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Summary of Our Views
Key Investor Debates
India’s inflation is structural
Equity valuations are rich
Rising equity supply will depress equity returns
Negative earnings revisions
Equity returns are over-dependent on foreign flows
Politics might play spoilsport.
What’s in the Price?
The second order of growth is falling but it seems to be in the price. A normalization of real rates also seems to be in the price, in our view.
Our residual income for the Sensex implies an ERP of c5%, which means long-term valuations are at just above fair level (relative to our view). At a 10-year bond yield of c8%, this denotes a long-term return of 13%. Future growth has been assigned 63% of the MSCI Index value, which is higher than the historical average, but still places equities in a positive light for long-term investors.
Trades and Themes
Sectors: O/W: Energy, Industrials, Materials, Telecom, Utilities, U/W: Cons. Disc., Consumer Staples, Financials, Healthcare, Technology
Catalysts
Global risk appetite: China, Europe, & US growth
Growth indicators & corporate fundamentals
Inflation
Sentiment
Stocks: See page 26 for Focus List
Themes
1.
Buy disinflation trades
2.
Surprises from the government
3.
Protect the portfolio from tail risks
4.
Macro in Vogue – Focus on sector trades
5.
Buy long bond proxies
6.
Buy capex proxies
7.
“Growth” is policy
8.
From cash flow generators to asset gatherers
9.
3U stocks and sectors
Market Outlook: Relative valuations are on the richer side and, hence, we expect moderation in index returns in 2011 (in low double digit zone from current levels). That said, we remain in a structural bull market so any dip will enhance returns and provide an opportunity to buy equities. Our probability-weighted outcome for the BSE Sensex is 22,100 for end-December 2011, 8% above the current level.
Base Case (65% probability) BSE Sensex: 21,115
Our base case calls for a “muddle-through” world, some degree of policy initiatives, reasonable capital flows, no sudden spike up in crude oil prices, a slow exit by the RBI and moderate equity supply (less than US$25bn) with Sensex earnings growth of 22% and 18% in F2011 and F2012.
Bull Case (25% probability) BSE Sensex: 26,727
Our bull case assumes global calm and a measured recovery in global growth, strong domestic policies, range-bound crude oil prices, slow exit by the RBI and moderate equity supply. Sensex earnings growth of 28% and 22% for F2011 and F2012 and 30% upside to the index.
Bear Case (10% probability) BSE Sensex: 16,773
Our bear case assumes weak policy action, extreme global outcomes, a rapid increase in crude oil prices causing a sharp policy rate response, and/or excessive equity issuances. Sensex earnings growth falls to 13% and 12% for F2011 and F2012 and 18% downside to the index.
Key Investor Debates
Debate #1: India’s inflation is structural: We view the high inflation of the past 12 months as transient. Even cyclically India’s inflation seems favorably poised, i.e., it’s declining whereas inflation appears to be moving higher in other parts of the emerging world. India has also already raised rates considerably compared to the rest of Asia.
Debate #2: Equity valuations are rich: In our view, valuations are getting rich, but are not at levels that would detract from equity performance. Our residual income model for the BSE Sensex suggests that it is at fair value.
Debate #3: Negative earnings revisions: Earnings are in good shape, especially vs. the rest of the world; we see scope for upside surprises. Of course, earnings growth is slowing down consistent with our EGLI.
Debate #4: Rising equity supply will depress equity returns: Equity supply is rising – but it is not high enough to hamper returns in the coming months.
Debate #5: Equity returns are over-dependent on foreign flows: We do agree that India’s balance sheet is a source of risk, especially given its funding by flows from financial markets. India’s current account deficit is an issue and it means that the best case for India is a “muddle through” world. Any extreme outcome, either that of risk aversion or surging commodity prices, can hurt Indian growth and, hence, equities. The good news is that India’s current account deficit is likely to decline in the coming 12 months. Watch: China Inflation, Europe and US growth outcomes.
Debate #6: Politics might play spoilsport: We think investors may be underestimating the significance of the Bihar election outcome, which reaffirms the evolving dynamics of “development” politics in India. Indeed, our conversations with policy makers reveal that “growth” is India’s policy and we think that growth can surprise on the upside. That said, the recent flurry of scandals does create vulnerability on the policy front as well as growth.
What’s in the Price
Slowing growth in the price: The market seems to have already priced in a slowdown in nominal growth just as it had priced in a pick-up in growth in late 2009. Our work shows that the market is expecting nominal industrial growth to drop to c14% by the end of 1Q11 – in line with our economist’s forecast and compared to the trailing 3M print of c19%.
Rising real rates in the price: The market is also pricing in a normalization of the real rates. The current real rate (using WPI inflation and 91-day yields) is at -2.1%. We expect moderation in inflation in the coming months and a steady rise in short-term yields and hence real rates to rise to 1.0% by March 2011. This appears to be what the market is pricing in.
Market at fair value on our residual income model: Our residual income for the Sensex implies an equity risk premium of c5% – around our top-down assumption – which means long-term valuations are at fair level (relative to our view). At a 10-year bond yield of c8%, this denotes a long-term return of 13%. Future growth has been assigned 63% of the MSCI Index value, which is higher than the historical average, but still places equities in a positive light for long-term investors.
Key Catalysts
Catalyst #1: Global risk appetite: The global picture remains a critical factor for India equities even as the market has been showing signs of decoupling. APXJ/EM and China currently seem to have the most influence on Indian equities, with three-month return correlations at over 80% and 71%, respectively. However, too much risk appetite is not good given the commodity inflation it could bring into India as India negotiates its already high inflation over the coming 12 months.
Catalyst #2: Growth indicators and corporate fundamentals: Earnings could be a key driver for short-term equity market performance. No doubt, earnings revision breadth has weakened in recent months, but it is still not at levels that tends to hurt stocks. India's corporate fundamentals remain very strong - earnings and ROE are both on the ascent and have seemingly decoupled from the rest of the world.
Catalyst #3: Inflation: Inflation has been sticky over the past 12 months, driven by a slow supply-side response to a big recovery in demand helped by strong stimulus and a negative food supply shock. We expect both these factors to recede and hence inflation to decelerate in 2011. Indeed, the inflation peak may already be behind us. If inflation declines, as we expect, it could be positive for equity returns. Historical data shows that India’s relative performance has been positive in three out of the four disinflation cycles of the past decade.
Catalyst #4: Sentiment: The recent correction has hurt sentiment. To that extent, the market looks a lot more healthy. We think this is just another average bull market correction. Key to prospective returns is that relative valuations are on the richer side and, hence, we expect moderation in index returns in the coming 12 months (in the low double digit zone from current levels). That said, we remain in a structural bull market so any dip will enhance returns and provide a great opportunity to buy equities.
We go back 17 years of market (BSE Sensex) history to assimilate data on bull market corrections. Here are the observations from history:
a)
There have been four bull markets over the past 17 years (including the current one) and within those bull market there have been 32 corrections of 5% or more (including the current one).
b) The average fall during these corrections has been 12% and average duration of these corrections is 17 days. The worst fall (May-June 2006) was 31% whereas the longest fall excluding the ongoing correction (July to September 1993) lasted 28 days. India has historically underperformed emerging markets during corrections and outperformed on rallies save for a couple of occasions.
c) The average realized inter-day volatility during corrections is 1.6% slightly more than the average during rallies. The subsequent rally post the correction produces an average return of 31% over 48 days.
d) The Sensex has fallen below its 200 DMA only on two occasions during these 30 corrections, i.e., in 2004 and 2006. Over the past 30 years, the market has penetrated its 200 DMA four times during a bull market with an average fall of 9.3% below the 200 DMA with the average time spent below the 200DMA being 46 days (excluding the ongoing correction).
e) There is no clear-cut message from the valuations at which the market troughs, i.e., the valuation range is 11x trailing earnings to 45 times with the average over 30 corrections being 20x trailing earnings. We are currently at 21x trailing earnings.
Key Themes
Theme #1: India’s inflation is likely to decline: Inflation has been sticky over the past 12 months, driven by a slow supply-side response to a big recovery in demand helped by strong stimulus and a negative food supply shock. We expect both these factors to recede and hence inflation to decelerate in 2011. Indeed, the inflation peak may already be behind us. If inflation declines, as we expect, it could be positive for equity returns. Historical data shows that India’s relative performance has been positive in three out of the four disinflation cycles of the past decade. Key sectors that do well during disinflationary cycles are industrials and financials. Technology tends to underperform. A corollary of declining inflation is that real rates are rising – this may not augur well for consumer stocks.
Theme #2: Surprise from the government: Expectations from the government appear tepid. There are three areas where the government can spring a surprise: a) Accelerate infrastructure spending further – key stocks to buy are Larsen & Toubro (Rs1,979), IVRCL (Rs129), and Nagarjuna (Rs141); b) FDI liberalization in retail – our favorite is Pantaloon (Rs367); and c) rein in fiscal deficit more aggressively – long bond yields decline – buy SBI (Rs2,811).
Theme #3: Hedging the risks: India’s key risk is that it is pursuing growth assertively. Consequently, public spending is still at elevated levels, and the current account deficit is at record levels. India is joined at the hip to global financial markets, given that this deficit is funded by capital markets. India’s best-case outcome is a “muddle through” world. The economy and the market may not tolerate extreme outcomes. A deep risk aversion event could cause India’s growth to falter and markets to react adversely – Sun Pharma (Rs485) and Bharti (Rs358) are good hedges in this context. The flip side is that the world recovers and commodities do well – India could still falter. Our favorite to protect portfolios is Reliance Industries (Rs1058).
Theme #4: Macro in vogue – Focus on sector trades: At the end of last year, the influence of the market (read: macro) on stock returns was at an-all time high, with stock-specific, idiosyncratic factors taking a backseat – it was a clear signal to abandon macro over stock-picking. Through 2010, stock-picking has been in fashion. The evidence of how little influence macro has had on the behavior of stocks is in the correlation of returns from individual stocks (market effect) with the market, which has collapsed over the past 12 months. It is likely that macro effect rises now, and, to that extent, stock pickers may have to take a back seat in the coming months. The message is to focus on sector trades. Our sector positions are wider than at the start of 2010: We are overweight Industrials and Commodities and underweight Consumer Sectors.
Theme #5: Equities look more attractive than long bonds but not by a big margin: We think equities are likely to continue to beat long bonds in 2011, although the gap in performance may narrow compared to 2010. The likelihood is that long bond yields have peaked. State Bank of India (Rs2,811) is our favorite stock on this trade. The rest of the PSU banks space looks less attractive.
Theme #6: Buy capex proxies – demand and supply side supportive of capex trough: We expect a disciplined capex cycle in 2011 and believe that capex-related sectors, such as industrials, property and materials (most of these have underperformed in 2010 and are not favorites with the consensus), to do a lot better. Key stocks are DLF (Rs292), ACC (Rs1076) and Larsen and Toubro (Rs1979). Consequently, the Consumer Sector, which seems to be pricing in a lot of the prospective growth, could underperform.
Theme #7: “Growth” is policy: The significance of the Bihar election outcome should not be underestimated, as it reaffirms the evolving dynamics of “development” politics in India. Indeed, our conversations with policy makers reveal that “growth” is India’s policy, and we think that growth could surprise on the upside. The government is taking risks with the external deficit to fulfill its target of 9-10% GDP growth. This policy entails strong rural support through high levels of government spending until private sector demand takes over fully. Two stocks that strike as beneficiaries of this growth environment and do not appear fully valued are Jain Irrigation (Rs211) and Exide (Rs167).
Theme #8: From cash flow generators to asset gatherers: 2010 was all about cash flow generators. Stocks of companies with long duration cash flows distinctly underperformed. This is all about a hesitant bull market that we are in. High beta, low ROE and low free cash flow have underperformed in 2010. We think that, as the bull market matures, it may shift its attention to longer duration cash flow companies. Again, a peaking 10-year bond yield may help. Our favorite stocks are Jaiprakash (Rs106), Reliance Infrastructure (Rs842), Adani Power (Rs130) and IRB (Rs226).
Theme #9: Market is at fair value – Buy Undervalued, Under-owned and Unloved stocks (3Us): Our residual income for the Sensex implies an equity risk premium of 6% – around our top-down assumption – which means long-term valuations are at a fair level (relative to our view). At the sector and stock level, we are focused on the 3Us. Key sectors that pass the test are Materials and Utilities. The Consumer sector fails the test, as do financials.
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