NIFTY Valuations appear low, but you haven't seen the worst of the Indian Economy yet (and why HUL is not such a safe haven as you think)

In my memory, I have never been so bearish on the Indian equity market. No sir, not even after the 'Lehman crisis'. The 2008 crisis was easier to handle for an Indian investor - commodity prices had crashed, the Indian banking system was robust and largely unscathed, fiscal deficit was much better than what we have seen in this country’s past, interest rates were at comfortable levels, and brent crude fell to USD 140/bbl and stayed below USD 80 almost till end of 2011.

Closer to end of 2012, none of these positives exist anymore. In fact, I believe that it would take quite some time before the sins of the banking sector are washed away. For fiscal deficit, there is absolutely no hope with crude at current levels and tax collection growth sputtering to a halt. You can, of course, look at the Nifty PE and rejoice that the market valuations are below historical averages. But then, the overall valuations are being dragged down by a host of construction and capital goods companies, which nobody wants to touch with a barge pole. If you want to buy into ‘quality’ earnings, you would have to pay something close to a PE of 25 for TCS (close to its five-year median, when the world was a much better place for IT outsourcing), an eye-popping 40-plus for the likes of Nestle and HUL, where the general belief seems to be that if they cannot eat bread, why don’t they consume cake instead, and 20-plus for almost all pharmaceutical companies, where the upside is not so much from an unhealthier world than an unhealthier rupee. If you ask me, I would still go for the pharma companies than the overvalued IT and FMCG pack. There are still Unichem Labs and Ajanta Pharmas of the world that are reasonably valued. In fact, it makes me wonder, in a world where the FMCG index has been outperforming almost all others for quite some time now, what exactly are we thinking?

Source: ACE Equity

Now, coming back to the Nifty PE, one can always argue that market has given more than 15% returns ‘x’ percentage of the times when it traded at a similar PE and history is therefore with us. We saw a similar run up when the Nifty traded at close to 14-16 times in 2004-05 (same as current levels). That might be a grievous mistake. The problem is, on a forward basis, even factoring in FY14 EPS, there is not much to cheer about (unlike 2005). What are the chances that India grows at GDP rate of 7.5% and more in the coming four years? What all needs to come back on track? Assign a probability to each of these events, multiply them, and I would say 15-20% at best. You would need to see
1) a lot of liquidity,
2) a strong, unbroken mandate at the Government’s centre,
3) lot of FDI money flowing into India to compensate for the weakening exports,
4) Brent crude at less than USD 100/bbl, and
5) none of the tinderbox countries of Iran, Israel and a fistful in the African continent going to war.

The probability of a downside is huge. GDP can slip back to the Hindu rate of growth because the service sector juggernaut collapses, something which should be a logical aftermath of stagnating IIP, while the aftermath of the Eurozone crumbling down would dent export growth.  A nightmarish scenario also includes crude getting just too expensive, and where Indian banks see ballooning NPAs because they have lent just too much to a few large industrial groups (whose assets by the way are valued extremely cheap by the equity market). The probability of this bear case too would be 15-20%. Thus, in the case of a 4-6% in GDP growth, the PE is either just right, or for the cautious investor, the market is overvalued.

The worst sector to invest now would arguably be the consumer plays, including the auto sector. How can 90% of the Indian industry make losses or stagnate, while the general populace goes on a shopping spree? And mind you, there is no Government stimulus in this case too. Where is the money in the customer’s pockets coming from? Probably the market feels that any growth is better than negative growth. That is not for me. I would keep my hands away from Nestle (which is selling elite, packaged food, something that is among the first things to be cut on the grocery list when earnings take a tumble) and HUL (where the products are already so saturated that while you can digest the assumption that more people would be using beauty products, the growth in soaps and toothpastes is not sufficient to shell out 40 years of earnings). In the case of HUL, one should also realize that its fundamentals are no better off today than they were five years earlier, but the PE is significantly higher. You just can’t read so much into a few quarters of earnings. And P&G is not dead yet