Nov 2012 : Stock markets trailing economic growth

The Indian stock market was steady through most of the month. The rally towards the end of the month helped it close strongly – up 4.6% for the month. After a strong September, driven by policy action from the government, the market consolidated for a good 6-7 weeks and then once again surged upwards. The Nifty hit 12 month highs, despite the continuing negative news surrounding economic growth, inflation and slow policy action. Our portfolios did well during the month, mostly performing better than the Nifty.
The Indian stock market peaked in January 2008 and has pretty much gone nowhere over the last 5 years. Over the same period, the Indian economy has grown from Rs 42.9 trillion in FY2007 to Rs 88.6 trillion in FY2012. The RBI announces GDP in Rupee terms annually (technically called ‘GDP at current market prices’), which interestingly has more than doubled over the past 5 years, averaging an annual growth of 15.6%. Notice that this is very different from the real GDP growth which newspapers talk about, which is closer to 7%. Nominal GDP growth in the prior 5 year period of FY2002-FY2007 was actually slower. GDP grew from Rs 23.5 trillion in FY2002 to Rs 42.9 trillion in FY2006-07, an annual growth rate of 12.8%. The stock market, on the other hand nearly quadrupled from FY2002 to FY2007 while it has been almost flat in the next 5 year period. The reason for this disparate performance over these two time frames, is the valuation at which stocks were trading at the beginning of each period. Today, the stock market is trading closer to the valuations in 2002 than to the valuations in 2007.
Since we invest in companies, or small slices of companies in the form of shares, the prospects of our investments are linked to the respective company’s revenue and profit growth. On an aggregate basis, all companies’ revenues are more correlated to the growth of GDP at current market prices, rather than the real GDP growth. A good bit of the difference can be explained by inflation, but other factors also come into play. We are pleased to confirm that the basket of companies we have chosen to invest in have grown at a rate of about the 15.6%, or better, over the past 5 years.
As you can imagine nominal GDP heading in one direction (and as a corollary the revenues and profits of the companies heading in the same direction) and stock prices not following them is not a sustainable situation. One cannot have companies, with very strong free cash generating capability, growing their revenues but their stock prices not growing correspondingly. Many stocks are bridging this gap and as a result we have seen equity markets perform in the current year. Despite a decent stock market performance for the year to date, we continue to see interesting opportunities on a selective basis.
Economic growth has been fairly strong over the last decade and it is highly likely that growth will continue to be good over the next decade. Stocks, when chosen well, should be able to track this growth and deliver satisfactory rates of return to investors. With markets having stayed flat over the last 5 years, there is an additional margin of safety built into the system at current levels.