Both the Bombay Stock Exchange’s Sensex and the National Stock Exchange’s Nifty indices crossed important levels of 20,000 and 6,000, respectively, on Tuesday. This is the first time after January 2008 that these levels have been reached, and both are only about 4% lower than their peak levels in early 2008. In local currency terms, the MSCI Emerging Markets Index is around 18% lower compared with its peak in late 2007, while the MSCI India Index is lower by around 10%.

The Indian markets have been the main beneficiaries of increased foreign investor fund flows into emerging markets this year, with investors being captivated by the superior growth prospects. But a look at the chart alongside shows that while the rally between 2003 and early 2008 was supported by a rise in the return on equity (RoE) of Indian firms, the current one comes in the backdrop of declining RoEs. From around 25% in April 2008, RoE of Nifty companies has declined to 16% currently.

Also See Divergent Trend (Graphic)

Are investors ignoring the rapid decline in return ratios or are they instead expecting a rise in return ratios in the coming years? Adrian Mowat, JPMorgan’s chief Asian and emerging markets strategist, says one shouldn’t give too much importance to return ratios in the past couple of years since there was a synchronized global recession. While there was a recovery in 2009, the improvement wouldn’t be fully reflected in return ratios of fiscal 2010. He points to the expected improvement in MSCI India’s RoE to 18.2% in fiscal 2011, from 16.7% in fiscal 2010 and 14.7% in fiscal 2009.

In comparison, RoE for the MSCI Emerging Markets Index constituents is expected to be 16.6% in fiscal 2011, putting India in the top quartile among emerging markets in terms of return ratios. Mowat says that return ratios are higher in markets such as Mexico and Indonesia because many companies in Mexico enjoy oligopolistic conditions, while Indonesian companies bear a relatively higher cost of capital. Consensus RoE estimates for MSCI India for fiscal 2011 are higher than fiscal 2010 based on market data from Datastream, according to an equity strategist at a domestic brokerage.

Another reason for the drop in return ratios is the change in the composition of benchmark indices such as the Nifty and MSCI India, with an increasing proportion of low-return firms from infrastructure-related sectors joining these indices.

Having said that, it must be noted that capital expenditure in India has continued to be high through the slowdown and is expected to remain high in the near term. If Indian companies don’t manage to make commensurate returns on this invested capital in the next couple of years, expectations of a rebound in return ratios would be belied. This would put to question the high premium Indian equities are enjoying.

Graphic by Paras Jain/Mint

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