Strategy CY2011: Life during and beyond QE2:: kotak sec

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Strategy
CY2011: Life during and beyond QE2. The US Fed’s QE2 program and likely strong
earnings growth may support the Indian market’s valuations at 15-18X FY2012E ‘EPS’,
above its 12-16X historical range. We see a few sub-themes playing out in CY2011E,
once the ‘effects’ of QE2 fade. These are (1) possible deregulation in the energy sector
led by likely low inflation in 2HCY11E and (2) rupee depreciation.


Fair valuations but QE2-led FII inflows and strong earnings growth may provide support
The Indian market (BSE-30 Index) trades at 14.6X FY2012E ‘EPS’ but we do not rule a further
expansion in multiples led by (1) continued strong FII inflows, (2) positive macro-economic outlook
and (3) strong earnings growth. We estimate FY2012E ‘EPS’ to grow 21.3% (21.4% on a freefloat
adjusted basis) to `1,358 (`1,270).

Consumption stories face challenges other than those of steep valuations
In our view, the rich valuations of domestic consumption companies do not reflect potential risks
to earnings from (1) rising competition in automobiles and consumer staples, (2) likely negative
regulatory changes in telecom (MNP and possible dissolution of telecom circles) and (3) accounting
changes in real estate (implementation of IFRS from April 1, 2011).

A few hedges in the portfolio, just in case
We position our portfolio to (1) limit exposure to standard ‘consumption’ plays that trade at rich
valuations; scope for positive surprises are limited and (2) prepare against certain probable events
as a hedge. (1) Deregulation of energy prices (coal, gas and oil) may result in realizations of
government-owned companies moving closer to global levels; government-owned oil stocks are
inexpensive and are factoring a low probability of reforms. (2) Possible depreciation in the Indian
Rupee despite QE2-led inflows as India’s weak CAD position is an issue; we like Technology stocks
anyway given a strong demand environment.

Weak CAD position may result in rupee depreciation; interest rates likely stable
We project FY2012E Current Account Deficit (CAD) at US$66 bn (3.7% of GDP) based on crude
price of US$81/bbl (Dated Brent). We do not rule out a sharp depreciation in the Indian Rupee
without offsetting large portfolio inflows if crude prices sustain at US$85-90/bbl levels. We expect
interest rates to likely remain largely stable (modest upside risk) through CY2011E after a period of
hikes in policy rates by the RBI.


stocks. We are
overweight on banking and technology and underweight domestic consumption stories such
as automobiles, consumer, real estate and telecom. More important, we follow a stockspecific
bottom-up approach to build our portfolio based on our views of fundamentals of
sectors and the Indian economy. Full valuations across sectors and earnings issues preclude a
top-down, theme-based approach.


We did not see any significant positive or negative surprises in 2QFY11 results that changes
our earnings view. The BSE-30 Index’s net profit increased 29.1% in 2QFY11 versus our
expected 24.7% (see Exhibit 3). For stocks in our coverage universe, net profits increased
43% versus our expected 18%, largely due to downstream companies receiving
compensation of `130 bn versus nil assumed by us; on a ex-Energy basis, net profit was
exactly in line with our expectations.