India – Several debates; one conclusion – Buy the Dip – Morgan

Market participants are worried about inflation, rich valuations, high earnings expectations and the rising external deficit (especially in the context of volatile global financial markets). Morgan agrees with the last issue but is more sanguine about the implications of inflation, the state of valuations and the prospects for earnings. On the whole, remain constructive on Indian equities but remain wary of pressures from external sources.

High inflation will hurt equities – Inflation is undoubtedly reaching worrisome levels. Non-food, non-fuel inflation is at 5%. Historically, when this number has exceeded 10%, the market has posted negative returns on a six-month forward basis. When the number is lower than 10%, equity-return implications have been random.

Valuations are rich – Equity valuations look middling at 18x trailing earnings. At a 30% premium to emerging markets, this is lower than the average at which Indian equities traded over the past six years.

Earnings expectations are high: The acceleration in industrial growth will help revenue growth to exceed the mid-teens in the coming quarters while the gap in ex-food consumer and producer price inflation will push corporate margins to close to new highs in 2011.

High external deficit makes India vulnerable to global events: The rise in the external deficit attracts the least attention – but to us is most relevant: The external deficit – trade deficit at over 10% of GDP – seems high in the context of where we are in the growth cycle, i.e., the investment cycle is yet to start in earnest.

BSE SENSEX Valuation and Target – For the Sensex, top-down EPS estimate is about 11% higher than the consensus whereas for Morgan coverage universe, analysts are about 5% in front of the consensus estimates for F2012. Residual income model projects a fair value of 18,570 for December 2010. The probability-weighted outcome for the BSE Sensex is 19,400 for December 2010, 18% above the current level.