Mark to Market: RoE is rising: will stocks follow?
Sep 21, 2012 (Menafn - Mint - McClatchy-Tribune Information Services via COMTEX) --Morgan Stanley India Co. Pvt. Ltd published an interesting report last week saying the correction in India's return on equity (RoE) seems to have completed. The foreign broker believes the trend of declining profit margins is likely to stop in the coming 12 months. Additionally, it says that asset turnover ratios have picked up and are at a three-year high.
Put together, India's RoE gap with emerging markets is expected to resume an upward trend after falling for the past five years. As the report notes, India's RoE is still better than that of its peer group, but the gap is now close to an all-time low at a mere 1%.
India's relatively high return ratios have helped it command premium valuations in the past. Will an improvement in RoE result in an improvement in valuations in the near future? Morgan Stanley doesn't draw any market-wide conclusions; it says its RoE analysis can be "useful to highlight stocks that may be over- or under-valued and especially as a filter or potential starting point for portfolio construction".
To be sure, investors are unlikely to be impressed merely with a gradual improvement in return ratios. The bigger worry is the unimpressive rate of earnings growth expected in the next two years. An equity market strategy report by Kotak Institutional Equities says, "The Indian market looks quite expensive in the context of very modest earnings growth over the next two years."
According to Kotak's estimates, the Sensex trades at 15 times earnings multiple based on its FY13 estimates, while earnings of the underlying firms are expected to grow by merely 8% and 11.5%, respectively, in FY13 and FY14.
One can argue that the recent reforms announced by the government, coupled with the improvement in return ratios, are likely to attract foreign fund flows. But as analysts at Kotak point out, it makes more sense to focus on fundamentals rather than get carried away by liquidity.
"Liquidity by itself cannot sustain markets forever, unless it is backed by strong real economic growth and corporate earnings. We note that India has received over 42 billion of net inflows by foreign institutional investors from January 2010 and yet the market has returned a paltry 3% over this period (minus 13% in dollar terms)," says the report titled Long on Liquidity, Short on Idea.
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