BofA Merrill Lynch, India Strategy — Stress-testing risk:reward for Nifty companies

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India Strategy — Stress-testing risk:reward for
Nifty companies
Country Overview
Market woes to continue as global tail risks mount
We have been negative on Indian markets this year due to – a) high inflation and
rising interest rates leading to a slowing economy, and b) earnings downgradesled
margin pressure from rising costs. In the past month, global tail risks have
come to the fore, pressuring the market further – the Euro crisis is likely to grab
mindshare over the next few weeks. Meanwhile, the probability of a US recession
is also rising – our US economist has raised his recession probability to 40%.
Stress-testing risk:reward for Nifty companies
The slowing US economy poses further downside risk to our earnings. Given the
macro gyrations globally, we have done a stress-test of the stocks in the Nifty
index. Our stress-tests look at both – likely downside to our current earnings
estimates, as well as possible contractions in valuations in an environment where
risk premium expands. We also look at an upside scenario where rates in India
are cut faster than currently expected and global commodity prices fall. A
summary of our expectations is in Table 1 (see page 2).
Downside case: Sensex earnings CAGR at 8% (current: 17%)
Our bottom-up analyst forecasts currently indicate a Sensex EPS CAGR of 17%
over FY11-13. Top-down, we believe this is optimistic and expect downgrades. In
our downside scenario, the Sensex EPS CAGR over the next two years works out
to 8%. By comparison, growth during FY08-10 (Lehman crisis) was close to 0%.
Stock and sector views – We like Maruti & ICICI Bank
The absolute risk:return figure may not be the best way to look at Table 1 (pg 2).
The probability of and the scenarios under which these returns can be achieved is
also important. Our key conclusions are:
1. In the current risk-averse environment, limited downside risk stocks are
preferred. Stocks like HDFC Bank (HDFCB IN), HDFC (HDFC IN) and ITC (ITC
IN) fit the criteria - high quality, though not cheap.
2. Stocks we like on risk:reward basis are ICICI (ICICIBC IN) & Maruti (MSIL IN).
3. Stocks with unfavorable risk:reward (where analysts are negative) are Ambuja
(ACEM IN) and Bajaj Auto (BJAUT IN), in addition to metal names like SAIL
(SAIL IN).
4. High-risk, high-reward plays are Jaiprakash Associates (JPA IN) and DLF
(DLFU IN). While they have high upside potential, we think they need a “risk on”
environment where investors are more willing to tolerate high-gearing companies.