Equity outlook - India ‘Modi’vated Investors rejoice and bid goodbye to decades‐long fragile governance : RBS

After thirty years of coalition-based governments, the recent

decisive electoral mandate has led to an “all out equities”

outlook. This is the first time since foreign institutional

investor (FII) investments were permitted into the market

that a pro-reformist party has received a simple majority on

its own.

The recent political mandate offers the opportunity to

manage macro challenges and return to healthy high growth

for longer periods of time while containing inflation. The new

government may keep domestic and external demand in

balance and unlock the untapped potential to build

infrastructure.

The widely expected structural measures to address supply

chain infrastructure and skill gap fulfilment to contain the

inflation over the medium term could also help sustain

growth for longer compared to earlier cycles.

Faster and longer growth

India’s economic growth appears to have already bottomed

and started recovering. Favourable demographic factors like

a large working-age population and healthy rural demand

support domestic consumption.

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The previous government has cleared investment decisions

worth over USD100bn. However, the developers in these

investments were waiting for clarity on the political scene

before moving forward. Since the political outcome has

surpassed expectations, we expect to see a pick-up in

investment-led growth in the coming months.

Equities to outstrip economic growth

In the last 12 years, domestic gross domestic product (GDP

in nominal terms), NIFTY earnings and NIFTY Index grew at

a compounded growth rate of 14%. However, during the

high growth phase(HGP) of 2003-2008, the GDP grew at

pace of 16% compounded annually, while NIFTY earnings

and NIFTY index rose at a much faster clip of 26% and 40%

respectively during the same period. Although the recovery

phase after the global financial crisis (2009-2010) was

shorter in duration, we saw a similar growth spurt in the

earnings and index. However, the absence of investment

push has made it a short-lived recovery with supply side

constraints.

During the high-growth phases, the expansion in operating

and profit margins led by the financial and operating leverage

drove higher return on equity (ROE) and caused the

multiple expansions for Indian equities. This explains why

the growth in earnings and price was much higher than the

economic growth between 2003 -2008.

Growing FII interest in India

Given these factors, India appears to be gaining foreign

investor interest as an attractive investor destination relative

to other emerging markets. There are ongoing political

concerns in Indonesia and Thailand, while China is dealing

with slowing growth and credit concerns. In contrast, India

now offers a stable political environment, credible monetary

authority and potential fiscal reforms – making a strong case

for foreign investments.

Valuations moving ahead of fundamentals

The NIFTY index is currently trading at 14.7x on a 12-month

forward earnings basis against a historical average of 14.2x.

Historically, during the recovery phase, valuations tend to

move ahead of fundamentals with renewed optimism and

investor confidence. This will have a spiralling effect and it

will eventually help recover demand and earnings and

provides valuation support for price stability.

Expect sustained market levels with upside bias

Stable commodity prices and labour rates together with the

sharp currency depreciation over the past three years will

offer competiveness over other countries and potentially

recover corporate demand and profits. Going forward,

improvements in operating and financial leverage will help

recover return ratios from current lows and help in re-rating

valuation multiples.

Historic moment for investors

We expect to see the sustained market levels with an upside

bias over the medium to longer term. Given the current

change in environment, we believe that the market has the

required impetus to repeat the earlier HGP over next five to

seven years period. Hence, we think that investors could

consider increasing equity allocations from the medium- to

longer-term opportunity perspective to grow assets multi

fold in a high growth environment, instead of getting swayed

by the current market levels and multiples in the short term.

Routes to Markets – Direct Equity

Core Portfolio Strategy - Indian Olympians - Series II

A stable equity strategy that could weather frequent bouts

of risks is now necessary. This situation is driven by elevated

volatility in equities over the past five years led by global

factors and domestic macro fundamental weakness. The

investment horizon has also become extended over a longer

term. Investors have started looking at long-term growth

and reducing volatility in their portfolio to weather high

inflation and interest rates coupled with sluggish growth

while meeting return objectives.

Recognising these investor needs, we launched a portfolio

strategy namely ‘Indian Olympians’. This strategy aims to

identify companies that demonstrate a strong economic

moat over its competitors, earnings consistency and free

cash generation.

After an objective scrutiny of the National Stock Exchange of

India’s CNX 500 index, we have identified a set of 10

companies that came out as winners in an equal weight rank

system. The rank system quantifies business quality (growth

as well as consistency), capital structure and cash flow

allocation policy and shareholder dividends.

We assigned equal weightage to the previous criteria on the

constituents of CNX 500 index, which encompass more

than 90% of India’s stock market capitalization.

Opportunistic Allocation: Infrastructure stocks will benefit

The new government is likely take steps to revive economic

growth and job creation in the coming months to meet the

electorate’s hopes. Given the fiscal compulsions, economic

revival can happen only through prepping up the investment

cycle.

Corporate capital expenditure is still some time away given

the low corporate capacity utilisation and weak demand.

Hence, the focus will be on building infrastructure, specifically

in transportation and power. Roads, sea ports, airports and

railways are likely to be primary beneficiaries from future

project announcements and related reforms. We have

identified four stocks representing each of these sectors to

Opportunistic Basket

capture the upside from such policy announcements.

In the power sector, generating capacity additions are swiftly

underway. Up-linking these generating stations to the power

grid and addressing power losses would improve the

efficiencies in the sector. Crompton is the key stock likely to

benefit from the pickup in demand in the power

transmission and distribution sector.

Valuations of these sectors appear to be expensive against

their historic multiples. However, these multiples are based

on the compressed earnings environment what we have

witnessed in these segments over three years. A pickup in

demand and improvement in utilisation will help improve

earnings and return ratios in the coming quarters.


Routes to Markets – Mutual Funds

well-managed strategies with extremely good risk-
adjusted returns and provide a considerable alpha over the

The equity markets have reached new highs on the back of

overwhelming mandate received by the BJP in the 2014

general elections.

Mutual funds have also greatly benefitted from the market

rally with the biggest gains by infrastructure, public sector

undertaking (PSU) and mid-capitalisation (mid-cap) funds. At

the same time, the technology, fast moving consumer goods

(FMCG) and pharmaceutical funds were the worst

performers.

Many funds that languished until now have also benefitted

from the rally and tend to look attractive based on recent

returns.

It is important for the investor to separate the wheat from

the chaff and consider the long-term track record and

returns consistency of funds. Additionally, it is important to

consider the risk-adjusted returns of funds while making an

investment decision.

Large-capitalisation (large-cap) funds form the core holding

in an investor’s equity portfolio. These funds typically display

more consistent returns with lower volatility as compared to

mid-cap or sector-based funds. We recommend Axis Equity

Fund & Birla Frontline Equity Fund. Both these funds are

index.

Mid-cap funds tend to perform better than large-caps in

trending bull markets and offer an attractive beta over the

broader indices. Given the divergence of returns in mid-cap

stocks, astute stock selection is key to delivering consistent

returns. We recommend investing into the DSP Small-&

Mid-cap& ICICI Prudential Value Discovery Fund. DSP Small-

& Mid-cap Fund tends to perform better than the market in

bullish markets. ICICI Prudential Value Discovery Fund has

the mandate to buy into value stocks with a mid-cap bias,

this strategy not only captures the upside in bullish markets,

but also protects the downside in bearish markets as value

stocks tend to depreciate lesser than the broader market.

Infrastructure stocks, ignored for the last 4-5 years, have

seen a significant amount of interest returning with the

decisive electoral mandate. The market expects the new

government to kick-start the infrastructure investment and

spending cycle. This should help many of the infrastructure

companies improve capacity utilization and also turn around

distress assets. We recommend investing into the IDFC

Infrastructure Fund, which is one of the few true-to-label

infrastructure funds as it is primarily invested into the core

infrastructure sectors and have stayed out of peripheral

sectors like banking &financial services.