Indian equities will underperform the rest of the region: Garry Evans

Despite the recent correction in Indian equities, there are still some things about the market that leave HSBC’s global head
of equity strategy Garry Evans unimpressed. He’s been
underweight on India for some months now, and when an
avalanche of foreign capital inflows landed on Indian shores last year, he called India an “overloved market”. That call has proved right, but in an interaction with DNA, he flags the risk of sticky inflation and relatively overextended valuations to explain why he will wait for further correction before buying again into India’s long-term structural growth story. Excerpts:

On why he’s underweight Indian equities even after the recent correction:
There are three reasons why we’re underweight India. First, there’s the inflation issue: India does have the highest inflation in Asia.

People have just woken up to this risk, and are now starting to take notice of that. Consequently, some of the big flows of foreign money that went in last year are now starting to reverse.

Second, India is still the most expensive of the BRIC economies, somewhere like 16x earnings, as against 12.5x for Asia.

Third, it has the highest earnings growth forecast this year: about 22%. That’s now starting to be revised down. Analysts had assumed that margins in India will rise this year, and that’s wrong.

I don’t think the situation in India is grim or anything: we still have a 5% upside for this year. It’s just that it’s likely to underperform the rest of the region.

On when he might re-enter the Indian market:
When those three criteria I mentioned are met and when valuations come down to a reasonable level. We’d like to see the RBI begin to get its act together on inflation. If we have a couple of rate rises, we could start to feel more comfortable. Thirdly, earnings projections need to come down to more reasonable levels. Analysts’ 22% growth projection is too high. I’ve pencilled in 15% or so. Once analysts too come down to those levels, the bad news is out of the way.

The capital flows into India worry me. Of the money that went into Asia last year, about half—about $29 billion—went into India. There were a lot of foreign investors who were pretty overweight on India.

Don’t get me wrong. The long-term story in India is still good. And many people are looking to see when India will overtake China in terms of growth; and companies are on the whole better managed in India. It’s just a question of valuations: three months ago, you were paying 17.5x for India, against 11.5x for China. And today the inflation issue in India is bigger than in China.

Give it a quarter or two, and if those things that I noted begin to happen, the Indian market could start to look interesting again.

On his Sensex target for end 2011, and his choice of sectors:
We have a Sensex target of 21,000 for end 2011, which works out to about 5% upside; that implies that the current forward PE (about 16x) will contract further to about 15x over the next year.

Sectorally, we continue to favour investment over consumption: we remain overweight on infrastructure, industrials, utilities and metals. We remain underweight cement and oil & gas. We are neutral on consumer discretionary, consumer staples, IT, telecom and healthcare. We have downgraded property to neutral on account of rising interest rates and the potential impact of a credit squeeze on volumes.

On other markets in Asia that he likes:
For Asian equities in general, it’s going to be a good — but not a great — year. Analysts’ earnings forecast for Asia is 13%, but those are too optimistic. Analysts haven’t factored in that margins will be under pressure from rising wages and rising commodity prices.

It’s also going to be hard for price-earnings multiples (PEs) to go up any further from the current 13x, which is a little above the 10-year average.  In an environment of inflation, PEs don’t expand. Our target is of for 11% upside for Asia ex-Japan markets.
2011 is also the third year of a bull market, and typically the third year is much more stable, with mature growth. Playing macro calls will be much harder, and we must be ready to move from one sector to another and from one market to another rapidly.

Sectorally, my big call is for technology to do well, largely on the strength of new gadgets: iPads and iPhones sales are going to take off this year. We could see 50 million iPads sold globally, and many more other tablet devices. Also, we prefer capex stocks rather than consumption plays.

On China, we worry that inflation will prove sticky. Also, there are medium- to long-term worries about Chinese equities: even if growth is strong, profit growth may not be. Policymakers in China want growth to come from consumption — from wage hikes — and not from profits.