Market Strategy 2012:: ICICI Securities,

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The year 2011 had one theme consistent across various asset classes i.e.
safety first. Risk aversion remained at elevated levels forcing investors to
dump sovereign bonds of troubled European countries in favour of
relatively safer US bonds, thereby driving their yields to historically lower
levels. Within commodities, gold remained in a sweet spot due to
perceived benefits of hedge. The emerging equity markets including the
BRIC brigade slumped with Indian equities at the bottom of the league.
CY12 would be an equally challenging year and is likely to be a
rollercoaster ride for the investors. Politically, this year would be a mega
carnival of leadership changes in major economies such as the US, China
and France among others. Policy responses in the US and Europe region
would be directed towards applying the liquidity balm to iron out current
issues while solvency issue would be postponed. Emerging economies
would spend their time and energy towards preservation of growth as
higher inflation and interest rates eat up growth. In addition, global growth
faces risk from higher crude prices due to Iran-Israel induced tension,
political uncertainty in the Arab world, North Korea, Afghanistan and Iraq
among others. Commodity markets may crumble under the Chinese
slowdown fears. Domestically, the Indian economy could spot relief in
terms of interest rate cuts and lower inflation while higher fiscal deficit,
currency volatility and crude oil could still knock off a few basis points from
our economic growth. In addition, perceived policy paralysis and gloom
associated with it would continue to lead to procrastination in our thoughts
and capture headlines.
We expect the Indian equity markets to witness time based correction.
Hence, we expect the Sensex to be boxed in the range of 15442 (14x FY12
Sensex EPS of 1103) – 17822 (14x FY13 Sensex EPS of 1273, upside of
14%) in line with earnings growth of 15% in FY13 and historical average
multiples of 14x. The fortunes of equities are also tied to the relative
attractiveness of fixed income, gold and real estate. Any deterioration in
risk return trade off in these asset classes would be a blessing in disguise
for equities else equity markets may continue to be sidelined. In the
event of an unlikely global sell off, Sensex multiples could shrink to 10-
11x FY13 earnings, implying a downside of ~15%. The long term case for
investments in Indian equity markets still remains intact through periodic
investments while investors should grab any opportunity arising due to
sharp sell off where multiples contract further to 10-11x. Otherwise,
investors should look at the next year end as a buying opportunity as by
then we would have captured FY13 growth and a likely double digit
growth in FY14 on the anvil, which would limit downsides from thereon.
Parallel levels on the Nifty are 4637 on the lower side and 5351 on the
higher side.
We believe that relatively safer sectors would continue to lure investors as
the capital preservation despite lower returns theme is unlikely to fade
away. Accordingly we continue to prefer IT (rupee to benefit though
valuation expensive), pharma (rupee & patent expiry to benefit yet
valuation seems expensive), telecom (financials to improve, reducing
regulatory uncertainty) and auto (lower base, lower commodity, peaking
interest rates).

We are neutral on FMCG (expensive valuation, pressure on margins),

banking (NPA concerns mounting, valuation cheap), oil & gas (elevated

crude prices, limiting pricing headroom).

We have a negative bias on capital intensive sectors such as infra (highly

leveraged, valuations a trap), capital goods (order-book growth concerns,

valuations attractive), metals (muted demand, Chinese slowdown fears),

hospitality (single digit RoEs, demand growth), real estate (heavy leverage,

tepid demand), cement (supply overhang, large caps remain expensive

while balance sheets of midcaps are leveraged), shipping (long term

visibility poor, valuations cheap), aviation (highly leveraged, elevated crude

prices). We would be revisiting our view on these in mid 2012 post visibility

on rate cuts, cooling of commodity prices, demand revival and other factors.

Has anything gone wrong with India’s growth therapy

Indian current economic growth and corporate woes continue to mount and

multiply forcing all of us to ponder whether we have digressed from our

long term growth trajectory. The world today is more complex and

interconnected and every major economy has lost sheen and is staring at

limited options to prevent the current downward spiral. There are mountain

of worries domestically with alarming decibel levels thereby confusing all of

us between a signal and a noise.

Domestically blame game has been running smooth and has become a

breeding ground for collective pessimism and for everything which is not

working in our respective interest. The participating members of this game

are politicians, corporates, economist, bureaucrats, intellectuals, analyst and

other stakeholders. While these are beyond doubt challenging times for us

but the current situation also paints high expectations, misguided

assumption, poor due diligence by corporates, hysteria, suspicion,

scepticism etc.

We attempt revisiting of crucial growth phases, challenges, policy actions

which have shaped our growth so far without seeking pointers for future or

a silver bullet to all our current woes.

We believe the ongoing rough patch is reminiscing of the earlier bumps

which our economy had faced in early 90s and early 2000. Marco-Economic

woes such as GDP tapering down to 6.9%, WPI inflation hovering above

8%, Fiscal Deficit inkling closer to ~6% and interest rates are at peak have

depleted the confidence and investment climate like it did in the past. In

addition, usual snail pace of policy responses to current and past concerns

is also creating dissonance in our abilities to sustain the long term growth.

Elevated criticism over government's decisions like putting FDI in Retail at

the back-burner Lokpal Bill, uncertainly over implementation of GST, Land

acquisition delays and uproar over mining bill has added to the collective

gloom. However, faced with difficult situation earlier, government has taken

landmark policy decision in past whether it is opening up the economy in

early 90s or aggressive disinvestment in early 2000s, which has proved to

be catalyst for the structural long term growth. In early 90s, GDP growth fell

below 5%, fiscal deficit was above 7%, Indian rupee devalued by 19% and

average inflation was above 9%. Similarly in early 2000s, GDP growth fell

below 5% and fiscal deficit shot up above 6%. However, subsequent

reforms and policy changes led to the robust GDP growth for the next 4-5

years and concomitantly fiscal deficit going down below 5% and 3% in 1996

and 2007. We believe current concerns about slowdown in GDP, higher

fiscal deficit and sticky high inflation, though valid, but overdone.

Global concerns

CY 2011 has been a volatile year where factors such as the ongoing Euro

zone sovereign debt crisis, slowdown fears in the US and higher than

anticipated jump in inflation in BRIC countries impinged the global growth

ecosystem. Also, spike in key commodities such as crude due to political

instability in Middle East and Japanese tsunami disrupting global supply

chain etc. kept markets on their toes. CY2012 is likely to be an equally

challenging year as climax of eurozone issues would toss up volatility across

global financial system. US, on the other hand, may attempt laying down

steps for bridging the fiscal deficit while BRIC countries would shift gears to

strike an optimum balance between managing growth and monetary

tightening stance. Key commodities such as crude may gyrate on potential

build up of Iran- Israel tension while base/industrial metals may take cues

from the vociferousness of slowdown in China. Additionally political

calendar, across the globe, is very tight as elections in US, France, Russia,

Greece and leadership changes in China would ensure anxiety and

nervousness across global markets.

Indian economy – better or worse

India after being the poster boy of the global markets with its decade best

performance slumped to the bottom of the performance table in CY11 due

to a confluence of domestic and global concerns. Medium term concerns on

the domestic front such as high fiscal deficit, slippery GDP growth, currency

depreciation, mounting NPAs, evaporating infra spend and corporate

confidence, high interest rates and lack-luster policy responses in

addressing these issues is sending vibes that we may have digressed from

our long term growth trajectory. In all this overwhelming negatives there are

few bright spots such latest food inflation coming down to six year lows of

0.42%, consumption still resilient, currency depreciation benefiting the

export sector, domestic consumption centric economy, gold imports

dipping in Q3 CY11 providing cushion to current account deficit, improved

rate cuts prospects among others etc.

Indian economy – getting better…

Indian economy after clocking 8-9% economic growth under its belt in the

past 5 years is witnessing medium term turbulence in its growth equilibrium.

We believe the long term growth trajectory would remain intact due to its

unique consumption model, favourable demographics, less dependency on

exports (15.7% of nominal GDP in FY11), lower credit to GDP ratio (~52%)

besides others. Medium term concerns such as high fiscal deficit, low

growth, higher inflation & interest rates may get self addressed in the event

of rate cuts, lower crude and commodity prices to a great extent.

Better monsoons, a key ingredient for the prosperity of rural India has

remained favourable since last year. This also had its positive ruboff on food

inflation which has seen a sharp dip to a four year low of 1.8% on a weekly

reading in December 2011. The series of rate hikes of 375 bps done in last

21 months is expected to achieve its desired effect of moderating demand

side inflation as already experienced in slowing IIP and GDP numbers. But

while walking the tight rope of balancing inflation and GDP growth various

monetary policy actions had been taken, now inflation fear seems to be

cooling off and growth concerns have risen. This may lead to a strong case

for interest rate cuts coming around Q1FY13E.

Also, India’s consumption story has weathered the current slowdown in

economy quite strongly. This is evident from the fact that private final

consumption expenditure (PFCE) has remained relatively strong contributor

to H1FY12 GDP growth at 6.1%. PFCE contribution to GDP has remained

stable while Gross Fixed Capital Formation (GFCF) has fallen by ~| 50,000

crore on a quarterly basis from Q2FY09 (370 bps dip in contribution to GDP).

Thereby we believe, with consumption remaining the strength area of the

country, the government would have to boost PFCE, GFCF through

monetary policy tools as the room for Government final consumption

expenditure (GFCE) has become limited with already high fiscal deficit. Also

GFCF reaching near its six year low of 30.5% of GDP is also a indicator of an

imminent rate cut, which may turn beneficial for FY13E GFCF, PFCE growth.

Widenening of trade deficit due to depreciating rupee is experienced in the

short term as India remains to be a net importer. Crude is the major concern

which constituted ~58% of trade deficit in FY11. However, sectors like IT

and pharma, smaller export oriented units tend to benefit from rupee

weakness.

We remain believers of school of thoughts of Indian economic growth to

revive faster than estimated and interest rate cuts to start by Q1FY13

Indian economy – getting worse…

CY11 saw macro headwinds engulfing the economy on multiple fronts and,

thereby, impacting the growth, fiscal position and trade deficit. Adding to

the woes, policy paralysis has also impacted the investment environment

and is finally percolating to corporate performance. With the GDP growth

rate of 6.9% (in Q2FY12) touching a nine-quarter low, high inflation (9%+

throughout CY11) and interest rates and currency (down ~18% in CY11YTD)

also playing spoilsport, India Inc. also saw a southward movement in their

profitability. This is further accentuated by deteriorating fiscal deficit on

account of increase in crude prices (unlikely to come down in near future)

and other subsidy bills.

However, the current trend in inflation has shown signs of moderation

(currently at 9.1% in November, 2011 from the high of 10% in September,

2011). Furthermore, the RBI expects it to come down to 7% by March, 2012

on the back of easing food inflation. This would hold the key for growth

coupled with policy reforms and state elections.

Outlook 2012

Watch not only valuations but other variables also…

During gloomy times, one tends to become oblivious to the fact that post a

steep correction markets do start looking very attractive as P/E ratios in

relation to market levels keep coming down, presuming earnings to remain

constant/face less downgrade. On the contrary, both market levels and

earnings growth rates are moving targets. Hence, the end results can be

highly contrary to general anticipation.

Putting the above theory in the current perspective, the markets may be

looking attractive as they are trading at 14.1x and 12.2x their FY12E and

FY13E EPS, which is 13% below their historical P/E average of 14x.

However, what the markets may be pricing in vis-à-vis the consensus is a

higher decline in EPS for FY12 and FY13 given the macro and local

headwinds the country and corporates are facing. In such an eventuality,

looking at forward P/E multiples in isolation can become hazardous.

Rather than only focusing on projected estimates, it is also prudent to watch

out for the following factors:

􀂃 One year and two year forward P/E multiples coupled with standard

deviation of the same (looking at variances can cushion the deviation

in earnings estimates)

􀂃 Troughing of market multiples based on Trailing Twelve Months

earnings

􀂃 P/BV multiples based on TTM basis (serves as an effective valuation

tool at the time when relatively earnings visibility is not clear, thereby

rendering forward P/E multiples less effective)

􀂃 Interrelation of movement of broader markets with macro variables

such as interest rates and industrial production

􀂃 Correlation of markets with other financial assets like crude oil and

currency movement

􀂃 Attractiveness of debt yields vis-à-vis earnings yield of the BSE Sensex

Apart from the above, we have also observed that whenever earnings

growth comes out of two or three year hibernation the markets react sharply

to that event. This phenomenon is better explained from FY03-FY11 where

the correlation strength between market returns and Sensex earnings is

strong as compared to the periods of FY92-FY11 and FY02-FY11. Hence, this

time around we believe the earnings growth trajectory would stagnate or at

best may produce single digit growth rates. However, at the same time, we

expect earnings to catch up by CY13/FY14. Therefore, the markets will also

mirror the trend, in our view.

Sectoral Outlook

High macro uncertainties will create visibility issues for most of the

sectors and we expect CY12 (at least H1CY12) to be the year where stock

specific actions will prevail. We may however see some sector specific

momentum in the latter half on account of subsiding of macro economic

headwinds.

For CY12 we are positive on sectors that exhibit high revenue visibility,

stable cash flows, exhibit pristine balance sheets (low gearing and

marginal exposure to foreign liabilities) and will benefit from cyclical turn

of macro variables like interest rates and commodity prices. Hence we are

positives on sectors such as Automobiles (Monetary and commodity price

reversal to provide earnings and valuation upgrade), Technology (Market

share gains and depreciating rupee to aid valuations), Pharma (High

growth visibility and players with diversified geo mix to benefit), and

Telecom (Improving key metrics and regulatory clarity)

On the neutral side, sectors that stack the list include Banking (Asset

quality issues to neutralise monetary reversal coupled with low

valuations), FMCG (expensive valuations albeit improved realisations),

Media (Ad growth to moderate), Oil & Gas (Attractive valuations to get

subdued by regulatory uncertainties), Retail & Textile (Inexpensive

valuations discounting moderation in consumption).

As far as negative sectors are concerned we believe that Murphy’s Law

will prevail at least in the H1CY12. Therefore the list include sectors that

are more concerned with government actions, Capex intensive sectors and

sectors with highly geared balance sheets. Hence we expect

Infrastructure/Power & Capital Goods/ Real Estate to underperform

(Leveraged balance sheets, Regulatory hurdles; stressed investment cycle

to outweigh benefits arising from softening of interest rates and low

valuations). The list also includes Metals (Uncertain global environment

rendering haziness on demand outlook amidst attractive valuations),

Cement (Utilisation rates to remain tepid, Tier 1 companies commanding

rich valuations), Hotels (Incremental supply will hurt utilisations rates and

ARR’s)

Key events to watch in 2012

New Pharma pricing policy: We may see some impact on account of the likely

implementation of the new PPP, which will increase price control to over

60% of the drugs from the current ~20%. Although the policy is still under

discussion, if implemented, we may see some negative impact for some top

brands. As per AIOCD data, the impact would be around | 1500 crore.

Generic Drug User Fee Act: Approval for Generic Drug User Free Act (GDUFA)

in the US would be an important event for Indian companies. Under the act,

companies need to pay fees when they are filing ANDA or seeking approval

for manufacturing facilities. The USFDA is aiming to collect US$ 1.5 billion

for five years from all generic players, which would be used to expedite

ANDA approvals and reduce time for inspection of new/existing

manufacturing facilities.

US guidelines for Biosmiliars: The USFDA will take public comments on

Biosmiliar guidelines and user free act for the US market till the middle of

January and submit the final agreement to the United States Congress.

We remain positive about the outlook for the pharma and healthcare sectors

for 2012. Our belief is based on the capabilities that most of the players have

developed over the years to cope with challenges in a particular geography.

We expect players with optimum geographical mix to perform better than

players with focused markets. The US will remain the key market to conquer

on account of impending patent cliff and, hence, opportunities in both FTF

and generics. Brands worth ~$25-30 billion are expected to lose patent

exclusivity in 2012 itself. Although we remain positive about the sector

outlook, we may not see outright outperformance of the Healthcare index

vis-à-vis the Sensex on account of substantial valuation premium (~30%

currently). We may, however, see select pharma companies outperforming

the broader index.