New Delhi: The high valuation of Indian stocks was perceived to be the reason for their underperformance in recent times. However, it emerges now that investors’ concern is more fundamental in nature, rather than their ability to pay higher price.
A study done by Morgan Stanley analysts Ridham Desai and his team found that the return on Equity (RoE) premium which Indian companies enjoyed over their emerging market peers has significantly narrowed.
Morgan Stanley notes:
Corporate India’s massive capex cycle between 2005 and 2008 seems to be the key top-down reason for the compression in RoE. It appears from the bottom-up data that capacity utilization has not reverted to the levels as in the early part of the previous decade. Another theory is that capital intensity has risen over the past few years causing an ROE decline.
High capital expenditure and the subsequent slowdown in global economy compressed Indian companies’ returns. RoEs are expected to improve as capacity utilization gathers pace. Higher capacity utilizations are expected to help Indian companies improve margins. However, increasing margins are unlikely to reach previous highs.
Desai & Co write:
Even as ROE may rise from its current low levels as growth gains pace and capacity utilization rises, the excess ROEs relative to local long bonds that large Indian companies earned between 2004 and 2008 may be difficult to replicate. Excess ROE could, of course, recover from current levels.
So what led to lower RoE? Falling asset turn seems to be one reason
However, not all is doomed on RoE front. Over the last one-year, consumer staples and healthcare companies are leading the expansion in RoEs. In the long run, Morgan Stanley analysts also found RoE expansion in consumer discretionary and companies in the energy space.
Here is why Morgan Stanley analysts think RoEs will improve:
1) GDP growth, industrial growth, and earnings growth correlate well in India–higher growth should translate into earnings growth; 2) balance sheets are under levered–Indian corporations have historically exhibited good discipline in raising equity, although easier access to global capital flows is the downside risk, and 3) India’s growth dynamic–including its balanced economic model–lends itself to lower cyclicality in earnings, as we have seen over the past 10 years.