2006-The year that was of Asians!!!

Standing at the end of Road No. 2006 and waiting for the green signal to enter into Road No. 2007, I looked back and summarized 2006 in a small note...In a way this is my projection for 2006!!! while I stand on the zebra crossing to enter 2006.

Asian economies and its stock markets once again showed resilience during 2006!!!, after delivering robust performance during the last 3 years since 2003. The rough patches in the US did not affect the emerging export driven Asian economies. The export slowed down due to slowdown of the world’s largest engine-the US and also due to the depreciating greenback…but that did not deter the Asian economies to post another stupendous year!!!

Japan showed its vengeance once again and the market showed stupendous performance, thanks to its rising economy. After experiencing 15 years of deflation the Japanese economy turned the stone during November 2005 when it experienced 0.3% of inflation, and is expected to close 2006 with an inflation rate of around 1%. The Real GDP growth rate, which was crawling at around 2% during past 2-3 years (remember nominal GDP growth was less as Japan experienced deflation during the period), is expected to be in the range of 2.25-2.5% (that too with inflation!!!, where real is less than nominal unlike earlier) during 2006. The consumption cycle has finally started and investments are showing results.

China has surpassed the UK and France to become 4th largest economy of the world, behind the USA, Japan and Germany. The rest of Asia had surpassed Japan in terms of GDP last year, thanks to China and India. During 2006 they extended their lead. The rising middle class in Asia helped the export driven economies to gradually shift towards consumption driven economies. The in-bound demand in the emerging economies compensated for the slowdown in their exports. The rising middle class of the emerging Asia helped the domestic economies to march ahead with full steam, not being affected by the US slowdown. The middle class in emerging Asia, which is in excess of 150mn (as defined by those having income more than $4500 p.a.) in China, India, Thailand, Indonesia and Philippines took charge of the consumption. Asia is also preparing for the second level middle class- those whose income lie around $2000 p.a. India alone has in excess of 150 mn second rung middle class, that makes the case for sustainable strong Asian economy in general and India in particular.

I will mention the middle class earning more than $4500 p.a. as 1st rung MC and those earning around $2000 as the 2nd rung MC. The first rung middle class people are known for their discretionary consumption pattern that opt in for luxury goods since they have disposable income left after having consumed necessity items. China alone consumes 11% of the world’s luxury goods; and China combined with India would consume 1/5th of the world’s luxuries in the near future!!! The 2nd rung MC does not have much to spend on the luxury items presently. But assuming an annual GDP growth rate of around 7.5% and the declining prices of the luxury items, the consumption pattern would shift towards the items other than necessities.

The US economy did not do well during 2006, due to problems of its own. Housing markets cooled off, interest rates though now halted but is at 5 years high of 4.75%, USD depreciated against major currencies due to trade deficit and emerging countries’ foreign currency reserve shift from USD to other major currencies. The domestic consumption took a hit and the Americans started saving (the rate of which was negative during past few years)…and these all factors led to the lackadaisical performance of the US stock markets (continued its last year’s trend) and once again underperformed the world market.

The European market once again closed higher but did not gain as much as during 2005. The growth in the market was led by moderate improvement in the housing market in the UK, economic growth in Germany, declining unemployment rate in Germany and other EU countries, consolidation and M&As activities, and heightened private equities’ activities etc. Increase in the ECB rate to 3% from 2.25% at the start of 2006 made investment a bit tough but the same was compensated by the plough back of improving cash flows of the European companies. Nevertheless, the appreciation of Euro and Sterling against USD hurt the export oriented companies there.

So, now that 2006 is behind us…what’s in store for 2007. Will Asians dominate once again the world market or the US would rise from the slumber!!!

GLOBAL CONVERGENCE OF STOCK MARKET: A HEALTHY TREND FOR PROPER STOCK VALUATION

What is common about the current stock market surge, heated real estate markets and reversal in the interest rate cycle …they are global phenomenon…not just confined to India. We, along with other emerging markets are at historic highs while developed markets are at their 3-4 years high…It is happening globally and every country which has opened itself to the outside world is experiencing the same trend. In short this is global convergence!!! The economic and financial integration among nations is leading to a global convergence.

The economic activities and progresses of one country are viewed and compared against others’. Every action will be judged against the international standards. It leads us to follow the best practices wherein we judge how globally competitive our companies are? This is the reason why Infys and TCSs of India are getting recognized globally every passing day and they rightly deserve higher valuation…and on the other hand Indian PSU banks lags their global peers in terms of valuations, because they are still far from the global standards. Hence convergence gives us the tool to put premium or discount on a company’s valuation.

Currently one school of thought say that India is highly valued…relative to its emerging market peers like South Korea, China, Taiwan, Malaysia etc. Indian PE of 17x is considered high as compared to others’ 8-12x. We compare the GDP growth rate, prevailing interest rate scenario, political and financial strength, increase in disposable income so on and so forth. Without which we cannot be sure whether strong fundamentals or so called ‘Punting’ is driving the local market? Of course there is another school of thought that thinks the valuation is reasonable.

We often compare company with its domestic and global peers to find out how attractively or expensively it is valued, and is there any serious disconnect? If any, why? And this improves the stock’s valuation technique as we go on for finding various exogenous factors besides the internal factors that might impact the valuation of the company. The other day I was talking to an analyst as to how he values a company in his sector. He explained take for example our very own biggest mobile operator Bharti Televentures. On the face of it, it may look very expensive at 25-27x PE. As there is no listed mobile oriented telecom operator we directly jump to compare it with its global peers like Vodafone and Sprint and we will find it to be highly valued. But its not over. Then we ask a simple question…are we making an apple to apple comparison…does Bharti Tele share same growth profile as the US and European peer?….No…its 5 year CAGR of more than 20% easily surpasses to that of less than 10% CAGR of its US and European peer. Then what should we do….. Then we check it with its peer in the similar emerging market. America Movil (which operates in emerging markets in Latin America) also trades at higher valuations of 23-25x, we then arrive at a conclusion that the Bharti is getting the premium what it deserves to get.

With the emergence of global stock exchanges like NASDAQ, Euronext, Luxemburg, Amsterdam the stock of one country gets listed to another. So a stock does not depend on the whims and fancies of the local traders and the company does not follow the local market regulations but follow the global practice and thus gets a reasonable valuation.

Thanks to the high tech information age, there isn’t any information gap and it alleviates the global integration process. Investors have become global. Thanks to the monetary liberalization in many parts of the world the investors can move to many markets. One can trade 24/7. Have a morning cup of tea and trade in the Nikkei-Japan or Strait Times-Singapore, have breakfast and trade in BSE…have lunch and trade in FTSE-UK and DAX-Germany….have some snacks and trade in Nasdaq and NYSE (both US) and if you want more risk and return trade in Mexico and Brazil…. Take a nap and Japanese market is again open. The commodity markets like currency, oil, bullion remain open 24/7. The convergence brings the international investors into the market and with them comes the valuation tools which they apply to companies across the world to find out the valuation. Whether it being a Microsoft, an Accenture or an Infosys. Best methodologies are followed to value the market and stocks.

People across the world listen to what the Fed Chairman Mr Greenspan speaks in the FOMC meet? Because the change in interest rate in the US affects the global markets including Indian market in general. The recent rise of the Fed Rate to 4.25% and the accompanying statement by the Fed (that hinted the loosening of the interest tightening policy) sent our banking stocks higher the next day. And so did the US banking stocks, despite the fact that rise in interest rates reduces the value of companies as the cost of capital increases and bond value decreases. The markets discounted the future outlook of Greenspan’s statement that hinted that the Fed rate would not keep going up for long.

Not just interest rates, the direction of the movement of currency of one country determines the impact on the companies of other countries. Earlier last month Japanese market was down on a report that Japanese Yen appreciated for a short period against the USD. As it would hit the export driven Japanese companies. The same holds true for export driven sectors of India like IT. Most part of 2005 USD has appreciated against INR and the IT stocks like Infosys and TCS had euphoria.

Global convergence has been there for long and we know how the world market crashed after the great October 1987 crash of the US market that saw 22% decline in the Dow Jones, collapsed Mexican peso in 1994, sovereign debt default by the Latin Americans in late 1990s and the Asian crisis of 1997. And latest to join are 9/11 in the US and to an extent 26/7 of the UK. It is only that India has lately joined the global fray as the economy has become more open and robust and is gradually maturing to global level.

Global convergence also pressurizes domestic companies to remain competitive else some international company would make an easy inroad like what Toyota is doing to GM and Ford in the US and South Korean brands like LG and Samsung are doing to their Indian counterparts. The open market also pressurizes the govt to maintain fiscal discipline to attract global investors. And the lack of it will take a huge toll. The example of China is in front of you, soon to be the no. 4 economy of the world and despite being the world’s growth driver with annual GDP growth rate of 9% for the past few years- closed 2005 with a loss of 8% in its stock market index-its 5th straight year of decline. India attracted more funds in terms of FII than China thanks to its investor friendly policies, robust banking system, better political structure, more transparent economic and legal system, it outperformed China on one important parameter. Govt also need to maneuver the exchange rate properly to keep the domestic industry competitive enough and on the other side not to get the wrath of fellow nations by keeping the currency too much undervalued to remain globally competitive. Take for example China…It had pegged its Yuan against USD for around 10 years and the Yuan was artificially undervalued leading to increasing US trade imbalance with China. After a great deal of negotiations China appreciated its Yuan by 2%. So, the convergence gives the outward looking approach.

There are certain fallouts of the convergence like the irrational exuberance across most of the world markets during the Internet and Telecom boom during the late 1990s and early 2000s. The case of global convergence also gets weaken if certain factors present in the markets are strong enough to wither out the external factors. Like the liquidity factor is primarily driving the Gulf markets which have multiplied 4-5x during the past 2-3 years since the time the oil prices are rising. The country specific factors also play a vital role…like country specific risk related to its political and financial set up. And that is the reason why Russia trades at a huge discount due to its riskier political and discretionary scenario.

Having viewed the benefits of convergence from various angles, and having watched the world market in general and the Indian market in particular it can be safely concluded that the Indian market is hugely benefited by more and more integrating itself with the global markets and because of this our market has been the lover boy of global FIIs that have put around $8.5bn and $10bn during 2004 and 2005 respectively and delighted us by raising India to historical high of around 9400.

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