates of economic growth. I have constructed a PEG ratio using GDP growth in the denominator. The ratio looks at the market price/earnings ratio for the MSCI index divided by GDP growth.

The idea is that higher rates of earnings growth support higher market multiples. We use GDP growth as a proxy for earnings growth because GDP is more stable. This creates a conservative measure of market valuations.

In 1998 and 2003 the market bottomed at PEG ratios well under 2 (1.75 and 1.5 respectively). These PEG ratios were associated with negative earnings growth for the broad market. The current PEG ratio of roughly 2 likely represents a bottom for India’s market given the positive rate of earnings growth associated with current and expected GDP growth rates.

The long-term story of convergence toward developed economy status appears intact and current valuations are very attractive for investors with suitable time horizons.

Higher inflation will naturally lead to a fall in market valuations, but the current policy response to inflation by the Reserve Bank of India suggests that a boom-bust outcome is unlikely. Instead, expect a continuation of strong economic growth in India although at less than peak rates witnessed in recent history. – Levi Folk is president of Generation Capital (, manager of a quantitative-based equity strategy. He is also president of the Fund Library,, an investor-research Web site.


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