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Eye on India
危机 (pronounced “Wéijī”)
Event
This Chinese word means “Crisis”. John F Kennedy in his address on 12 April
1959 said, "When written in Chinese, the word "crisis" is composed of
two characters. One represents danger and the other represents
opportunity." That rings just as true today on 12 August 2011.
This week we stress-test earnings for Sensex stocks and run valuation
screens to identify where the market could bottom out. Our analysis suggests
the Indian market is fairly valued, but not at the absolute bottom as yet. The
market is currently trading at a one-year-forward PER of 14.1x, which is below
the past 10 years’ average of 14.7x, and still implying nominal average annual
earnings growth of 17% for the next 10 years. Moreover, the implied equity
risk premium is less than 1 sd away, as compared to 2 sd for Asia ex Japan.
Our stress-test of Sensex stocks earnings suggests that there can be an 18%
and 23% hit for FY12 and FY13 earnings estimates in the worst-case
scenario. Stock selection is key. Our analysis suggests that a number of
Sensex companies could potentially register annualised earnings growth of
10% over the next two years even under our bear-case assumptions: ONGC,
HNDL, ICICI, ITC, HDFCB, SUNP, HDFC, LT, JSP, STLT, HUVR and SBI.
Impact
Markets continue to be weak: The Indian market fell nearly 4% this week,
outperforming emerging markets by 100bp and underperforming the
developed world index by 160bp. Last week saw nearly US$1.2bn net selling
by FIIs (YTD +US$980m) and US$370m worth of net buying by domestic MFs
(YTD US$1.2bn). Amongst sectors, IT and Metals were the worst-performing
sectors (-9.7% and -7.2% respectively) while the Auto index was the best
performing sector (1.4%). Our top 10 stocks underperformed the broader
market, led by a 10% fall in Infosys; M&M was the only stock that was up
(+7.2%). Our top-10 list continues to outperform the MSCI India Index by
460bp.
Mixed macro data but both hawkish: IIP data surprised on the upside,
recording an 8.8% yoy growth vs the consensus estimate of 5.5%. The May
data was revised up from 5.6% to 5.9%. On the other hand, weekly food
inflation spiked up to 9.9%, the highest in more than three months. Both data
points are hawkish in nature and it would be interesting to see what stance
the RBI takes in its mid-quarter announcement next month. Our economist,
Tanvee Gupta Jain, believes that the current situation in the US and Europe
and the recent decline in oil prices have lowered the probability of a rate hike
in September; however, the data over the next few weeks would need to be
closely monitored to have a firm view on the mid-quarter meeting.
Outlook
One thing looks certain – VOLATILITY: There is a plethora of results lined
up today and given past experience, the weaker companies usually announce
at season’s end. Markets have been in selling mode and will most likely
continue to oscillate around current levels. Don’t rush to buy, take your time.
Where is the bottom?
This week we take a closer look at valuations and earnings. The Indian market has seen some
correction, but by no means hit the bottom. All analysis points to a possible bottom around 14,500–
15,000 at the Sensex level, in our view. This is highlighted by the fact that we are trading at a oneyear-
forward PER of 14.1x, which is not far from the 10 years’ average of 14.7x and 15 years’
average of 14.3x. In comparison, Asia ex Japan is already trading at 9.5x, which is well below the 10-
year average of 13.2x. In terms of implied equity risk premium, Indian markets stand below 1 sd,
while Asia ex-Japan is at 2 sd and Australia is at nearly 3 sd! So there is still some way to go before
Indian markets are done.
Our analysts have also stress-tested Sensex earnings, and their analysis suggests there could be
further downside of 18% and 23% to our FY12 and FY13 earnings estimates, respectively, from our
base case. Many stocks still screen well on earnings growth even in our bear-case assumptions and
could be potential buys on weakness in this uncertain environment; these are ONGC, HNDL, ICICI,
ITC, HDFCB, SUNP, HDFC, LT, JSP, STLT, HUVR and SBI. We also stress the need to assess
stocks in light of their earnings quality, cash flow positions and balance sheet strength. Screens
based on these appear in Figures 9 and 10.
Global risk adds to domestic macro overhang
The past week was dominated by the US sovereign rating downgrade, which spilled over to global
equities, resulting in a large sell-off across all markets. For the Indian market, it adds one more
dimension (in addition to domestic macro issues) to the overall tentative mood seen since the
beginning of 2011. The sudden spurt in global risk aversion assumes greater importance compared
to the ongoing domestic issues, especially considering what we experienced back in 2008. We would
exercise caution in the near term as global events would continue to dictate the market’s direction
and keep it volatile. Hence, we continue to advocate a more stock-specific approach and advise
building long-term positions in large-cap quality stocks.
While domestic macro issues are yet to be addressed, the current global weakness has made certain
factors tilt in favour of India:
a) lower oil and commodity prices;
b) possibility of inflation and interest rates peaking sooner than expected;
c) relative attractiveness of India due to its lower economic dependence on other markets; and
d) absolute valuations now trading below long-term averages.
While these factors do make Indian equities appear attractive from a long-term perspective, we
believe the current global and domestic macro issues will keep markets weak in the near term. On
the other hand, key triggers for a longer-term rally would be:
a) positive outcomes on economic reforms;
b) peaking inflation;
c) pause in interest rate hikes; and
d) revival in investment activity.
In the worst-case scenario, if global macro deteriorates from here on, we see a further 15% downside
to the Sensex from current levels.
What is being priced in at current market valuations?
Valuations below long-term avg – implied nominal growth seems reasonable
The Sensex has declined 11% in the past two weeks and is now trading at a 12-month forward PER
of 14.1x versus a 15-year average of 14.3x and 10-year average of 14.7x. Using a combination of
perpetuity valuation models we estimate that the market is currently pricing in an implied average
nominal growth of 7.5% in perpetuity (Fig 2), assuming a 10% cost of equity, which appears fairly
reasonable from a long-run growth perspective.
We also revisit our two-stage DDM to validate the growth assumptions implied by current valuations.
In our model, we have defined the high-growth period as the next 10 years with 18% earnings CAGR
and 14% cost of equity, whereas our stable growth assumptions included 6% nominal growth in
perpetuity and 10% cost of equity. Keeping our stable growth assumptions unchanged, at the current
value of the Sensex, the implied growth rate for the high-growth period turns out to be around 17%,
100bp below our assumption. Our assumption of 18% earnings CAGR itself is predicated on average
annual IIP growth of 7.5% and average real GDP growth of 8% over the next 10 years. These
assumptions need to be seen in the context of 8.5% average annual growth in both IIP and GDP
over the past eight years, since the beginning of a new phase of high economic growth since
FY2004.
While we feel there is no doubting the long-term growth potential of the Indian economy, we believe
the market is currently discounting the macro overhang due to the current high inflationary
environment, slow pace of reforms and political stalemate on a variety of issues. In this context,
market valuations appear reasonable, thereby implying limited upside from current levels. Any rerating
from these levels would depend mainly on an improvement in the macro environment.
Risk premium reflecting heightened risk aversion but still below previous peaks
While Asian and developed market risk premiums are now nearly 2–3 standard deviations above
their long-term average, risk premium in India, while having risen nearly 200bp over the past one
year and above its long-term average, is still below its 1 standard deviation level and its previous
peaks over the past 10 years. Our measure of the risk premium is based on the spread between the
earnings yield (inverse of PER) on the 12-month forward PER and the real bond yield (nominal yield
– core inflation). We prefer to look at this version of the so-called Fed model as it gives a better
picture of implied market risk premium – the current high level of inflation is masking the near-18%
de-rating of equities and the increase in risk aversion over the past eight months. We believe risk
premiums in India are not yet as high as in other regions for the market to rally from here on. The
market appears fairly valued, in our view, and any rally unaccompanied by an improvement in the
macro environment would be an opportunity to sell. Till that time, we would continue to advise a more
stock-specific approach.
Bottom-up worst-case scenario for Sensex indicates 15% downside from current levels
Based on a worst-case scenario analysis, our current estimates of Sensex companies’ aggregate
PAT are likely to take a hit of 18% for FY12 and 23% for FY13. This would reflect no growth in profits
in FY12 and a 9% decline in profits in FY13, on an aggregate basis, compared to the currently
estimated 21% and 18% growth for FY12 and FY13, respectively. The resultant change in their stock
valuation indicates a 15% downside from the current level of the index, which in our view would be
the likely absolute bottom if the global macro situation were to worsen significantly from here on.
Looking at the long-term trend of the Sensex’s 12-month forward PER, current valuations are not too
far from the 10-yr average of 14.7x and 15-yr average of 14.3x PER. The 1-standard-deviation level
stands at 11x, which indicates that statistically, the worst-case bottom for the market could be a
further 25% decline from current levels. But note that this level has been breached only thrice in the
past 10 years – and one of these times was the global credit crisis in 2008, when the 12-month
forward PER hit a bottom at 9.2x. In our view, the current slowdown is not akin to the previous crisis,
and therefore does not warrant such a drastic de-rating. This gives us comfort around current
valuations and our worst-case estimate of 15% downside from here.
Market and Sector Performance
Global markets continued to slide this week, with developed markets recording a cumulative 2.3%
decline and emerging markets falling nearly 5%. The Indian market dropped 4%. Overall, the
Indian market outperformed emerging markets by 100bp and underperformed the developed world
index by 160bp.
Amongst sectors, IT and Metals were the worst-performing sectors (-9.7% and -7.2%,
respectively) on the back of global macro worries, while the auto index was the best-performing
sector (1.4%). Year-to-date, consumer stocks continue to be outperformers, with the FMCG Index
up 6.3% and the consumer durables index up nearly 1%, reflecting investors’ defensive stance
since the beginning of the year. However, the gains have come off their highs on the back of the
recent sell-off in equities. YTD, the worst-performing sector continues to be real estate (-35.8%),
followed by metals (-29.4%).
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Eye on India
危机 (pronounced “Wéijī”)
Event
This Chinese word means “Crisis”. John F Kennedy in his address on 12 April
1959 said, "When written in Chinese, the word "crisis" is composed of
two characters. One represents danger and the other represents
opportunity." That rings just as true today on 12 August 2011.
This week we stress-test earnings for Sensex stocks and run valuation
screens to identify where the market could bottom out. Our analysis suggests
the Indian market is fairly valued, but not at the absolute bottom as yet. The
market is currently trading at a one-year-forward PER of 14.1x, which is below
the past 10 years’ average of 14.7x, and still implying nominal average annual
earnings growth of 17% for the next 10 years. Moreover, the implied equity
risk premium is less than 1 sd away, as compared to 2 sd for Asia ex Japan.
Our stress-test of Sensex stocks earnings suggests that there can be an 18%
and 23% hit for FY12 and FY13 earnings estimates in the worst-case
scenario. Stock selection is key. Our analysis suggests that a number of
Sensex companies could potentially register annualised earnings growth of
10% over the next two years even under our bear-case assumptions: ONGC,
HNDL, ICICI, ITC, HDFCB, SUNP, HDFC, LT, JSP, STLT, HUVR and SBI.
Impact
Markets continue to be weak: The Indian market fell nearly 4% this week,
outperforming emerging markets by 100bp and underperforming the
developed world index by 160bp. Last week saw nearly US$1.2bn net selling
by FIIs (YTD +US$980m) and US$370m worth of net buying by domestic MFs
(YTD US$1.2bn). Amongst sectors, IT and Metals were the worst-performing
sectors (-9.7% and -7.2% respectively) while the Auto index was the best
performing sector (1.4%). Our top 10 stocks underperformed the broader
market, led by a 10% fall in Infosys; M&M was the only stock that was up
(+7.2%). Our top-10 list continues to outperform the MSCI India Index by
460bp.
Mixed macro data but both hawkish: IIP data surprised on the upside,
recording an 8.8% yoy growth vs the consensus estimate of 5.5%. The May
data was revised up from 5.6% to 5.9%. On the other hand, weekly food
inflation spiked up to 9.9%, the highest in more than three months. Both data
points are hawkish in nature and it would be interesting to see what stance
the RBI takes in its mid-quarter announcement next month. Our economist,
Tanvee Gupta Jain, believes that the current situation in the US and Europe
and the recent decline in oil prices have lowered the probability of a rate hike
in September; however, the data over the next few weeks would need to be
closely monitored to have a firm view on the mid-quarter meeting.
Outlook
One thing looks certain – VOLATILITY: There is a plethora of results lined
up today and given past experience, the weaker companies usually announce
at season’s end. Markets have been in selling mode and will most likely
continue to oscillate around current levels. Don’t rush to buy, take your time.
Where is the bottom?
This week we take a closer look at valuations and earnings. The Indian market has seen some
correction, but by no means hit the bottom. All analysis points to a possible bottom around 14,500–
15,000 at the Sensex level, in our view. This is highlighted by the fact that we are trading at a oneyear-
forward PER of 14.1x, which is not far from the 10 years’ average of 14.7x and 15 years’
average of 14.3x. In comparison, Asia ex Japan is already trading at 9.5x, which is well below the 10-
year average of 13.2x. In terms of implied equity risk premium, Indian markets stand below 1 sd,
while Asia ex-Japan is at 2 sd and Australia is at nearly 3 sd! So there is still some way to go before
Indian markets are done.
Our analysts have also stress-tested Sensex earnings, and their analysis suggests there could be
further downside of 18% and 23% to our FY12 and FY13 earnings estimates, respectively, from our
base case. Many stocks still screen well on earnings growth even in our bear-case assumptions and
could be potential buys on weakness in this uncertain environment; these are ONGC, HNDL, ICICI,
ITC, HDFCB, SUNP, HDFC, LT, JSP, STLT, HUVR and SBI. We also stress the need to assess
stocks in light of their earnings quality, cash flow positions and balance sheet strength. Screens
based on these appear in Figures 9 and 10.
Global risk adds to domestic macro overhang
The past week was dominated by the US sovereign rating downgrade, which spilled over to global
equities, resulting in a large sell-off across all markets. For the Indian market, it adds one more
dimension (in addition to domestic macro issues) to the overall tentative mood seen since the
beginning of 2011. The sudden spurt in global risk aversion assumes greater importance compared
to the ongoing domestic issues, especially considering what we experienced back in 2008. We would
exercise caution in the near term as global events would continue to dictate the market’s direction
and keep it volatile. Hence, we continue to advocate a more stock-specific approach and advise
building long-term positions in large-cap quality stocks.
While domestic macro issues are yet to be addressed, the current global weakness has made certain
factors tilt in favour of India:
a) lower oil and commodity prices;
b) possibility of inflation and interest rates peaking sooner than expected;
c) relative attractiveness of India due to its lower economic dependence on other markets; and
d) absolute valuations now trading below long-term averages.
While these factors do make Indian equities appear attractive from a long-term perspective, we
believe the current global and domestic macro issues will keep markets weak in the near term. On
the other hand, key triggers for a longer-term rally would be:
a) positive outcomes on economic reforms;
b) peaking inflation;
c) pause in interest rate hikes; and
d) revival in investment activity.
In the worst-case scenario, if global macro deteriorates from here on, we see a further 15% downside
to the Sensex from current levels.
What is being priced in at current market valuations?
Valuations below long-term avg – implied nominal growth seems reasonable
The Sensex has declined 11% in the past two weeks and is now trading at a 12-month forward PER
of 14.1x versus a 15-year average of 14.3x and 10-year average of 14.7x. Using a combination of
perpetuity valuation models we estimate that the market is currently pricing in an implied average
nominal growth of 7.5% in perpetuity (Fig 2), assuming a 10% cost of equity, which appears fairly
reasonable from a long-run growth perspective.
We also revisit our two-stage DDM to validate the growth assumptions implied by current valuations.
In our model, we have defined the high-growth period as the next 10 years with 18% earnings CAGR
and 14% cost of equity, whereas our stable growth assumptions included 6% nominal growth in
perpetuity and 10% cost of equity. Keeping our stable growth assumptions unchanged, at the current
value of the Sensex, the implied growth rate for the high-growth period turns out to be around 17%,
100bp below our assumption. Our assumption of 18% earnings CAGR itself is predicated on average
annual IIP growth of 7.5% and average real GDP growth of 8% over the next 10 years. These
assumptions need to be seen in the context of 8.5% average annual growth in both IIP and GDP
over the past eight years, since the beginning of a new phase of high economic growth since
FY2004.
While we feel there is no doubting the long-term growth potential of the Indian economy, we believe
the market is currently discounting the macro overhang due to the current high inflationary
environment, slow pace of reforms and political stalemate on a variety of issues. In this context,
market valuations appear reasonable, thereby implying limited upside from current levels. Any rerating
from these levels would depend mainly on an improvement in the macro environment.
Risk premium reflecting heightened risk aversion but still below previous peaks
While Asian and developed market risk premiums are now nearly 2–3 standard deviations above
their long-term average, risk premium in India, while having risen nearly 200bp over the past one
year and above its long-term average, is still below its 1 standard deviation level and its previous
peaks over the past 10 years. Our measure of the risk premium is based on the spread between the
earnings yield (inverse of PER) on the 12-month forward PER and the real bond yield (nominal yield
– core inflation). We prefer to look at this version of the so-called Fed model as it gives a better
picture of implied market risk premium – the current high level of inflation is masking the near-18%
de-rating of equities and the increase in risk aversion over the past eight months. We believe risk
premiums in India are not yet as high as in other regions for the market to rally from here on. The
market appears fairly valued, in our view, and any rally unaccompanied by an improvement in the
macro environment would be an opportunity to sell. Till that time, we would continue to advise a more
stock-specific approach.
Bottom-up worst-case scenario for Sensex indicates 15% downside from current levels
Based on a worst-case scenario analysis, our current estimates of Sensex companies’ aggregate
PAT are likely to take a hit of 18% for FY12 and 23% for FY13. This would reflect no growth in profits
in FY12 and a 9% decline in profits in FY13, on an aggregate basis, compared to the currently
estimated 21% and 18% growth for FY12 and FY13, respectively. The resultant change in their stock
valuation indicates a 15% downside from the current level of the index, which in our view would be
the likely absolute bottom if the global macro situation were to worsen significantly from here on.
Looking at the long-term trend of the Sensex’s 12-month forward PER, current valuations are not too
far from the 10-yr average of 14.7x and 15-yr average of 14.3x PER. The 1-standard-deviation level
stands at 11x, which indicates that statistically, the worst-case bottom for the market could be a
further 25% decline from current levels. But note that this level has been breached only thrice in the
past 10 years – and one of these times was the global credit crisis in 2008, when the 12-month
forward PER hit a bottom at 9.2x. In our view, the current slowdown is not akin to the previous crisis,
and therefore does not warrant such a drastic de-rating. This gives us comfort around current
valuations and our worst-case estimate of 15% downside from here.
Market and Sector Performance
Global markets continued to slide this week, with developed markets recording a cumulative 2.3%
decline and emerging markets falling nearly 5%. The Indian market dropped 4%. Overall, the
Indian market outperformed emerging markets by 100bp and underperformed the developed world
index by 160bp.
Amongst sectors, IT and Metals were the worst-performing sectors (-9.7% and -7.2%,
respectively) on the back of global macro worries, while the auto index was the best-performing
sector (1.4%). Year-to-date, consumer stocks continue to be outperformers, with the FMCG Index
up 6.3% and the consumer durables index up nearly 1%, reflecting investors’ defensive stance
since the beginning of the year. However, the gains have come off their highs on the back of the
recent sell-off in equities. YTD, the worst-performing sector continues to be real estate (-35.8%),
followed by metals (-29.4%).
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