Decoding Growth Expectations in Investments

By employing this expectation investing approach, investors can gain insights into the growth expectations priced into the stock and assess whether they align with their investments. However, before employing expectation investing, investors should exercise caution and consider the assumptions and uncertainties when determining growth expectations. The article explains the process to be followed and highlights the pitfalls 

The initial quarter of the fiscal year 2024 presented a complete contrast to the final quarter of fiscal year 2023 in terms of equity markets returns. Following a period of negative returns from January 2023 to March 2023, the equity market underwent a notable improvement, experiencing three consecutive months of positive returns. This performance stands out as one of the strongest quarterly performances since December 2020. 

Even if we compare it to the various equity indices globally, the performance of BSE Sensex from India has been notable. Despite relatively lower YTD returns of 5.80 per cent, the index showcased a commendable June quarter performance with returns of 9.49 per cent. This indicates a strong recovery in the latest quarter. Comparatively, other major indices like Nikkei 225 from Japan, Bovespa from Brazil and Nasdaq Composite from the USA demonstrated higher YTD returns of 29.06 per cent, 11.01 per cent and 32.74 per cent, respectively. It is worth noting that BSE Sensex’s positive momentum and steady growth are significant in the context of global equity markets in recent times. 

Although the table alongside may suggest that Indian equity indices have not outperformed other equity indices, a deeper look at the data reveals that the Indian equity market has actually performed the best. In fact, it is the only major economy whose equity indices are trading at all-time highs. The chart shows how far the major equity indices are from their all-time highs. Nasdaq and Nikkei, for example, have both generated returns of around 30 per cent year-to-date, but they are still 7 per cent and 16 per cent away from their all-time highs, respectively.

Why is the Indian Equity Market Moving Upwards? 
 

1) Strong GDP Growth — There are three primary reasons why the stock market in India is outperforming other major global equity markets. First is the accelerated GDP growth that we may see in the coming years. Besides, the fourth quarter results were better than what analysts were expecting and finally huge FII money that has once again started flowing into the Indian equity market. The Indian economy grew at a faster-than-expected pace in the last quarter of FY22-23. The National Statistical Office (NSO) reported that the GDP growth rate was 6.1 per cent, higher than the earlier estimate of 6 per cent. 

This growth was driven by strong performances in several sectors including manufacturing, services and agriculture. Economists believe that this momentum is likely to continue in the coming years. S & P Global Ratings has forecast that India will grow at 6.7 per cent for the next three years, making it the fastest-growing major economy in the world. The rating agency has kept its growth forecast for the current fiscal year unchanged at 6 per cent, and has projected a sharp bounce-back to 6.9 per cent in the following two years. The consensus expectation of economists in India is 6 per cent GDP growth in FY24 while the Reserve Bank of India pegs it at 6.5 per cent. 

There are upside risks to the country’s growth forecast on the better-than-estimated global growth outlook, lower global oil prices and robust services exports. Besides, the current fall in crude oil will also act as a tailwind of the Indian economy. As per a report, crude oil may average at USD 75 a barrel in FY24 if the country imports 25 per cent of its oil need from Russia — much lower than the earlier estimate of USD 90 a barrel. A 10 per cent decline in average crude oil prices would push real GDP growth higher by 20 bps if the fuel costs are passed on to consumers. 

Another key enabler for India’s GDP growth is the robust trend in services surplus, which could support net exports (of goods and services) contribution to overall growth even as the global growth headwinds remain. This growth is being driven by a number of factors, including strong domestic demand, rising exports and government reforms. The government has also taken steps to boost investment and infrastructure, which is expected to further support growth in the coming years. India is a bright spot in a slowing global economy and a weakened China. Manufacturers and investors are looking for alternatives to China, and India is the best bet in all of Asia. 
 

2) Better than Expected March 2023 Quarter Numbers — In the fourth quarter of FY23, India Inc. experienced solid growth in net sales, recording a yearly increase of 10 per cent. Sequentially, net sales showed improvement with 4 per cent growth, bouncing back from the previous two quarters of flat growth. The profitability of the corporates was supported by easing price pressures, resulting in a 5.7 per cent annual increase and a 15 per cent sequential increase in operating profit. However, corporates also faced challenges as total expenditure continued to rise, albeit at a slower pace compared to the previous quarters. The growth in costs of services and raw materials moderated to 6.3 per cent on a yearly basis, benefiting from lower global commodity prices. 

On the other hand, employee costs continued to rise sharply, increasing by 16.8 per cent year-on-year. Financing costs, which had been consistently rising, saw a sharp increase of 23.3 per cent in Q4FY23. In conclusion, the fourth quarter of FY23 showcased positive growth in net sales and operating profit, driven by easing price pressures. However, corporates faced challenges in managing rising total expenditure, particularly in terms of employee costs and financing costs. The moderation in the growth of costs of services and raw materials was a positive development, reflecting the benefit of lower global commodity prices. 
 

3) FIIs Inflow — In a significant turnaround, foreign institutional investors (FIIs) displayed a positive shift in sentiment towards the Indian equity market in the last few months especially after March. After experiencing consecutive years of net outflows, the FIIs’ inflow into Indian equities in the first three months amounted to an impressive ₹ 121,728 crore. This reversal highlights the renewed confidence and interest of FIIs in investing in the Indian market. The positive inflows can be attributed to various factors, including improved economic conditions, attractive investment opportunities, policy reforms, and changing global market trends.
 

The shift towards positive FIIs inflow not only boosts market liquidity but also enhances investor sentiment and acts as a catalyst for further growth in the Indian equity market. FIIs’ activity plays a significant role in shaping the dynamics of the Indian financial markets. In June, the Indian equity market experienced a surge in foreign investment, driving stocks to record highs. Financial services emerged as the top sector, attracting foreign portfolio investors (FPIs), with net inflows of ₹ 19,229 crore, representing a 9 per cent increase from May. This is reflected in the Nifty Financial Services index, which has witnessed a remarkable 13 per cent gain since March, achieving its highest-ever level. 

Additionally, the automobile and automotive ancillary sector received significant attention, although inflows in June dipped slightly compared to May. The sector’s robust growth prospects, driven by product launches and the increasing focus on electric vehicles, have contributed to its upward trajectory. The automotive index is also trading at a lifetime high with gains as much as 22 per cent in the last three months. The capital goods sector has also attracted FPIs with consistent inflows for five consecutive months, reaching a remarkable ₹ 5,571 crore in June alone. 

In contrast, the information technology sector witnessed FPIs selling shares worth ₹ 3,355 crore in June, continuing a four-month trend of negative sentiment. Most of the analysts anticipate the continuation of foreign inflows into India given its status as one of the strongest emerging markets with favourable macroeconomic conditions and healthy corporate profits. The recent influx of foreign investment is just a fraction of the outflows witnessed in the previous years, indicating the potential for sustained robust FII flows in the near term.
 

Growth Expectations

The sustainability of the ongoing bull run hinges upon the growth expectations embedded in stock prices. The market’s perception of a company’s future performance is reflected in the current share prices and equity indices, providing valuable insights. By carefully analysing and anticipating market expectations, you can enhance your chances of attaining superior investment outcomes. The ability to properly read market expectations and anticipate revisions of these expectations is the springboard for earning superior long-term returns. Stock prices express the collective expectations of investors, and changes in those expectations determine investment success. 

Stock prices are gifts of information waiting for you to unwrap and use. If you have got a fix on current expectations, you can evaluate where they are likely to go. Like the great hockey player Wayne Gretzky, you can learn to ‘skate to where the puck is going to be, not to where it has been’. While many investors believe they consider expectations in their decision-making, few do so diligently and explicitly. Hence, it becomes imperative to conduct reverse engineering to ascertain the plausibility of the growth level implied by the current prices. An asset’s present value is the sum of its expected cash flows discounted by an expected rate of return. 

That return is what investors anticipate earning on assets with similar risk. The present value is the maximum price an investor should pay for an asset. There are primarily two ways through which we can determine growth implied in the current prices. First is the long-term discounted cash flow (DCF) and second is the dividend discount model. Traditional discounted cash flow analysis requires you to forecast cash flows to estimate a stock’s value. We can reverse the process to understand what the aggregate investors have embedded in growth expectation as regards the price of the stock or the index. It starts with the stock price and the rich and combined wisdom of investors, and determines the growth in cash flow expectations that justify that price. Those expectations, in turn, serve as the benchmark for decisions to buy, sell or hold a stock. 

Let’s understand the process of this scenario. We reverse the process of DCF analysis to estimate the growth expectation embedded in the current share price. For example, the current share price of Asian Paints is ₹ 3,345 and we can perform the following steps: 

◼ Gather Financial Data — Collect historical financial statements of Asian Paints, including income statements, balance-sheets and cash flow statements.

◼ Perform DCF Analysis — Calculate the present value of future cash flows using a discount rate that reflects the company’s risk profile. Estimate the cash flows based on growth assumptions.

◼ Reverse the DCF Process —Instead of estimating the fair value of the stock, we reverse engineer the process. We input the current share price and back-calculate the growth rate that would justify the current valuation.

◼ Assess Plausibility — Compare the calculated growth rate with industry benchmarks, historical growth rates and analyst forecasts to evaluate its plausibility. Consider macroeconomic factors, market conditions and the company’s competitive position. 

Applying all the above steps for Asian Paints with weighted cost of capital at 12.8 per cent we find that the first five-year market is expecting a 16.5 per cent growth in its cash flow assuming it maintains its current PE of 78x. Nevertheless, if the PE witnesses a decline, the growth rate needs to be increased. Now, let’s see the growth rate at which Asian Paint’s cash flow has increased annually in the last five years. It has increased by 17.86 per cent. So, the current price of Asian Paints is rightly approximately to its growth rate in the future. Nevertheless, if someone believes that new players with deep pockets may enter the paints market and may dent its growth rate or lower its PE, then in that case the stock is definitely over-priced. 

The second and easier way of approximating the growth rate imbibed in the current share price is using the dividend discount model (DDM). To estimate growth expectation, we can reverse the DDM process by following these steps: 

◼ Gather Dividend Data — Collect historical dividend payments made by Asian Paints over a period of time.

◼ Determine Required Rate of Return — Determine an appropriate required rate of return (discount rate) based on factors such as the riskiness of the stock, market conditions and investor preferences.

◼ Reverse the DDM Process — Instead of estimating the fair value of the stock, we input the current share price and the expected future dividends and arrive at the growth rate that would justify the current valuation.

◼ Assess Plausibility — Compare the calculated growth rate with what analysts are estimating along with any change in the industry or sector landscape. 

We will again take the example of Asian Paints, which has been continuously distributing dividend since 2007. In the last five years ending June 2023, its dividend per share has increased at an annualised rate of around 16 per cent. Compare this with the growth that is embedded in the current share price using DDM, which stands at 12.5 per cent. This shows that there is still some upside left in the share price of Asian Paints. Applying the reverse engineering process in both the valuation models, it seems that the share price of Asian Paint is largely pricing in the growth that the company is likely to record. The market is also discounting some slowdown in the growth rate as new players have forayed into the market. 

Now let us apply the DDM model to Nifty 50 to understand if the current bull market has overshot or if growth in the dividend of Nifty 50 justifies the current value. We took the rolling dividend per share growth of Nifty 50 since 2001 for every 10 years. The dividend has grown at an annualised rate of 10.64 per cent every year. The cost of equity for Nifty works out to be 12 per cent currently. If we take the current Nifty value of 19,363 and try to find what growth rate analysts are expecting, it works out to 10.96 per cent, which is similar to the growth that we have witnessed in the dividend growth of Nifty 50. Therefore, we believe that despite the recent gain, Nifty 50 is not overpriced. 

By employing this expectation investing approach, investors can gain insights into the growth expectations priced into the stock and assess whether they align with their investments. However, before employing expectation investing, investors should exercise caution and consider the assumptions and uncertainties when determining growth expectations. Investors should be aware that these expectations may not materialise as projected. Besides, relying solely on growth expectations may overlook other important factors affecting stock prices, such as market trends, industry dynamics, competitive landscape and macroeconomic conditions. Investors should conduct comprehensive analyses that incorporate various aspects of investment decision-making. 

The most important factor is that expectation investing should be approached with a long-term perspective. Short-term market fluctuations and deviations from expected growth rates are common. Investors should focus on the fundamental strength of their investments and avoid making knee-jerk reactions based solely on short-term expectations. By exercising caution and adopting a balanced approach, investors can effectively utilise expectation investing as a tool to gain insights into market expectations while considering the inherent uncertainties and risks associated with future projections.