Investors can still get 20% annual returns: Lehman

NEW DELHI: Even as rising equity valuations may have turned short-term prospects of the stock market weak, investors can still achieve annual returns between 12% and 20% over the next five years, according to a Lehman Brothers report.

It says that given the prospects for a sustained high rate of nominal and real economic growth, the stock market should perform well over the medium- to long-term period.

The report titled, ‘India: Everything to play for’, expects Indian equities to outperform developed and emerging market indices over a five-year period, basing its optimistic view on sustained high rate of economic growth as “a structural acceleration in growth is happening in India today, lifting the economy’s potential output growth rate.”

Data for the recent past shows how the accelerated pace of economic growth has reflected in corporate profits. The 113% expansion in India’s nominal GDP over the past six years has been associated with a 168% increase in earnings of 30 Sensex companies.

What’s more, as per the report, while return on equity has declined in India over the past one year it is still above that in emerging markets and much higher than what it was five years ago. It’s not surprising then that Indian companies have been increasing their investments. Their capital expenditure to sales ratio has also expanded steadily compared to emerging markets.

Moreover, a large chunk of this capex is financed out of retained earnings which are basically a part of profits, rather than debt. This has ensured that balance sheets of Indian companies are not heavily geared. “Non-financial companies have a net debt-to-equity ratio of 28% compared with emerging markets as a whole at 38%,” as per the report.

Using the data from the FTSE India Index, the report says valuations in India appears expensive, and among emerging markets only three other economies are valued more than India — Argentina, Chile and China.

Valuations are also expensive when compared with the global emerging market index, though the report points out that these valuations do not reflect consolidated earnings in several companies that are executing new businesses through step-down subsidiaries, either because it’s different from the core business of the company or because their subsidiaries are not yet operational.

As per the report, assuming the global economy manages to steer away from a severe downturn, India’s gross domestic output (GDP) will grow 8.8% in FY08 before picking up 9.2% in FY09. Such growth acceleration typically tends to be a part of an upward economic growth cycle, which ends up overheating the economy, resulting in tight policy measures that slow down growth.

However, international experience shows that economies can witness growth accelerations that are more structural than cyclical. This can happen when growth acceleration is capacity-enhancing, either due to higher growth in capital or labour employed or due to higher productivity and this is what is happening in India today.