INDIA STRATEGY: Shaping up; Valuations have slimmed ... but are they attractive yet?::Motilal oswal,

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INDIA STRATEGY: Shaping up; Valuations have slimmed ... but are they attractive yet?

Sep-2011 Results Preview

 Backdrop: A tale of two markets

In September 2010, Indian markets were in a euphoric mood. Sensex was at a new high of 20,500, Sensex P/E at 18.5x (rolling 12-month forward) was almost at 25% premium to long-period average (15-year), and CY10 net FII flow at USD29b was an all-time high.

By September 2011, Indian market is down 18%, and figures among the worst performing global markets. Fund flow has dried up (nil net FII flow in YTD CY11), cash traded volumes are down 39%, and valuations are 10% below long-period averages. Looking back, it was almost as if the markets had added excess flab of optimism, and required a series of work-outs to get back into shape.

Work-out #1: Dumb-bells of rising inflation and catch-up rate hikes

-     Inflation is at a 13-month high, but a cool-off is on the cards as QE-II impact is wearing off on global commodities and global growth outlook is moderating.

-     Repo rates are at 36-month high; expect rates to peak out in 3QFY12 and start easing as inflation cool-off would lead to real interest rates going well above LPA.

û  Impact #1: Sharp impact to earnings and valuations of interest-rate sensitives e.g. Financials, Autos, Infrastructure.

Work-out #2: Treadmill of policy and political headwinds

Over the last one year, policy and political headwinds appeared in three broad forms -

1.   Unearthing of a series of scams;

2.   "Policy holiday" with little or no progress on key reforms such as FDI in multi-brand retail and insurance, lowering of oil subsidy through diesel/LPG price hikes, GST resolution, large infra projects etc.

3.   Likely fiscal failure due to no/lower disinvestment proceeds and slowing down of revenue collections.

û  Impact #2: PSU valuations downgraded; capex and infrastructure related sectors and companies hurt.

Work-out #3: Weight-training of global headwinds

In the last 12 months, Indian markets have directly and indirectly borne the brunt of several global headwinds. The major ones among them are -

1.   US: QE-II, political deadlock over government debt ceiling, rating downgrade

2.   Euro zone: Sovereign debt crisis

3.   Global growth slowdown.

û  Impact #3: FII flows plunge, INR goes into a tailspin, global plays derated.

Work-out #4: Cycle of earnings downgrade

-     Since 2QFY11, Sensex EPS for FY12 has been downgraded by 9% and for FY13 by 10%. We now expect FY12 earnings growth of 11.8% and for FY13 at 16.9%.

-     Earnings downgrade cycle has continued in 2QFY12 as well, with FY12 earnings down 1% and FY13 down 2.8%.

-     The key contributors to FY12 earnings downgrades since 2QFY11 are: SBI (35%), ONGC (14%), NTPC (13%), Bharti (12%), etc. Earnings upgrades contributors are TCS (12%) and Reliance (11%).

û  Impact #4: Market P/E is down 28% YoY, and is at a discount to adjusted LPA.

Valuations below historical averages, risk-reward favorable

-     Indian market 12-month forward PE at 13.3x and 12-forward P/B at 2.4x are at 10% below the respective 15-year average valuations.

-     Indian valuation contraction has coincided with 1] a rate tightening cycle led by high and persistent inflation 2] pressure on margins coupled with high interest rates driving down RoE to 18% from historical average of over 20% 3] economic slowdown partly contributed by government indecision and governance issues 4] earnings downgrade cycle with FY12 earnings being downgraded by 9% in the past 4 quarters.

-     We believe that most of the negatives on the domestic side have largely played out with inflation and interest rates expected to peak in 3QFY12. Also, we expect the GDP and corporate earnings downgrade cycle to be largely complete.

-     Any further risk / downside to valuations now emanate largely from global factors. The historical low valuations (PE of 9-11x and P/B of 1.6-1.7x) have followed global events that drove large-scale risk aversion like the 9/11 and the global financial crisis post the collapse of Lehman.

2QFY12 Earnings Preview - Another slow quarter

2QFY12 earnings will be reported amidst an adverse macro backdrop. Interest rates are up further 50-75bp during the quarter, demand continued to weaken in domestic economy and India rupee depreciated by ~10% against the USD. Key highlights of the earnings season:

-     Aggregate (ex RMs) Sales growth 20.9%, EBIDTA growth 11.7%, PAT growth 9.7%.

-     EBIDTA margin will contract 190bp YoY to 23.6% (2nd lowest in last 8 years), PAT margin will contract 120bp YoY to 12.7% (lowest in last 8 years)

-     Number of companies in our Universe with growth rates of over 30% is the lowest at 19%, while percentage of companies with YoY decline is at a 8 quarter high of 33%. 

-     Top 3 contributors to aggregate earnings are Financials, Oil & Gas and Metals, accounting for 57% of the 2QFY12 earnings.

-     Sectors with strong YoY PAT growth include Cement (67% YoY due to low base effect), Private Banks (+23% YoY) and Oil & Gas (excl. RMs) 21% YoY.

-     FMCG, Private Banks and Retailing are the only 3 sectors where all companies will report earnings growth.

-     Sectors with disappointing / muted growth are PSU Banks, Telecom, Autos. Telecom with a decline of 44% shaves off 200bp from aggregate growth.

Investment strategy

-     We believe the markets, led by uncertainty and fear, have gone through a significant correction over the last one year to make them attractive for long-term investing. Earnings downgrade cycle is arguably in its last leg, and this, along with below-average valuations, provide cushion.

-     In our model portfolio, we have raised weights on stocks where valuations now trade below long-term averages while our outlook remains positive on them. Our top bets are Infosys / HCL Tech,Bharti / Idea, SBI / Axis Bank, Hero Motocorp / Tata Motors, NTPC, Cipla. We have also allocated weights to several mid-caps across sectors (Financials, Pharma, Infrastructure, Real Estate, etc), where we believe return potential could be significant.