Ambit- Strategy -ERr Grp- The Rebooting of India

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

The rebooting of India With this note we inaugurate a new series, India Rebooted, which will focus on the policies of the new Government and their consequent impact on the economy and the stockmarket. As highlighted in our 24th December note, a decisive victory for Mr Modi would result in our FY15 GDP estimate going up. We now our raise our FY15 GDP estimate from 5.1% to 5.6% (vs 4.7% in FY14) and we raise our end-FY15 Sensex target from 24K to 30K.

Raising our FY15 GDP growth estimate to 5.6%

As highlighted in our 24 December 2013 note, a comparison of the average GDP growth rate recorded in Gujarat and Maharashtra over two time periods - namely the pre-Modi period (FY91-01) and the post-Modi period (FY02-12) - suggests that Gujarats lead over Maharashtra in terms of GDP growth expanded from 0.4% YoY in the pre-Modi phase to 0.9% YoY in the post-Modi phase. Hence, we highlighted that we would add another 50bps to our GDP growth estimate if two conditions are satisfied: (a) Mr Modi emerges as the PM post the General Elections; and (b) the BJP is able to get 210 or more seats on its own. Given that both these conditions have now been satisfied, we shift our base-case GDP growth estimate for FY15 to 5.6% YoY (from 5.1%).

Raising the Sensex target to 30,000

Given that the BJPs majority will almost certainly lead to elevated expectations on economic reform, we raise our trailing P/E target from 17.0x to 20.0x. This combined with a FY15 Sensex EPS estimate of Rs1,500 (implying 14% YoY growth) leads to our new end-FY15 Sensex target of 30,000 (vs the previous target of 24,000 and implying 24% upside).

As highlighted in our 11 March thematic, after three waves of growth in the last 30 years, India is entering its fourth wave. In the previous three waves, more than two-thirds of all stockmarket returns have come in the first three years (with the Sensex CAGR at 33% in this window).

Three sense checks on the ongoing rally

We believe that the markets rally over the past nine months has more to it than just expectations on the political front.

(1) The RBI governors commitment towards positive real interest rates should go a long way towards tackling inflation and preparing the grounds for a shift from consumption to investment and from real assets to financial assets,

(2) Corporate profitability cycle appears set for the next wave up in sync with economy and polity, and

(3) Global data points to a reflating world economy and this should provide tailwinds to Indian equities.

Investment implications for the market uptrend!

The quality at a reasonable price approach followed in our G&C 7.1 portfolio, which results in a portfolio tilted towards cyclical, value and small-cap stocks, remains our preferred positioning for the market upmove. Since September 2013, this approach has delivered more than 1,100bps of alpha vis-a-vis the BSE500. We also highlight in this note a set of firms with high operating leverage; the earnings growth of these firms should disproportionately benefit from an economic revival.

Strategy

THEMATIC May 19, 2014

G&C 7.1-Quality at a reasonable price Company name Sector Weight (%)

Bajaj Auto Auto 4.3

Tata Motors Auto 4.3

Exide Inds. Auto Anc 4.3

MRF Auto Anc 4.3

Federal Bank BFSI 4.3

ICICI Bank BFSI 4.3

I D F C BFSI 4.3

LIC Housing Fin. BFSI 4.3

Grasim Inds Cement 4.3

Larsen & Toubro E&C 4.3

HCL Technologies IT 4.3

Coal India Mining 4.3

NMDC Mining 4.3

Oil India Oil & Gas 4.3

O N G C Oil & Gas 4.3

Bharti Airtel Telecom 4.3

Power Grid Corpn Utilities 4.3

McLeod Russel Agro 2.1

TVS Motor Co. Auto 2.1

ING Vysya Bank BFSI 2.1

Engineers India E&C 2.1

Bharat Electron Industrials 2.1

Sadbhav Engg. Infra 2.1

MindTree IT 2.1

D B Corp Media 2.1

Petronet LNG Oil & Gas 2.1

Cadila Health. Pharma 2.1

Oberoi Realty Realty 2.1

Sobha Developer. Realty 2.1

Torrent Power Utilities 2.1

Source: Bloomberg, Ambit Capital research

Analyst Details

Saurabh Mukherjea, CFA [email protected] +91 99877 85848

Gaurav Mehta, CFA [email protected] +91 22 3043 3255

Ritika Mankar Mukherjee, CFA [email protected] +91 22 3043 3175

Karan Khanna [email protected] +91 22 3043 3251

Strategy

May 19, 2014 Ambit Capital Pvt. Ltd. Page 2

CONTENTS

Section 1: Raising our GDP growth estimate to 5.6% YoY.. 3

Section 2: Raising our FY15 Sensex target to 30,000.. 7

Section 3: Three sense checks on the ongoing rally. 9

Section 4: Investment implications. 15

G&C 7.1- Implied sector weights 21

Strategy


Section 1: Raising our GDP growth estimate to 5.6% YoY Against the backdrop of India having voted in a single-party majority government (headed by a pro-development leader) after three decades, we re-visit our growth estimates for FY15 and raise the same marginally from 5.1% YoY to 5.6% YoY. Moreover, we expect Indias GDP growth trajectory to head upwards over the next few years, as CY14 appears likely to mark the beginning of Indias fourth sine wave of economic growth (click here for our note, Investing into Indias fourth wave).

India votes out caste-based politics, communism; demands good governance Besides electing in a single-party majority Government on 16 May 2014, the Indian electorate systematically delivered four clear messages, namely:

Indias readiness to sample market-driven economics or capitalism as is evident not just from the rise of the BJP but also the voting out of the Left,

The election results indicate Indias readiness to sample market-driven economics or capitalism as is evident not just from the rise of the BJP but also the voting out of the Left

The declining relevance of caste-based politics as is evident from the decline of regional parties such as the SP and BSP,

The rising intolerance towards corruption as was evident from the annihilation of parties such as the Congress or the DMK, and

The willingness to give a chance to parties that offer good governance or plain transparency as evident from not just the rise of the BJP but also smaller parties such as the AAP or BJD.

Refer to the table below for details.

Exhibit 1: The 2014 election results vs the 2009 election results

Party 2009 Actuals 2014

Actuals Swing

(09 vs 14) NDA 141 338 +197

BJP 116 284 +168

Shiv Sena 11 18 +7

SAD 4 4 0

TDP 6 16 +10

UPA 234 57 -177

Congress 206 44 -162

NCP 9 6 -3

RJD 4 4 0

DMK 18 0 -18

AIADMK 9 37 +28

TMC 19 34 +15

AAP 0 4 +4

BSP 21 0 -21

SP 23 5 -18

BJD 14 19 +5

CPI(M) 16 9 -7

JD(U) 20 2 -18

TRS 2 11 +9

YSRC 2 9 +7

Others 168 148 -20

Total 543 543 0

Source: CSDS, Ambit Capital research

We raise our FY15 GDP growth forecast from 5.1% YoY to 5.6% YoY

Strategy


Looking back at the post-poll surveys

Rajeeva Karandikar, the leading psephologist whose work had projected 276 seats for the NDA as per his last survey, highlighted that the underestimation of the BJPs seat count is attributable to the fact that his vote-to-seat conversion model by design underestimates the winners seat count. Hence, whilst the CSDS projected the broad story accurately (i.e. that the NDA would breach the 272-mark), the survey did end-up underestimating the BJP seat count by ~40 seats and the NDA seat count by ~50 seats. He went on to make the point that the entire exercise once again shows the power as well as limitation of survey-based projections in India.

GDP growth normalisation to begin in FY15 In our note dated 24 December 2013 (click here for details) we stated that we expect GDP growth, in a base case, to rise to 5.1% YoY in FY15 (vs 4.7% YoY in FY14, as per Ambit estimates), driven by faster industrial sector growth and a minor improvement in services sector growth. Furthermore, we made the point that we would add another 50bps to our GDP growth estimate if two conditions are satisfied, namely that Narendra Modi emerges as the PM post the General Elections and the BJP is able to win 210 or more seats on its own. Given that both these conditions have now been satisfied, we shift our base-case GDP growth estimate for FY15 to 5.6% YoY (see the exhibit below for details).

Exhibit 2: GDP growth in India is likely to resume the process of normalisation in FY15 GDP Growth (YoY change, in %) FY13

FY14 (CSO)

FY15 (Ambit Est.)

Change (FY15 v/s FY14)

10 year average (FY03-14)

Agriculture 1.4% 4.6% 2.0% -260bps 3.6%

Industry 1.0% 0.7% 4.2% +350bps 7.2%

Services 7.0% 6.9% 7.1% +20bps 9.0%

GDP 4.5% 4.9% 5.6% +70bps 7.6%

Memo Item: Investment 0.8% 0.2% 5.7% +550bps 10.6%

Source: CEIC, Ambit Capital research Despite the prospect of the El Nino effect playing out in FY15, we retain our normal farm sector growth estimates owing to three sets of mitigating factors namely,

1 Our discussions with food experts suggest that ground water levels in India currently are above average,

2 We expect a Modi-led Government to focus intensively on boosting farm sector growth given Narendra Modis track record of boosting the same significantly in his home state, and

3 The Indian Meteorological Department forecasts the Indian south-west monsoon to be recorded at 95% of the long-term average (LTA) in FY15, which is only 100bps below the normal range of 96-104% of LTA.

The rationale for the 50bps Modi premium The rationale for the 50bps Modi premium is based on his track record of significantly improving Gujarats economic performance as its Chief Minister (CM). Modi has governed Gujarat as its CM since FY02 and a 380bps lift in Gujarats trend GDP growth rate has materialised during this period (see the exhibit below). However his performance and success at the state level cannot be extrapolated at the national level for obvious reasons, including the existence and rise of stronger check and balance institutions (eg. CAG, Lokpal, RTI, and AAP), which look likely to remain activated post-elections as well.

The post-poll survey conducted by CSDS, once again shows the power as well as limitation of survey-based projections in India

We add 50bps to our base-case GDP growth forecast as a Modi-led majority Government assumes power

Strategy


Exhibit 3: Modi lifted Gujarats GDP trend growth rate by 380bps as the states CM (refer to the dotted line which jumped by 380bps post Modis chief-ministership)

Source: CEIC, Ambit Capital research

Exhibit 4: Gujarat increased its growth differential to Maharashtra by 0.5% YoY after Modis entry

Source: CEIC, Ambit Capital research

We thus compare Gujarats performance with that of its neighbour, Maharashtra, a state which is comparable to Gujarat in its level of economic development. Given that Maharashtra has had middle-of-the-road CMs and has not had the benefit of being managed as effectively as Gujarat, this state makes for an effective benchmark for delineating the Modi effect on growth. A comparison of the average GDP growth rate recorded in these two states over two time periods namely the pre-Modi period (i.e. FY91-01) and the post-Modi period (i.e. FY02-12) suggests that Gujarats lead over Maharashtra in terms of GDP growth expanded from 0.4% YoY in the pre-Modi phase to 0.9% YoY in the post-Modi phase (see the exhibit above).

What is likely to drive the higher growth in FY15? Based on the economic philosophies of Modis two most favourite economists - Jagdish Bhagwati and Arvind Panagariya (henceforth referred to as B-P) - as well as the BJP manifesto, we highlight the five key imperatives that a Modi-led Government is likely to pursue (click here for details of our 18 February note, Modis macro men and his manifesto):

(1) Promoting infrastructure growth: Our reading of B-Ps work suggests that they are keen to ensure that the pace of project clearances is expedited, the process of land acquisition is simplified with suitable amendments being made to Land Acquisition Act, the pace of road building is increased and more power is generated. These views are mirrored in the BJP manifesto as well.

(2) Enhancing agricultural sector productivity: Being a sector that Modi has successfully reformed in the state of Gujarat, this sector which has hitherto been ignored is likely to be a key focus area for a Modi-led Government. Besides undertaking policies aimed at improving the productivity of this sector, both B-P as well as the BJP manifesto advocates reforming the state-level APMC Acts.

(3) Recapitalising banks: Both Dr. Panagariya and the BJPs Treasurer, Piyush Goyal, have spoken publicly about the need to recapitalise Indias ailing banking system quickly. Whilst it is unclear as to where the funding for this initiative is likely to be garnered from (the PJ Nayak Committee Report, which was published last week, states that upwards of US$40bn are required), recapitalising Indias banking system is likely to feature on the Modi administrations priority list.

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Gujarats lead over Maharashtra in terms of GDP growth expanded from 0.4% YoY in the pre-Modi phase to 0.9% YoY in the post-Modi phase

Strategy


(4) Power and coal sector reform: With Indias new Government enjoying an absolute majority in the Lower House of the Parliament, legislative activity is likely to pick-up in the coming five-year period and amending legislations to allow the non-captive use of coal is likely to be high on the new Governments agenda. We expect this sector to be a core focus area of the new Government especially in light of B-P as well as Mr. Modi being supporters of reviving the fortunes of this sector.

(5) Empowerment of States and passing GST: The NDAs PM candidate, Mr. Modi, has frequently mooted the idea of engaging Chief Ministers in the national development process. Given his own experience as a Chief Minister (CM), he is likely to work towards the creation of a council of CMs, with the goal of furthering initiatives such as the GST as well as labour reforms.

Thus, the administration of reform aimed at aiding industrial sector growth is likely to lift Indias GDP growth prospects in FY15. Additionally, given that India is a capital-starved country and given that our Strategy team expects equity capital availability conditions to improve in FY15, we expect investment growth to receive a fillip in FY15.

The administration of reform aimed at aiding industrial sector growth in India is likely to lift Indias GDP growth prospects in FY15

Strategy


Section 2: Raising our FY15 Sensex target to 30,000 We raise our FY15 Sensex target to 30,000 from our previous target of 24,000 which was published on 6 January 2014 (click here for that note). Our new Sensex target implies a trailing P/E of 20.0x to our FY15 EPS estimate of Rs1,500. Our previous target of 24,000 was premised on a 17.0x trailing P/E multiple, which is the last ten-year average, applied to an estimated FY15 Sensex earnings of Rs1,400 (which in turn was a 10% growth on our FY14 Sensex EPS estimate of Rs1,270).

Estimated FY15 EPS

As FY14 draws to an end, we are likely to end the year near a Sensex EPS of Rs1,320 (implying 11% YoY growth). Further, our sector leads bottom-up number for FY15 stands at around Rs1,530 (implying 15% estimated YoY growth).

In her 24 December 2013 note (click here for that note), our Economist had estimated another 50bps addition to her base-case FY15 GDP growth forecast of 5.1%, in the event of Mr. Narendra Modis ascension as Indias Prime Minister with 210 or more seats for the BJP, taking FY14 growth up to 5.6%.

Given the likely acceleration in the economy (from around 4.7% GDP growth in FY14 to 5.6% in FY15), we raise our top-down FY15 EPS to Rs1,500, bringing it closer to the bottom-up number of Rs1,530. At Rs1,500, the implied YoY EPS growth in FY15 turns out to be 14%.

Our new P/E target

Our previous P/E target was based on the last ten-year average of 17.0x trailing earnings. Given the decisive mandate for the BJP in the recently concluded General Elections, we firmly believe that the conditions outlined by us in our 11 March 2014 thematic have been fulfilled and this is the beginning of the fourth wave in Indias economy and its markets. Whilst we elaborate on this point a little later in the note, to recap, India has had three waves over the last 30 years: the first lasted from 1984 to 1991; the second from 1991-2004; and the third and most recent wave lasted from 2004-2013. For more details please click here for our 11 March thematic, Invest into Indias fourth wave.

Exhibit 5: The remarkable synchrony between political and economic cycles in India

Source: CEIC, Ambit Capital research; Note: LS refers to Lok Sabha i.e. the Lower House of Indias Parliament

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Congress-led coalition forms Govt. with 62% LS Seats

We raise our FY15 Sensex target to 30,000

with FY15 EPS estimated at Rs1,500 and applying a 20x trailing P/E multiple (which translates into nearly 17.0x on a forward basis)

We may be beginning the fourth wave in Indias polity, economy and markets

Congress wins elections with 78% of LS seats

Congress forms minority government headed by PV Narasimha Rao

Strategy


It is important to note that in each of these three waves, the market returns were frontloaded, with the first three years accounting for over two-thirds of all the returns generated in the three waves. Thus, over the last 30 years, two-thirds of all returns have come in the initial three-year period after the General Elections that have marked the beginning of these waves (i.e. as much as two-thirds of all returns have been concentrated in this 30% of time) (see the exhibit below).

Exhibit 6: Sensex returns have been concentrated in the initial phases of the sine waves


To put some numbers around this, whilst over the entire 30-year period, the Sensex has delivered 16% (in CAGR terms), in this initial three-year window following these three critical elections, it has delivered ~33% (in CAGR terms).

Whilst due to data limitations we do not have Sensex P/E and EPS data for the first wave (i.e. 1984-1991 period):

In the second wave, the Sensex returns in the first three-year period, (i.e. the 1991-1994 period) were primarily driven by P/E expansion, as the markets sought to discount the positive impact of liberalisation on the economy. Hence, the 47% CAGR in the Sensex over 1991-94 can be broken up into 10% CAGR EPS growth; 34% CAGR P/E expansion.

In the third wave, however, the returns in the first three-year period (i.e. in the 2004-2006 period) were driven primarily by EPS growth. Hence, the 35% CAGR in the Sensex over 2004-06 can be broken up into 31% CAGR EPS growth and a mere 3% CAGR P/E expansion.

Hence, whilst in the 1991-1994 period the Sensex P/E remained north of 20.0x throughout, the P/E in the 2004-2006 period averaged at about 18.5x.

(Please note, all of the P/E references here are to trailing P/Es.)

In the current context, whilst we stick to a modest 14% EPS growth for FY15, we assume a modest P/E expansion to 20.0x trailing (from 18.2x currently and vs the last ten-year average of 17.0x) given that the BJPs majority in Parliament will almost certainly lead to elevated expectations on economic reform. A 20.0x P/E on Rs1,500 leads to our new FY15 Sensex target of 30,000.

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and historically over two-thirds of all Sensex returns have been delivered in the initial 30% of the time entering into these waves

In the remainder 70% time, 33% returns

2/3rds of all upsides in the initial 30% of time

Strategy


Section 3: Three sense checks on the ongoing rally A. Is the current move all about the elections? The last few years have been characterised by negative real interest rates and persistently high inflation in India. This has in turn manifested itself in several related phenomena like declining savings rate and falling investment growth.

Eventually, all these put together have resulted in a polarised stockmarket, away from cyclicals and towards defensives (see Exhibits 7 to 11).

Exhibit 7: The last few years have been characterised by negative real rates, high inflation

Source: RBI, Bloomberg, Ambit Capital research

Exhibit 8: falling savings rates


Exhibit 9: and falling investments


Exhibit 10: thus leading to declining share of investments in Indias GDP vs consumption

Source: CEIC, Ambit Capital research. Note: The figures indicate the share of the said component as a percentage of GDP. The dotted line indicates the share of that component in the previous phase spanning over FY12-14 whilst the heavy black line indicates share of that component over FY04-11. This chart has been reproduced without any changes from our 11th March note.

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Last few years have been characterised by negative real rates, high inflation and falling savings and investment

Strategy


Exhibit 11: This has polarised the market away from cyclicals and towards defensives

Source: Bloomberg, Ambit Capital Research

The real interest rates and persistently high inflation have also resulted in a move away from financial assets towards physical assets. Whilst savings in the form of physical assets (such as gold and land) were lower than those in financial investments in 2008, they had increased to account for over two-thirds of all savings by 2013. This has resulted in the gap between physical and financial savings widening to multi-year highs (see Exhibits 12 to 14).

Exhibit 12: Whilst physical savings were nearly the same as financial savings in 2008


Exhibit 13: they were nearly twice as high in 2013


Exhibit 14: Gap between financial savings and physical savings at multi-year highs


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Strategy


Thankfully, the current RBI governor, Raghuram Rajan, is committed to arrest the persistently high inflation and to keep real interest rates positive, and thus, the stockmarket has reversed its multi-year pessimism. This in turn has reflected in the markets pricing of defensives relative to cyclicals, with the gap between the two starting to revert towards the long-term mean (see Exhibits 15 to 17).

Exhibit 15: With Rajans commitment towards positive real rates, defensives have started underperforming

Source: Bloomberg, Ambit Capital research; Note: the above chart plots the price ratio of the BSE FMCG Index to the Sensex.

Exhibit 16: whilst cyclicals have made a comeback

Source: Bloomberg, Ambit Capital research; Note: the above chart plots the price ratio of the BSE Capital Goods Index to the Sensex.

Exhibit 17: thereby narrowing the valuation gap between the two

Source: Bloomberg, Ambit Capital research.

B. Will corporate profitability support the rally? Similar to the three sine waves of economic growth in the last 30 years, there have been similar waves in corporate profitability of India Inc too. An analysis of the profitability of the Sensex companies during each of the previous two sine waves has been presented in the exhibits below. Whilst the fundamental data for Sensex companies during the first sine wave is not available in public domain, an analysis of these companies during the previous two sine waves suggests that the corporate profitability of India Inc appears to be ready for the next wave too.

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The current RBI governors commitment to positive real rates should support an unwinding of some of these phenomena

Like the fourth wave in polity and economy, corporate profitability looks ready for the next wave too

Strategy


Exhibit 18: Over the past two decades, Sensex companies have seen two waves in operating margins

Source: Bloomberg, Capitaline, Ambit Capital research

Exhibit 19: which can also be seen in the PAT margins


Exhibit 20: Corporates have seen two waves in RoCEs


Exhibit 21: which was also seen in the RoEs of these companies


C. Will global conditions be conducive? Can the global backdrop be a spoiler in Indias party? Historically, a rise in global bond yields has been indicative of normalcy returning to global growth. Indeed, phases characterised by rising bond yields in developed nations (such as the US) have historically coincided with strong equity returns in India (see Exhibit 22 below).

However, some investors have expressed concerns that the current rise in US yields is more to do with liquidity withdrawal than any expectation of the economy improving. At the same time, emerging market equities in general (including India) have lagged far behind developed market equities so far, raising concerns about the existence and sustainability of this global reflation.

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Rise in global bond yields have been positive for Indian equities historically

Strategy


Exhibit 22: A gradual rise in US yields has been positive for Indian equities historically


Exhibit 23: and India is currently gently rising after years of underperformance relative to the developed markets*

Source: Bloomberg, Ambit Capital research. Note: * The Defty is the dollar-adjusted Nifty.

There are however plenty of signs that suggest that the move up in US bond yields since the middle of 2012 has actually been reflective of a recovering global economy and that countries like India should participate sooner rather than later. For example, the world discretionary consumption (measured by the MSCI Consumer Discretionary Index to MSCI Consumer Staples ratio) has been uptrending since mid-2012 whilst safe havens, such as gold and US bond prices, have been declining relative to other commodities since then (see exhibits 24 and 25 below).

US inflationary expectations, too, are currently stable near 2% whilst the US yield curve (measured by the yield differential between ten-year bonds and two-year bonds) remains bullishly steep (see exhibits 26 and 27 below).

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Strategy


Exhibit 24: World consumer discretionary to staples ratio is uptrending


Exhibit 25: whilst gold has been declining relative to other commodities


Exhibit 26: US inflationary expectations stable near 2%


Exhibit 27: US yield curve stays steep


The balance of evidence therefore suggests that global trends are more likely to provide tailwinds to Indian equities than act as headwinds.

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Strategy


Section 4: Investment implications A. What exactly is happening in the markets currently? Three types of extreme market polarisations are normalising in Indian equities currently: defensives to cyclicals, large-caps to small-caps, and value to growth stocks.

Exhibit 28: Valuation premium of defensives to cyclicals is reverting from multi-year highs


Exhibit 29: Small-caps are reverting from excessive valuation discounts to large-caps


Exhibit 30: as are mid-caps


Exhibit 31: Value now appears to be staging a comeback


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Strategy


B. What works and doesnt work in a market uptrend Low RoCE stocks do not deliver irrespective of the market

phase! Exhibit 32: Performance of RoCE quintiles in the bear phase of 2008-13


Exhibit 33: Performance of RoCE quintiles in the bear phase of 1992-2000


Exhibit 34: Performance of RoCE quintiles in the normal phase of 2000-08


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similar to the bear phase of the 90s

However, medium RoCE stocks performed the best in the more optimistic setting of 2000-08

CAGR

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Strategy


High beta does not deliver irrespective of the market phase! Exhibit 35: Performance of beta quintiles in the bear phase of 2008-13


Exhibit 36: Performance of beta quintiles in the bear phase of 1992-2000


Exhibit 37: Performance of beta quintiles in the normal phase of 2000-2008


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However, medium beta stocks performed the best in the more optimistic setting of 2000-08

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Strategy


Value delivers, except in bear markets! Exhibit 38: Performance of P/B quintiles in the bear phase of 2008-13


Exhibit 39: Performance of P/B quintiles in the bear phase of 1992-2000


Exhibit 40: Performance of P/B quintiles in the normal phase of 2000-2008


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Performance of P/B quintiles

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Performance of P/B quintiles

CAGR 21% 14% 14% 5% 1%

Strategy


C. What works best in the current context?

The QARP approach of G&C 7.1 Summarising the current context

As described in the opening section of this note, the Indian economy looks likely to recover mildly in FY15. At the same time, the Indian stockmarkets three big polarisations are reverting to the mean.

Neither the markets obsession with quality nor its blind eye to valuations (as seen over the last few years) continues in a bull phase. More importantly, low quality never delivers, irrespective of the market phase!

In a normal market scenario, cyclicals and small/mid-caps outperform defensives and large-caps, with this inflection preceding the inflection in Sensex returns (see our 29 January note).

Implications for portfolio strategy

As we move toward a normal market scenario, combining valuations with quality should work best.

Our version of QARP involves identifying stocks that fulfil the following criteria:

Do well on our greatness and accounting frameworks (click here for our 26 November 2013 note explaining our greatness framework and click here for our 22 November 2013 note explaining our accounting framework); and

Are cheap on at least one of P/E, P/E and EV/EBITDA vs their own five-year history.

This quality at a reasonable price (QARP) approach to portfolio construction in todays environment results essentially in a play on cyclicality, value and small/midcaps without losing sight of quality.

We first incorporated the QARP approach into our G&C portfolio construction with the 23 September 2013 iteration of the portfolio. Since then, between the three G&C iterations (including the current one) that have used the QARP framework, cumulative alpha of over 1,100bps has been generated over the BSE500 Index (in a little less than 8 months).

In an uptrending market, value works best but quality cannot be completely ignored

a quality at a reasonable price (QARP) approach should work best

Strategy


Exhibit 41: G&C 7.1 - The composition

Company Ticker Sector Mcap (US$ mn)

6M ADV (US$ mn)

FY13 Net D/E

Earnings CAGR

(FY10-13)

Average RoE

(FY11-13)

Average PBITM

(FY11-13)

FY15 P/E

FY15 P/B

Bajaj Auto BJAUT IN Auto 9,522 10.1 (0.7) 23% 58% 18% 14.6 4.7

Tata Motors TTMT IN Auto 22,728 40.4 0.6 89% 50% 10% 8.4 2.1

TVS Motor Co. TVSL IN Auto 942 3.5 0.8 53% 18% 4% 18.6 3.8

Exide Inds. EXID IN Auto Anc 1,780 4.3 (2.3) 4% 21% 14% 18.1 2.7

MRF MRF IN Auto Anc 1,606 5.3 0.4 33% 21% 7% 10.3 1.6

Federal Bank FB IN BFSI 1,564 4.3 N/A 25% 13% N/A 9.6 1.2

ICICI Bank ICICIBC IN BFSI 28,838 70.0 N/A 28% 13% N/A 15.2 2.1

I D F C IDFC IN BFSI 3,205 18.9 N/A 20% 14% N/A 9.5 1.1

ING Vysya Bank VYSB IN BFSI 2,007 1.2 N/A 40% 14% N/A 13.9 1.5

LIC Housing Fin. LICHF IN BFSI 2,677 13.0 N/A 15% 20% N/A 10.1 1.8

Larsen & Toubro LT IN E&C 22,564 46.7 1.6 6% 16% 14% 23.1 3.1

Engineers India ENGR IN E&C 1,496 2.2 (1.1) 12% 35% 22% 15.9 3.1

Coal India COAL IN Mining 37,164 17.6 (1.3) 22% 38% 19% 13.1 4.5

NMDC NMDC IN Mining 10,939 6.6 (0.8) 23% 32% 74% 9.6 2.0

Oil India OINL IN Oil & Gas 5,809 3.2 (0.6) 11% 20% 35% 8.3 1.5

Petronet LNG PLNG IN Oil & Gas 1,796 2.5 0.4 42% 29% 7% 13.6 1.9

O N G C ONGC IN Oil & Gas 55,986 20.2 (0.0) 8% 19% 17% 10.2 1.7

Power Grid Corpn PWGR IN Utilities 10,654 18.8 2.5 27% 15% 70% 11.8 1.6

Torrent Power TPW IN Utilities 1,036 2.8 1.1 -24% 18% 20% 10.8 0.9

Grasim Inds GRASIM IN Cement 4,800 3.3 0.1 -6% 15% 17% 12.1 1.2

HCL Technologies HCLT IN IT 16,271 30.2 (0.0) 25% 25% 13% 13.7 3.9

MindTree MTCL IN IT 986 2.7 (0.4) 15% 23% 12% 12.3 2.9

Cadila Health. CDH IN Pharma 3,178 2.3 0.8 8% 30% 17% 19.3 4.4

Bharti Airtel BHARTI IN Telecom 22,522 27.2 1.3 -38% 9% 14% 24.7 2.0

Oberoi Realty OBER IN Realty 1,260 0.8 (0.3) 3% 15% 55% 13.3 1.5

Sobha Developer. SOBHA IN Realty 711 1.1 0.6 18% 10% 27% 12.7 1.7

McLeod Russel MCLR IN Agro 507 1.9 0.1 6% 17% 23% 8.0 1.2

Bharat Electron BHE IN Industrials 1,930 0.9 (0.8) 5% 16% 10% 12.4 1.4

Sadbhav Engg. SADE IN Infra 415 0.3 3.7 -45% 9% 11% 20.7 2.0

D B Corp DBCL IN Media 863 0.6 (0.0) 6% 27% 23% 14.6 3.8


Strategy


G&C 7.1- Implied sector weights Exhibit 42: G&C 7.1- Implied sector weights

G&C 7.1 weight (%) Delta between G&C 7.1 and Nifty

Agro 2.1 2.1

Auto 10.6 1.6

Auto Anc 8.5 8.5

BFSI 19.1 (8.0)

Capital Goods - (0.6)

Cement 4.3 1.2

E&C 6.4 1.7

FMCG - (12.5)

Industrials 2.1 2.1

Infra 2.1 2.1

IT 6.4 (9.7)

Media 2.1 2.1

Metals & Mining 8.5 3.6

Oil & Gas 10.6 (1.0)

Pharma 2.1 (3.2)

Realty 4.3 3.9

Telecom 4.3 2.6

Utilities 6.4 3.6

Source: Ambit Capital research; Note: This chart has been reproduced without any changes from our 22nd April note.

As highlighted earlier, for the construction of G&C 7.1, we look for stocks that do well on the greatness framework, pass our accounting tests, are cheap versus their own five year average multiples and are relatively liquid.

Even within this set of stocks, we assign 2x weightage to more liquid names (above US$2.5mn ADV) and 1x to illiquid names.

The sector weights, as displayed in the exhibit above, are implied weights and an outcome of the above process. We do not start with the Nifty as a reference point for portfolio construction.

As can be seen from this exhibit, there are four key sectors we are underweight on- Consumer Staples, Pharma, Technology and BFSI (banks and financial services). While underweights on the former three are by design, given your view of a recovery and consequently the G&C 7.1 portfolio being cyclically geared, clients will be surprised by our underweight in BFSI. This cautiousness on BFSI stems from our discomfort on asset quality issues facing large banks in India, private and public. While from a macro perspective we have written, over the last few months, on PSU banks rerating (eg .in the recent Inflation, corruption, thematic), from a bottom up perspective based on the historic and likely future trajectories on reported financials, it is very difficult to put buys on these names or include them in the G&C portfolio.

Strategy


High operating leverage With the economy poised for a recovery, firms with a high degree of operating leverage are bound to benefit disproportionately from such a recovery.

To identify stocks that would do well in such a scenario, we screen the BSE500 universe (after excluding BFSI firms and firms belonging to defensive sectors such as FMCG, Pharma, etc) for firms that fulfil the following criteria:

Have increased capacity by at least 40% (over FY10-FY13), i.e. firms with at least 40% growth in fixed assets (gross block + CWIP)

Have seen a decline in their asset turnover (FY13 vs FY11), and

Have fixed cost, representing at least 25% of the total cost (FY13). (This metric allows us to capture another dimension of operating leverage.)

The resultant list of firms that have seen a decline in their asset turnover yet increased capacity and with substantial fixed costs has been shown below.

(Note: This list has been filtered for accounting quality using our accounting framework)

Exhibit 43: List of firms with high operating leverage

Company Ticker Sector Mcap (US$ mn) 6M ADV

(US$ mn)

Growth in CWIP + Gross Block

(FY13 over FY10)

FC as a % of TC-FY13

F/A FY15 FY15

Turnover (FY13) P/E P/B

B H E L BHEL IN Capital Goods 9,660 18.3 60% 35% 4.8 17.7 2.4

Bharti Infra. BHIN IN Infrastructure 7,507 3.0 50% 100% 0.4 24.8 2.4

Carborundum Uni. CU IN Industrials 457 0.1 54% 55% 1.7 18.8 2.1

Elgi Equipment ELEQ IN Capital Goods 282 0.1 193% 31% 3.4 19.7 3.1

Engineers India ENGR IN E&C 1,496 2.2 68% 68% 12.7 15.9 3.1

Grindwell Norton GWN IN Industrials 303 0.1 62% 44% 2.3 15.6 2.9

Hind.Zinc HZ IN Metals 9,782 2.8 43% 87% 1.1 8 1.3

IL&FS Transport ILFT IN Infrastructure 659 0.3 391% 97% 1.7 7.6 0.7

Ingersoll-Rand INGR IN Capital Goods 248 0.2 144% 26% 6.7 19.7 1.1

Kalpataru Power KPP IN E&C 332 0.5 156% 53% 3.7 9.5 0.8

Larsen & Toubro LT IN E&C 22,564 46.7 54% 57% 5.1 23.1 3.1

NMDC NMDC IN Mining 10,939 6.6 149% 78% 4.3 9.6 2

NTPC NTPC IN Utilities 18,492 15.5 47% 99% 0.7 10.4 1.2

Oberoi Realty* OBER IN Realty 1,260 0.8 71% 111% 1 13.3 1.5

Phoenix Mills PHNX IN Realty 617 0.4 85% 93% 0.2 14.3 1.7

Power Grid Corpn PWGR IN Utilities 10,654 18.8 85% 98% 0.2 11.8 1.6

Prestige Estates* PEPL IN Realty 1,097 0.6 133% 125% 0.9 13.7 1.9

Sadbhav Engg. SADE IN Infrastructure 415 0.3 55% 84% 3.8 20.7 2

Shree Cement SRCM IN Cement 3,663 1.7 55% 61% 1.1 26.2 4.3

Sobha Developer. SOBHA IN Realty 711 1.1 53% 51% 3.6 12.7 1.7

SRF SRF IN Chemicals 411 1.7 46% 35% 0.9 8.6 1.1

S A I L SAIL IN Metals 5,500 5.3 54% 47% 1.1 11.9 0.7

Tata Power Co. TPWR IN Utilities 4,190 6.7 71% 77% 0.7 14.6 1.6

Thermax TMX IN Capital Goods 1,655 0.9 141% 30% 4.5 26.8 4.2

UltraTech Cem. UTCEM IN Cement 10,909 6.0 226% 51% 1.1 23.3 3.3

WABCO India WIL IN Auto Anc 696 0.2 56% 35% 2.9 26.8 4.6

Source: Bloomberg, Ace Equity, Ambit Capital research; Note; For the purpose of calculating Fixed costs as a % of Total costs, we have treated Power & Fuel cost, Employee cost, Other Manufacturing expenses, General & Administration expenses and Depreciation expense as fixed costs. Raw Material consumed and S&D expenses have been treated as variable costs, while Miscellaneous expenses have been ignored altogether; *FC as a percentage of TC is greater than 100% due to stock adjustments.

Firms with high operating leverage should disproportionately benefit in an economic recovery

Strategy


Integration of QARP and operating leverage Combining the two themes to portfolio construction highlighted here, i.e. the quality at a reasonable price (QARP) approach and high operating leverage firms should work even better for investors.

The list of firms that meet that meet our QARP and operating leverage criteria is displayed in the exhibit below.

Exhibit 44: Integrating QARP with operating leverage

Company Ticker Sector Mcap

(US$ mn) 6M ADV

(US$ mn)

Growth in CWIP + Gross

Block (FY13 over FY10)

FC as a % of

TC-FY13

F/A Turnover (FY13)

FY15 P/E

FY15 P/B

Engineers India ENGR IN E&C 1,496 2.2 68% 68% 12.7 15.9 3.1

Larsen & Toubro LT IN E&C 22,564 46.7 54% 57% 5.1 23.1 3.1

NMDC NMDC IN Mining 10,939 6.6 149% 78% 4.3 9.6 2.0

Oberoi Realty* OBER IN Realty 1,260 0.8 71% 111% 1.0 13.3 1.5

Power Grid Corpn PWGR IN Utilities 10,654 18.8 85% 98% 0.2 11.8 1.6

Sadbhav Engg. SADE IN Infrastructure 415 0.3 55% 84% 3.8 20.7 2.0

Sobha Developer. SOBHA IN Realty 711 1.1 53% 51% 3.6 12.7 1.7

Source: Bloomberg, Ace Equity, Ambit Capital research; Note; For the purpose of calculating Fixed costs as a % of Total costs, we have treated Power & Fuel cost, Employee cost, Other Manufacturing expenses, General & Administration expenses and Depreciation expense as fixed costs. Raw Material consumed and S&D expenses have been treated as variable costs, while Miscellaneous expenses have been ignored altogether; *FC as a percentage of TC is greater than 100% due to stock adjustments.

Strategy


Institutional Equities Team

Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 [email protected]

Research

Analysts Industry Sectors Desk-Phone E-mail

Nitin Bhasin - Head of Research E&C / Infrastructure / Cement (022) 30433241 [email protected]

Aadesh Mehta Banking / Financial Services (022) 30433239 [email protected]

Achint Bhagat Cement / Infrastructure (022) 30433178 [email protected]

Aditya Khemka Healthcare (022) 30433272 [email protected]

Akshay Wadhwa Banking & Financial Services (022) 30433005 [email protected] Ashvin Shetty, CFA Automobile (022) 30433285 [email protected]

Bhargav Buddhadev Power / Capital Goods (022) 30433252 [email protected]

Dayanand Mittal, CFA Oil & Gas / Metals & Mining (022) 30433202 [email protected]

Deepesh Agarwal Power / Capital Goods (022) 30433275 [email protected] Gaurav Mehta, CFA Strategy / Derivatives Research (022) 30433255 [email protected]

Karan Khanna Strategy (022) 30433251 [email protected]

Krishnan ASV Real Estate (022) 30433205 [email protected]

Nitin Jain Technology (022) 30433291 [email protected]

Pankaj Agarwal, CFA Banking / Financial Services (022) 30433206 [email protected]

Pratik Singhania Retail (022) 30433264 [email protected]

Parita Ashar Metals & Mining / Oil & Gas (022) 30433223 [email protected]

Rakshit Ranjan, CFA Consumer / Retail (022) 30433201 [email protected]

Ravi Singh Banking / Financial Services (022) 30433181 [email protected]

Ritesh Vaidya Consumer (022) 30433246 [email protected] Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 [email protected]

Ritu Modi Automobile (022) 30433292 [email protected]

Tanuj Mukhija, CFA E&C / Infrastructure (022) 30433203 [email protected]

Sales

Name Regions Desk-Phone E-mail

Sarojini Ramachandran - Head of Sales UK +44 (0) 20 7614 8374 [email protected]

Deepak Sawhney India / Asia (022) 30433295 [email protected]

Dharmen Shah India / Asia (022) 30433289 [email protected]

Dipti Mehta India / USA (022) 30433053 [email protected]

Nityam Shah, CFA USA / Europe (022) 30433259 [email protected]

Parees Purohit, CFA UK / USA (022) 30433169 [email protected]

Praveena Pattabiraman India / Asia (022) 30433268 [email protected]

Production

Sajid Merchant Production (022) 30433247 [email protected]

Sharoz G Hussain Production (022) 30433183 [email protected]

Joel Pereira Editor (022) 30433284 [email protected]

Nikhil Pillai Database (022) 30433265 [email protected]

E&C = Engineering & Construction

Strategy


Explanation of Investment Rating Investment Rating Expected return

(over 12-month period from date of initial rating)

Buy >5%

Sell

Documents

Ambit- Strategy -ERr Grp- The Rebooting of India