NURTURING WEALTH IN 2012

Loved in 2010, feared in 2011. As the year draws to a close, the question every investor is asking is—will India’s stock markets smile in 2012? They might, say experts, if the government can pull the economy out of its current mess. If not, they say, the markets are hugely undervalued and so have limited downside potential. Let’s see what investors can look forward to in 2012.

The 2011 Hangover

Experts are positive for 2012 but say the impact of what all went wrong in 2011 may be felt next year too. In 2011, just when we thought the 2008 global financial crisis was behind us—with stock markets rallying all through 2009 and 2010—came another shocker, the European debt crisis. After rising from 15,000 levels in January 2009 to around 21,000 in November 2010, the Bombay Stock Exchange (BSE) Sensex has slipped to the 16,000 level. Although this is not as steep a fall as that in 2008, there’s uncertainty over the future.

“The issues faced by the US and Europe, which have unsustainable debt levels, have pushed some countries on the verge of bankruptcy. The European countries are making cosmetic changes that may not solve their structural problems,”says Dipen Shah, head of fundamental research, Kotak Securities.

And global commodity prices, despite some slowdown, are rising, putting pressure on inflation and forcing the Reserve Bank of India(RBI) to keep interest rates high. Though it may stop for now in view of the sharp fall in industrial production, which shrunk 5.1% in October, experts are uncertain on when the RBI will signal a reversal in rates.

Global factors apart, India’s failure to solve its problems ensured its stocks underperformed most markets (See Indian Markets Vs Global Peers, Pg 38) in 2011.

“India is facing its own set of issues in the form of supply constraints and policy paralysis that have brought fresh investments to a halt,” says Lalit Thakkar, managing director, institutional broking, Angel Broking. The scale of supply problems in such important sectors as energy, food and mineral resources is mind-boggling.

“India has an issue on the food supply front due to structural problems such as small land holdings and lack of corporatisation of agriculture,” says Thakkar.

To top it all, two sectors where India could have had an easy going, coal and iron ore, have been wrecked by policy stalemate. This has put pressure on industries. These problems, say experts, have the potential to spoil the stock market party in 2012 too.

“As a result of these supply constraints, gross domestic product(GDP) growth has slowed from 8-9% to 7-7.5%. Corporate earnings growth has also decelerated to the 8-10% level,” says Thakkar (See Growth Pangs, Pg 32).

Companies, too, have been feeling the pinch of high inflation and interest rates in the form of high raw material and wage costs. Sensex companies reported 24% sales growth and 16% EBIDTA(earnings before interest, depreciation, tax and amortisation) growth in the second quarter of 2011-12. However, profit after tax growth was just 5%. Companies in the midcap index saw an even lower profit after tax growth of 3%.

So, what does this mean for companies in 2012?

Anish Damania, business head, institutional equities, Emkay Global Financial Services, calls this a funnel effect and says a small change in sales growth will have a magnified impact on net profit growth in the future.

The impact of global uncertain-ties is not limited to globallyexposed sectors such as information technology, services, metals, refining and petrochemicals but also sectors focused on the domestic economy such as banking, automobile and infrastructure. This can be seen in the stock prices of companies in these sectors.

Another dark cloud on the horizon as we move into 2012 is the 17% depreciation of the rupee against the US dollar in the last few months. This has had a big impact on companies that depend on imports and a handful of large companies playing the interest arbitrage game between their domestic and foreign loans. This can be another spoilsport in 2012.

Is There a Silver Lining?

As of now, it is difficult to see any of the above factors turning positive quickly enough to drive up the stock markets. Globally, Europe’s leaders have taken steps to rescue their troubled economies, but the general view is that more needs to be done. Any positive news from Europe could lift the gloom in 2012.

Thakkar of Angel Broking says it is a challenging situation and likely to keep the markets jittery.“Any calamitous event will affect India also in the short term irrespective of relatively better fundamentals,” he says.

However, there may be a positive surprise on inflation, which may begin to decline as the large base of last year takes effect. Apart from crude oil, prices of some commodities have cooled. It seems the wholesale price inflation may come down to 7-7.5% by March 2012 from the current level of 9%. If this happens, analysts expect the RBI to stop increasing interest rates and perhaps go for rate cuts in the coming months.

Thakkar of Angel Broking has a different view. He says with the rupee falling against the US dollar, making imports expensive, inflation could be 8-8.5% even in March, which most experts say is clearly not good enough.

Also, domestic concerns remain. For instance, in agriculture, supply is lagging demand and it appears that India may continue to grapple with food inflation for some time to come. Moreover, even if we put aside the near-term fluctuations in commodity prices, the experience of recent years shows that several emerging markets are facing resource constraints that have started to impact growth.

So, all in all, while we may get some relief from inflation and high interest rates, it may not necessarily be a material trigger for the markets. “Actual lending and deposit rates of banks will start heading lower only if inflation consistently stays in the 5-6% range, which cannot be assumed a given at this point,” says Thakkar.

Banking on FIIs

Another factor to watch out for in 2012 will be the return of foreign investors. Whether we like it or not, foreign institutional investor (FII) inflows have a huge influence on our markets. For instance, in 2007, FIIs pumped in $16 billion and the market rose 44%. This was followed by a 45% drop in 2008 when FIIs took out $12 billion. In 2009, the Sensex rose 85% amid FII inflows of$19 billion. It rose 25% in 2010 when FIIs invested $30 billion.

However, FII investments depend on global factors and attractiveness of India relative to other emerging economies. “We believe developed economies will grow at a very slow pace. Thus, money will seek more attractive destinations in emerging markets,”says Shah of Kotak.

India will be able to attract FIIs if it makes policies more investment-friendly. Also, more action is needed to control inflation and improve supply of food items and raw materials for industry.

“So, assuming that interest rates and reforms play out favourably, the markets may find support at current valuations, subject to volatility in the near term,”says Shah.

Are we in a Bear Phase?

The situation today is very different from a bull run, like the one seen in 2004-2008. That was supported by strong global growth. India, too, benefited due to low inflation, a strong fiscal situation and high corporate profitability. Its GDP was growing at 9% while the profit after tax growth of Sensex companies was 19%. Things are different now. The GDP growth rate is 7-7.5% while corporate profit growth between 2009 and 2012 is expected to be a more moderate 16%.

Globally, demand has started falling after the end of the stimulus after the 2008 crisis. India is afflicted with high inflation, rupee depreciation and falling savings/investment. Further, industrial output fell 5.1% in October compared to 3.5% expansion during April-October 2011 and 7.8% in the 2010-11 financial year. Since corporate earnings are sensitive to GDP growth, this will reflect in earning estimates of companies.

Based on these factors, the consensus estimate for Sensex earnings has been pegged at 10-12% instead of the usual 15-20%. Further, any shock from global macro-economic instability can result in stagnancy in earnings akin to in the 2008 crisis. Experts say greater portfolio risk-taking should happen when there is macro visibility, earning downgrades are over or valuations become attractive. None of these are evident now.

Having said that, the Sensex is at 12x–12.5x FY13 consensus estimates, the lower end of the longterm range. Based on this, it may not fall significantly unless there is a catastrophic event.

A Sea of Red

During the last one year, BSE realty, capital goods, metal and power indices suffered the worst losses as they bore the brunt of the global turmoil and rising interest rates

Growth Pangs GDP growth (in %)

Sensex’s Beating Retreat

Easing At Last Inflation (in %)