Valuations too high for Indian equities


India’s economy is growing strong and its equity market benchmark, the BSE Sensex Index, is trading at a high forward price earnings (PE) multiple as investors are pricing in further high growth.

For the financial year ending March 19, 2019 (FY19), the forward PE ratio is at 21.5 times. With an expected earnings growth of 23.7%, FY20’s forward PE ratio is at 17.4 times, which will bring the Sensex to slightly below its fair value.

Historically, analysts have been overly optimistic of India’s earnings growth, with an average revision of -9% annually since 2012.

Average estimated earnings growth since 2012 has been about 6.7% annually, a far cry from the estimated 23.7% and 17.6% growth priced in for the next two financial years.

We believe there is room for downgrades in the future, thus pushing valuations further up if prices do not come down.

If we account for analysts’ optimism and downgrade the earnings to be in line with the past, we will get an annualised returns of 5.1% (inclusive of dividends) on the Sensex for the next two years if we assume prices will revert to the mean, which is our fair PE of 18 times.

If we assume the consensus estimates are right, we will have an annualised return of 8.3% over two years.

Comparing this against the yields of its local 10-year corporate AAA bonds and sovereign 10-year bonds (8.7% and 7.4% in local currency as of Feb 4), the returns are not very attractive, particularly for an emerging market which is typically riskier.

Although we might miss out on some potential gains due to India’s fantastic growth story, the opportunity cost of lea-ving/investing funds in India is quite high and there are other markets that are looking more attractive.

On the upside, if the US Federal Reserve pauses or cuts rates, the Reserve Bank of India could follow suit, thus boosting earnings growth prospects.

At the sector-level, most sectors are forecast to grow at fairly high levels in  2019, save the consumer discretionary sector, which is heavily affected by Tata Motors Ltd’s heavy losses.

For healthcare and industrials, they are basically single stocks of Sun Pharmaceutical Industries Ltd and Larsen & Toubro Ltd respectively. For Sun Pharmaceutical, its price has been hit badly due to a financial scandal.

Reliance Industries Ltd makes up the majority of the energy sector and represents 10.75% of the whole Sensex. Its high estimated earnings growth for FY19 and FY20 of 14.7% and 20.5% is also a big factor for the aggregate estimated earnings growth.

Stocks like the State Bank of India, Axis Bank and Hindustan Unilever Ltd are overvalued — and investors have priced in questionably high growth prospects. 

Hence, we believe there are better investment opportunities in China if we examine the current environment from a risk-reward perspective.

If you currently have a large exposure to India, consider gradually reducing your allocation and rebalancing to other markets.

Although India remains a good investment prospect for the long-run, current prices may not be a good time to enter the market.