This article was published in the November edition of The Global Analyst.
It
is a common question to probe as to where would the Sensex be say in 5, 10 or
20 years. Currently Sensex is trading around 20,000 levels and its historic
peak was 21,206.77 achieved on January 10, 2008.
To
cut a long story short, let me tell you first my findings and launch into
explanation later. I expect Sensex to touch 51,000 by 2020 and circa 100,000 by
2025.
Sensex
had a modest beginning in 1978 when it was launched with a base value of 100.
Granular level data is available only from 1991 in the Bombay Stock Exchange
website. In the 90’s it crossed 1,000 and in the 2000’s it crossed 4,000. In
its 35 year history, Sensex averaged an annualized return of 17.3% outclassing
all other asset class performance.
While
the base case call for Sensex in 2025 is circa 100,000, the optimistic call
could be 155,657 and pessimistic call could be 68,454. The situation such
optimistic or pessimistic scenarios could unfold is explained later. The base
case call of 100,000 implies an annualized performance of 13.4% between 2012
and 2025 compared to 14.14% achieved during the last 12 years.
The
period between 1980 to 2000 can be classified as “lost decades” where average economic
growth (measured in real GDP) was below 6% with high inflation. Even under such
circumstances, Sensex performance was exemplary especially during the decade of
1981-90 where the annualized growth in Sensex was nearly 22%. The decade of
2001-2010 can be termed “golden” with economic growth averaging 7.5%, inflation
benign at 6.4% and Sensex performance was nearly 18%p.a. Viewed in this
context, the call of 100,000 for Sensex by 2025 implies an annualized
performance of 13.4% where economic growth is expected to average 6.18% with
inflation at close to 9%.
Period
|
CAGR of
SENSEX returns
|
Avg Real GDP
Growth (in %)
|
Average Inflation
(consumer avg prices, %)
|
1981-1990
|
21.60%
|
5.59
|
8.88
|
1991-2000
|
14.25%
|
5.58
|
9.05
|
2001-2010
|
17.84%
|
7.39
|
6.37
|
2012-2025*
|
13.41%
|
6.18
|
8.98
|
*Average computed only till the year 2018 as IMF
forecasts are available only till that year
|
The projection methodology
1. Historical
values (closing price, P/E, div yield, P/BV, earnings, book value and
dividends) from 1991 to 2012 were taken from BSE website.
2. Base case
scenarios were considered based on historical averages.
3. Ratios
(P/E, P/B & dividend Yield) were projected based on their respective
historical averages.
For
example, P/E ratio in ensuing 4 years was considered to be average of past 4
years (2012-2009) P/E and so on.
4. Earnings,
Book Value and Dividend growth for the first 6 years were assumed to be a
constant growth (average of past 6 years). Incremental projections included the
subsequent historical year.
5. In order
to project future values an upside of 25% (optimistic) and downside of 25% (pessimistic)
was considered for the parameters (ratios, earnings growth, div.& book
value growth) under consideration.
6. Based on
the various scenarios (optimistic, base case & pessimistic) the future
values were computed.
The Drivers
There
are two primary drivers and two ancillary drivers for Sensex. The main primary
driver is the economic/business cycle. According to Pami Dua and Anirvan
Banerji, the Indian business goes
through peaks and troughs. Normally the duration from peak to trough is
relatively much smaller compared to trough to peak. In the Indian context, the
duration of peak to trough lasts for approximately one year while the duration
of trough to peak lasts for 4.3 years yielding total cycle duration of 5.25
years. The path of peak to trough is marked by recession leading to curtailment
of investments and therefore negatively impacts company earnings and stock
price performance. The path of trough to peak is accompanied by growth leading
to capital investment and will normally witness earnings expansion. Hence
economic/business cycle tend to impact earnings either positively or negatively
depending on the nature of the cycle.
The
second most important driver for Sensex would be the earnings, through which we
derive in what is most famously followed metric called P/E ratio. The P/E ratio
can move higher either because of increase in market price (numerator) or
because of decrease in earnings (denominator) and vice-versa. As we can
decipher from the chart, the P/E for Sensex ranged from a high of 45 in 1994 to
a low of 13 in 1998 with a mean of 21. Episodes of bull market will magnify the
P/E and take it to over valuation levels while bear markets produces subdued P/E.
The key driver to the P/E ratio is the earnings (the denominator) which has
shown remarkable progress during the period since 1991. Sensex earnings have
since grown from a modest 85 in 1991 to 1,133 in 2012 implying an annualized
growth of 13%.
Another
key stock market metric is the price to book ratio (P/B). The book value
(denominator) is defined as the total net worth which includes both equity as
well as accumulated reserves (the portion that is retained in the business and
not distributed as dividends). Book value growth is concomitant on earnings
growth. Historically the P/B ratio hit a high of 6.35 (1992) and a low of 2.3
(2002) with a mean of 3.72. The book value rose from a modest 533 in 1991 to
6,307 in 2012 implying an annualized growth of 12%.
And
finally the dividend yield which is simply dividends divided by the market
capitalization. Higher dividends or lower market capitalization can improve the
yield and vice-versa. Business that are experience growth will be loath to
increase dividends as they feel that money can be better served in the business
than in the hands of investors. Mature companies tend to favor higher dividends
as they find fewer opportunities to redeploy earnings. The dividend yield
fluctuated from a low of 0.68 (1994) to a high of 2.14 (2002, 2003).
Factors
that can influence the Scenarios
In
my assessment, there are 4 key factors that will influence the performance of Sensex
in the next 12 years i.e., global growth, foreign investment, inflation and
credit rating. In a globalized and networked world, the performance of the
global economy (especially the developed world) will have a great significance
on the performance of emerging markets like India. The jury is still not out on
whether global growth has stabilized. Thanks to the global financial crisis,
leading multilateral agencies (like IMF and World Bank) have been continuously
revising the global growth outlook on the downside. There is a predominant view
that global growth has settled to a “new normal” low and high growth rates are
a thing of past. India’s stock market performance is significantly dependent on
whether global growth will stabilize and pick up (the optimistic case) or will
falter and fail (pessimistic case).
The
second factor is the foreign investment both on infrastructure investment (FDI)
and portfolio investments (FII). India’s track record on this has been dismal so
far especially when benchmarked with China. However, a change of guard in the
government and unleashing of policies that are foreign investment friendly can
produce the optimistic case. It is also possible that politics will dominate
economics here and India may continue to pursue “unfriendly” foreign investment
policies which will produce the pessimistic scenario.
The
third factor is inflation, which is an enemy for stock market performance. The
monetary policies of RBI has so far been a failure in containing inflation
since the problem is understood to have emanated more from a supply bottleneck rather than demand induced.
However, persisting high inflation will be viewed very negatively by investors
(read foreign) and may unleash the pessimistic scenario. However, if RBI and
the government succeed in taming the inflation, then we may be in for a
pleasant surprise in terms of stock market performance.
And
finally, India’s sovereign credit rating is now in the last leg of investment
grade. A notch below this will classify India into “junk” status and there are
many reasons (high current account deficit, fiscal deficit, inflation, etc.) as
to why this can happen. And if that happens, the pessimistic scenario will
unfold. However, if government policies can produce credible improvement in the
economic scorecard, we can even see India moving up the investment grade rating
which will be music.
The
final word
Equity
as an asset class has always performed far better than other alternatives but
with only one caveat i.e., volatility. What has been discussed and shown in
this article is only the return side of the story. However, the risk that one
has to take to achieve these returns is also equally significant. A simple tool
to measure risk is the standard deviation but there are other equally important
measures of risk as well. Equity is one asset class which will dissuade
investors from holding on due to its inherent volatility. Investors that can
stomach this volatility and hold on to the investment can certainly reap the
benefit. However, studies have repeatedly shown that investors show scant tolerance
to holding up their equity investments and make erroneous entry and exit
decisions that are harmful to their performance. In other words, they time
their investments mostly wrongly leading to underperformance. Technology has
enabled investors to buy the market (read Sensex) through cost effective
solutions in the form of exchange traded funds (ETF’s). All one has to do is to
invest in the ETF and ride through the time without getting distracted.
Difficult isn’t?
