Sep 2013 : Setup Conditions for Bull market falling into place

The Indian equity market was down over 8% over Jun-Aug due to currency weakness across emerging markets and a domestic economy that continues to face head winds. We had written last month that ‘crisis precipitates action’, and are pleasantly surprised to see a spate of positive announcements during the month. These included measures to encourage FCNR(B) inflows, allowing banks to borrow up to 100% of their networth overseas and freeing up FII debt flows. With the US Fed deciding to delay its ‘QE taper’, emerging markets recovered and so did Indian markets. The Rupee also saw a recovery.

Over the last 4 years, the Nifty has traded in a band of 5000 – 6000 for nearly 80% of the time. Though there is widespread concern about volatility in the Indian market, in reality, volatility in the Nifty has got crunched to historic lows. Here we are using a simplistic measure of volatility – assume the Nifty trades at a low of 100 and a high of 150 in any given year; we measure volatility for that year as 50% (150 / 100 -1). Over the last 20 years, the high-low volatility of the Sensex, as measured above, has averaged 56% per annum. Over the past 4 years, this volatility has dropped down to below 30%. In the current calendar year, despite the market being either up or down 3% on a given day a number of times, for the year as a whole, the volatility is only 17%. Over the past 20 years, the last few years of a bear market has been associated with low annual volatility.

When the market peaked in Jan 2008, it traded at 28.5x earnings. So far, this year’s bottom of 17,450 places the Sensex at 15.5x earnings, which is near the low of the range of 15 – 23x that the market has historically traded on average. Between 2008 and 2013, the revenues of the Nifty companies have been averaging 17% per annum growth. If revenues had been Rs 100 in 2008, then 2013 revenues for Nifty would have been Rs 225, a fairly attractive rate of growth. At the same time, earnings per share (EPS) have grown from Rs 100 to only Rs 138, indicating margin compression. This was partly due to a 35% fall in profits of the 16 companies that were replaced in the Nifty. The new entrants in the Nifty have been averaging 18% annual growth in profits. If we look at the current Nifty basket of 50 companies, EPS of Rs 100 in 2008 would have been Rs 177 today. Thus, the consolidation phase in the Nifty, over the last 5 ½ years, is combination of a price to earnings (P/E) compression and margin compression, which has been compensated to some extent by healthy revenue growth. Also, the poorly performing companies have been replaced by stronger companies.

We believe that the setup conditions for a structural bull market in India are beginning to fall into place. Firstly, the market is trading near the low end of its historical trading range. Corporate revenue growth, averaging 17% over the past 5 years, has been healthy.The surviving companies in the Nifty have been showing brisk revenue growth. We believe the margin compression cycle is nearing its end. The next bullish phase in the markets will be led by a combination of reasonable revenue growth, margin expansion and valuation expansion. Though the current macro-economic conditions are looking difficult, much of it is factored into the low valuations and compressed margins.