Why Morgan Stanley’s Ridham Desai Sees More Room For Rally
Ridham Desai says investors have not fully priced in the ‘ferocious earnings cycle’ expected in the next five years.
The Sensex has risen to a record and is trading higher than its historical valuations. Still, Morgan Stanley’s Ridham Desai says the valuations aren’t expensive and there’s room for growth.
“There’s still a fair bit of scepticism out there. I don’t think people have participated [in the rally],” Desai, managing director and head of Indian equity research at the New York-based investment bank, told BloombergQuint in an interview. “It’s been all too quick and swift.”
Desai expects growth in the shorter run if the pessimism surrounding the Indian markets subsides. “As far as valuations are concerned, I don’t think the market is rich.”
The valuations—at 3.2 times the price-to-book value—are neither expensive nor cheap, according to Desai. Investors know that the earnings cycle would turn, he said, but they aren't fully pricing in the “ferocious earnings cycle” that’s expected to kick in over the next five years.
With an increase in the inflow into passive or exchange-traded funds, foreign investors have a reduced exposure in the market than what was seen historically, Desai said. For him, that indicates room for more inflows.
Election Interest Feels Like 2004
Desai also said the general interest in Indian elections, growth prospects and economic agendas is similar to what it was 15 years ago. “This feels like 2004.”
The markets will correct if India decides to vote in a fragmented government, he said. The ongoing quarter, according to Desai, will be unfavourable due to uncertainty about the general election. A potential upside to global economic environment would hurt India, he said, as that would lead to higher prices of commodities such as crude oil. “India’s correlation with world equities have turned negative.”
Morgan Stanley expects the global markets to be okay, Desai said, noting that the bank has cut the probability of a recession in the U.S. to 20 percent from 30 percent.
We’re very optimistic on Chinese growth. There has been a fair bit of action by Chinese policymakers to offset the U.S.-China trade tensions, which will cause China’s growth to actually accelerate. If something gets resolved on the U.S.-China trade front, which looks increasingly likely as time passes, we’ll be surprised slyly on the upside with the global growth. It brings a little bit of risk to India, as it gets accompanied by higher commodity prices, notably oil, that does put a lid on India.Ridham Desai, MD, Morgan Stanley
- Expects banks to benefit from the slowdown in lending by non-banking financial companies.
- Sees slow growth in NBFCs, hurt by increased liquidity and lower demand.
- Says now is the time to buy automobile stocks.
- Says only rich valuations are seen in consumer staples.
Watch the full interview here:
Read the edited transcript of the interview here:
Last time, you said that conditions are not conducive for an up move but prices are. It may have been a labored move, but it happened. What’s next?
There is still a fair bit of scepticism out there. I don’t think people have participated. It has all been too quick and swift. There is too much of pessimism from October, November, December and to a lesser extent to January and February. The pessimism is still there in the air. It has not gone away. And therefore, the markets have little bit to go in the short run.
Equities remain a long-term asset class. These things keep happening and they go up and down in the short run. But investors are best advised to just hang on there and create a retirement fund out of equities.
Up until two to three months ago, your top index target would have been 11,500. No one even briefly mentioned re-scaling to previous highs.
We started the year with 42,000 [Sensex target], which looked very outrageous. But the point I was then making was the ballot will fade in importance by the time June comes. So, I was not even making a call on elections. I don’t get into it, because calling election is very hard. My premise was India’s growth cycle is turning. To that extent, the bids will come back to equities at some point in time. It came a little quicker because things changed on the political front. I still feel ballot will fade in importance and what will start to matter at the end of May is how India’s growth pans out, which is looking okay.
The only caveat there is oil and we have to keep an eye on it. Oil is going up for supply side factors and not demand. Supply is dominating and that is not a good thing for India. If oil keeps going up, then it will create little bit of headwind.
While we know that this will be a big liquidity-driven rally, has the retail participant sidelined in up move?
We have $6 billion of issuances ever since the start of the year. Institutional flows on a net basis has been less than that, foreigners and domestic. So, it means that retail is pretty much ahead. Otherwise, you would not be able to do $6 billion of issuances. It is a solid number as compared to last year, coming in the first quarter of this year.
This all has happened quickly in the last one month and almost on a daily basis you have been seeing a big up move coming in.
Flows lag prices. Let’s not think that flows drive shares prices. Prices went up. There is a small lag between flows and prices. So, prices go up, bid comes back and then flows come in. The bid is different from flows. The bid is psychological. The same shares were trading at a 20-percent low price a month ago, and nothing has changed and the prices have, because the psychology has changed. That psychology is about confidence in the future of the company, markets and the economy. That is the combination of various market participants playing in.
I would say retail, high-network has been as involved as foreign investors in the last two months of the move. That is evident in the way broader market has moved. It is not just large cap rally but broad-market based rally. So, psychology is back. Nothing has changed except the psychology, and that is why I have more confidence in India’s future.
There are more exchange-traded funds money coming to India which was not the case in February when other emerging markets got the money. Is that the case? Would you reckon that India-dedicated funds will start getting money looking at the outperformance, political stability or otherwise? Would that play a part in driving up the already expensive market to even higher levels? Also, are India-dedicated funds sizeable or will they get sizeable, apart from the fact if you remove from the emerging market allocation that comes in?
I don’t think the market is rich. It is 3.2 times price-to-book value that is bang in the middle of historical range of 2 times and 4 times. Earnings are very depressed versus history. If you want to look at price-to-earnings ratio, then normalise the earnings. Earnings are not secular. They are cyclical in nature. It is not like a consumer stable company earnings, which variably go up every year, and therefore PE is a good or reasonable metric. If the market is whole, the earnings go upswing and downswing. This market has seen an earnings draw down which is unprecedented in India’s context. It was down 22 percent from peak to trough. That is a very big decline in earnings. Whereas over these periods, if you use historical averages, the earnings should have actually compounded, maybe 13-14 percent every year. So, that is a big fall in earnings versus trends.We measure the profit share in the gross domestic product and that is at the level which was last seen in 2001. So, the market is not rich. But I don’t think it is cheap either. But it is somewhere in the middle. So, it knows that the earnings cycle will turn. When it is not fully pricing in of what would be the ferocious earnings cycle over the next five years. We could see earnings compound at 20 percent for five years and I don’t think that’s in the price. As far as valuations are concerned, I don’t think the market is rich. It looks interesting when you look at broad markets. So, one of the means to measure is the market cap to GDP where it is comfortable at about 70 percent, which is not outrageous. This market has traded 100 percent in the past. We have some journey to go for valuations to get worrying.
For the foreign investors, it is hard to authenticate with data because you don’t get granular data of flows. There is passive and ETF money which is coming in over last two years. This is good news. Active fund managers have trimmed their positions on India to eight-year lows at the end of the last year. It has now come back from there, but it is low relative to history. Exposure to India is a little lower than history and therefore, it has the room to go up. That means there is more money which is waiting to come.
Based on anecdotes and the conversations I am having, this feels like 2004. The type of people who want to know more about India as what is happening, what is happening in elections, what happened to growth, what is going to happen of the next government’s economic agenda, etc., it feels like a different type of people are now getting interested.
In your mind, do those people will stay interested even if the current dispensation doesn’t come back with a thumping majority?
If India decides to vote a fragmented government, there will be a correction. Now the market is pricing in a majority or a near majority. That is, if the next government comes in with 240-250 seats and will get another 30-40 seats and form a government. That is now increasingly priced in. May be there are a few more points to go before it gets fully priced in. That’s the risk. Any event,when you go into it and it is priced in, then the risk is that the market sells off.
I hate to make short-term calls, yet I make them. This quarter may not turn out to be a very good quarter in terms of share prices. So, India may underperform EMs. By the time, we get to the end of May the market may have priced in election outcome and then you will get some correction in June. If you are a trader, you want to sell this as it crosses all-time high. Now that it has touched an all-time high, it has made a move ahead. And then you have to lighten up, wait for the elections to get over and then come in. That’s the better risk management for a trader. It doesn’t apply to investors but for traders the next few weeks will give you an opportunity to exit and come back at a later stage. If India decides to vote a fragmented government then you will get perceptible correction in stocks. Going by what I feel is going to happen in the next four to five weeks is we will be fully priced in majority or near majority government.
It is interesting because we are just down three months this year and we are already at a record high.
Record high is not relevant at all. By its very nature, equities tend to gain overtime and they keep making new highs.
From investors’ point, it is not too late to make investments. Right?
From investors’ standpoint, the time to buy is when the sentiment is terrible. So,the time to buy was good in October and February. You have not missed the bus but that is a juicy stage. When you get into stocks and when they are hammered,and nobody wants to buy them, there is a lot of ego satisfaction you get when the rally comes. Now you don’t have ego satisfaction but returns, and it is less than what you would have if you had bought in January and February. It takes enormous amount of courage and patience to participate when the market is falling. When the market is rising it is a lot easier.
There are still a lot of stocks which look depressed relative to fair value. So, there is still a fair bit of juice left. Those are the ones which will outperform like industries, consumer discretionary, auto stocks, non-banking financial company stocks. They are well off their highs or fair value. They are still little bit left.
But the sentiment has still not changed for you to say that I will start investing right now?
It’s never too late to invest in equities. I was looking for an investment which was made for my daughter in 2000 and that is up seven-fold in a balanced fund which has a compounded annual return of about 12 percent. It’s not a bad outcome, even though I had invested when markets were at a high. It evens out over time. If you’re genuinely a long-term investor, if you have invested in the peak of January 2008, which in subsequent year turned out to be terrible decision because stock prices fell 50-60 percent, then you’re okay. You’re coming out fine now in 10-12 years. But you must have genuinely long-term view and ideally it should not be the only occasion to buy. Hopefully, if you bought in January 2008 and then you again bought later in 2009, your returns are actually good.
So, buying at an all-time high is not a problem. For investor with 5-10-year view, it’s not a problem. The chances are India will do well as an economy and a stock market and over 5-10 years you will make more than adequate returns. Equities will eventually outperform bonds, fixed deposits and real estates.
Banks have near steady and secular earnings growth and their price-to-book earnings for large quality NBFCs or banks are high.
May be a couple of them but not across the board. I don’t like to make distinction of corporate and retail as that distinction no longer exists. Banks do everything. Let’s talk about the banks which bore the brunt of previous non-performing loan cycle. They are trading somewhere between 0.5-2 times book with potential return on equity between 10-15 percent. You’re entering into a pretty strong earnings cycle for these banks. They may end up doing 50-60 percent compounded annual earnings growth for next three years because there is no credit cost. They must charge their profit and loss. It looks like pretty environment for these banks and therefore you will still make money from these levels. There are couple of bank stocks which have very high return on capital and therefore command a premium but those are very high-quality businesses. They have been rewarded because they did not participate in the non-performing loan cycle.
The banks don’t look rich to me. Banks aren’t the problem. The only segment where the valuations are rich, and the stocks refuse to sell off is consumer staples, but now they have started to underperform. Consumer staples underperform significantly in the month of March and the rest of the market plays catch-up.
Where within this whole wide spectrum of financials and not just banks would large money find comfort in coming in? Would it be those expensive names or corporate facing banks or something else?
There is still some anchoring to the performers of last five years. So, there is still some money left coming in those banks. Any company which has done well over the last 5-7 years, it was tough economic cycle. If you have done well, then it underpins strong management, businesses, moat and then people will back you. Money will also come in to those who have underperformed over last seven years if the economic cycle is turning as I feel it’s because those are the ones which will produce delta in earnings. You will get mixed bag in the middle and then the laggards start outperforming, then the money will come into them as well.
Consumer staples and automobiles as a pocket is very depressed and sentiment seems to be negative with regards to month-on-month volume numbers and even ground situation doesn’t seem to be picking up. How do things change from here? Anything interesting which suggests that now is the time to look at these markets?
Yes, certainly. I think the auto stocks are going through that November movement. Environment is not conducive but prices are. I am bullish on autos. I am buying all of them. You will see that data will turn. They have gone through issues. They underestimated the impact on demand coming out of liquidity crunch that the economy faced briefly between October and January. Inventory in the pipeline got stuffed and now they must wind that down. Secondary demand is okay but there is too much inventory and consumers are smart. They know this is the time when they can eke out discounts because people want to flush out that inventory. You have insurance problem. Then there are some changes happening due to emission norms. So, few things got bunched up and it will get settled in next couple of months. I am bullish. Now is the time to buy auto stocks.
You don’t think there is an NBFC problem which is causing a little bit of the drag?
It was, but now the worst is behind us. In November, a lot of people thought that NBFCs will collapse, which didn’t happen. It’s slowing in terms of growth because whatever happened in September and January forced them to increase liquidity on their balance sheets and increase capital which slowed growth. To that extent, demand was affected. Some of the growth will be taken over through banks but NBFCs are going to grow slower this year. Now, the markets are pessimistic about NBFCs.
It is not a bad environment because I sense that central bank has shifted its stance. They say that central banks kept real rates a tad too high because they have inflation target starting 2015. It is natural that central bank is pursuing the target and making sure that it did not miss it. It is possible that they keep the rates too high. We heard the RBI talk about it in the February policy that their inflation forecast has gone wrong which is essentially that we were keeping higher inflation rates so that we not miss the target. But now that you have successfully met the target, the recent action from the RBI, which is the dollar swap, suggested that they are lot more accommodative to grow. So, they are relaxed for inflation environment. That is good for NBFCs because liquidity will improve.
What about NBFCs curtailing offtake to investors who want to start making purchases in autos?
I think the worst is over. Auto financing is not a unique product for only NBFCs to perceive. Even the banks can do it. So, to that extent it is positive for the banks because some of the space which was being heavily competed by NBFCs has been vacated by NBFCs. NBFC which have good depository franchise and not hurt by this liquidity will gain share in housing finance too.
Couple of things have changed from 2018 like Federal Reserve’s and International Monetary Fund’s commentary. IMF commentary spoke about how fragile the world outlook is looking on growth. We started off our conversation with if India’s growth still looks okay but what if the world starts underperforming on growth? And there is this cushion which central banks provide, how do you read those situations and its impact?
There is a material shift in Fed outlook which has put floor to U.S. growth rate. If you go back to the start of the year, there was greater risk of U.S. sessions. We had put it at 30 percent. We lowered it at 20 percent. If anything becomes optimistic about growth, we are very optimistic on Chinese growth. There has been a fair bit of action by Chinese policy makers to offset the U.S.-China trade tensions which will cause China’s growth to accelerate. If something gets resolved in U.S.-China trade front which looks increasingly likely as time passes rather than not, we will probably be surprised with upside to global growth. To that extent, it brings risk to India because it gets accompanied by higher commodity prices, notably oil, and that put a lid on India.
This quarter India may end up underperforming. EM is linked to two things. One is our own idiosyncratic election event and second is the fact that the world would be okay. If globally equity needs to price in more growth. When we last checked, India’s correlation with world equities has turned negative. So, if the world is doing well India will likely underperform. It will not fall but it will underperform and that could be the template for this quarter. We are very bullish on EM. We are bullish on Japan and we have turned bullish on Europe. The only market which we are still not constructive is U.S. It is constructive view Morgan Stanley has on equities. India will do well on absolute basis but may have to take a few periods of underperformance while that gets rolled out.
What is one big opportunity and one big threat for Indian equity investors?
I think appreciating rupee could be a problem. Given that RBI has more dollar swaps in pipeline, and they have done just one and announced the second one which could be more and given that foreign portfolio investment flows will be strong and if oil is well behaved then India’s balance of payments could look good this year compared to the last year. To that extent, rupee may face upward pressure and when that happens it taxes earnings in India. I don’t want rupee to gain too much in real effective exchange rate basis. It should not be up while India suffers inflation differential with the rest of world. That could put strain on growth. That is a threat.
The opportunity is, notwithstanding the new high which we are seeing this morning, psychologically the market is not fully repaired. We will be surprised to the upside as how much more this rally may have before it gives its first decent correction because people will feel left out and then come to participate. I can see that. In my office, nobody bought shares in January and February. So, that could be a big surprise for the quarter which is that I go wrong and stock prices materially go high in India and have no problem outperforming the world.