After a strong rally of over 10 percent seen so far in the year 2017, the risk-reward is relatively unfavorable and there is very little of error considering the fact that most stocks are back to pre-demonetisation highs, Sanjay Mookim, Director, India Equity Strategy at BofA ML said in an exclusive interview with CNBC-TV18.
“In the near term, the ride through the earnings season will be very bumpy. Even in the March quarter, I expect some heartburn. I need companies to start delivering on growth again and is one area in which there is room for error in March quarter,” he said.
Going forward, there are two sets of risks which investors should be aware of. The global risk which everybody is aware of and the India risk is March quarter earnings which will be very interesting.
“There will some companies which may find it difficult to revert to growth after demonetisation. Yes, things have normalised, but given the fact that stocks have become very rich on multiples, restoration of volumes is not enough. I need that growth to come back,” said Mookim.
There is very little room for an upside at the moment. In the best case scenario, Sensex could hover around 29,000 by December end, highlighted the BofA-ML report. “We advise investors to stay liquid at these prices and stay with large-cap growth sector. They should avoid adding risk at current levels,” said Mookim.
However, in FY18 we should see double-digit growth largely on account of low base effect. Irrespective of the cuts, we should see acceleration in growth trend seen in the last three years supported by financials, and materials on a YoY basis.
Sectoral Outlook:
Pharma:
Investors should avoid taking a top-down approach with respect to pharma because there are a lot of regulatory headwinds. “We need to figure out which companies have what levels of regulatory overhang and where the pipeline is strong enough,” said Mookim.
“But, there are companies where there are very few regulatory issues and have a decent pipeline and has some amount of earnings visibility. We have to look at the sector from company to company basis,” he said.
Banks:
Commenting on the banks, Mookim said that the largest contribution to the profit growth is coming from financials because this sector is coming from a low base year of FY16 and 17. Regarding the NPA issue, it looks like the market has got some sense about the size of the NPA problem and that was an issue of many banks, explains Mookim.
People now understands the scale of the problem and investors are more aware as to how to adjust the valuation metric. “In the banking space, we like the private sector banks which are better placed and have the appetite to grow,” he said.
IT:
Bofa-ML is underweight on IT because of the overhang of the US administration policy with regard to VISA and any resolution to that overhang is unlikely to happen anytime soon.
The combination of overhang, slowing growth environment makes up underweight in the IT sector and we stay cautious in that space, said Mookim.
Discretionary:
We are underweight on discretionary space because it is likely that the effects of demonetisation are not been fully digested, said Mookim.
Our surveys which we conducted earlier in the year suggested that up to 40 percent of consumers have deferred their purchase of many items, he said.
Below is the verbatim transcript of an interview.
Anuj: The market has moved on even more since the last time we spoke post the Uttar Pradesh (UP) election outcome, making the risk reward even more unfavourable, a lot of people would argue but what is your sense, at current levels and with so close to earning season, is this a market which is still good enough to buy?
A: I do agree that the risk reward is relatively unfavourable at the moment. There is very little room for error now that stocks are back to their pre-demonetisation highs, the market is higher at the moment and I worry that at least in the near-term the rides through the earnings season is going to be very bumpy. Even in the March quarter, I do expect that there will be some heartburn. One line that we highlight is that when companies talk of normalisation and many companies are telling us that things are normalised, they are talking of a restoration of volumes to 100 going to 50 back to 99-100 and so on but equities need our restoration of growth. I need companies to start delivering that growth back again and that is a nuance but it is very important which is where I think there is room for error in delivery in the March quarter.
Sonia: How are you positioned in the pharma space because things are very erratic here, one day you will hear bad news and then suddenly things will turnaround for the better, how are you positioned?
A: We argue that you cannot take a topdown view on pharma as a sector. You need to figure out which companies have what levels of regulatory overhang and where the pipeline is strong enough. There are companies where there are concerns where issues around regulatory approvals are still very grey but on the other hand there are companies where there are very few regulatory issues and who have a decent pipeline of earnings visible. So we are saying that look you have to approach it bottom up, you have to look it company-by-company and as our analyst has been analysing for a while, we have a couple of companies that we like which we think the market is clubbing with the whole sector in terms of concern and where the opportunity might lie today.
Anuj: In terms of how to approach the market from hereon, what are the triggers, what are the risks for this market?
A: There are two sets of risks, I would highlight. One is the global uncertainty which we are all aware of and it is all in the background but very difficult to predict and many events are lined up for the next several weeks which could lead global markets either way and there is not much point trying to provide a different opinion on that at the moment.
However, from India perspective, the earning season is likely to be extremely interesting and like I said because many companies may struggle to revert to growth so quickly after demonetisation. Yes, things have normalised and people are gone back to levels that they were but given that stocks have become very rich on multiples and valuations just a restoration of volumes is not enough. I need that growth to come back quickly as well.
If that does not happen, I may see some bit of heartburn in the March quarter. Then getting into July, you are likely to get uncertainty around the transition to goods and services tax (GST).
So the actual numbers are likely to be volatile and there is a case to say that the market will look through all of this because this volatility can be explained. Nonetheless, there is very little room for upside at the moment, underlying metrics are not doing pretty too well and as a result, I do think that you have to stay liquid at these prices, you have to stay with a largecap growth sectors and not try and add risk at current levels.
Sonia: What is your view on banks now? We have had this discussion about the possible non-performing assets (NPA) resolution from the government, the talks of some M&A activity that could take place over the next few days as well, what kind of potential do you see here both for private and PSU?
A: To argue very top down view, the largest contribution to profit growth over the next two years is coming from the financials and this is simply arithmetic because financials are coming off a low base from FY16 and FY17. So it is not rocket science to say that they are going to deliver year-on-year (Y-o-Y) growth going forward. NPA resolutions to be honest, there is no magic wand that one single order is passed or some new thing is created which solves all problems in one go, there will be several measures and there have been several measures that have been taken. More need to be taken.
I would argue that the market so far has got in a good sense of the size of the NPA problem. That was an issue for many banks up to a little while ago, people were unable to get the heads around it, now at least I suspect that the people understand the scale of the problem, not all of it has probably been realised on banks books and some may still be due but at least from an investors point of view now you appreciate how big that is and how you can adjust your valuations so far.
Therefore, I think you need to start talking about topline growth in banks as well. Wherever you start seeing growth is the sort of banks and sectors or sub-segments of financials that will breakout or do better than the rest.
There I think the private sector of banks are obviously much better placed simply because they have the ability in terms of capital and of course the appetite to grow as well. Our differentiation therefore lies in saying we prefer the private sector growing banks, the standard names there.
Anuj: You are underweight on IT, which I would assume is also a consensus call but you are underweight on discretionary as well which is a bit of an anti-consensus call. What are your thoughts on both the spaces?
A: IT – there are two issues. One is this overhang on the US administration policies which we all appreciate and I would simply say that it could go either ways, it is very difficult to call. However, the resolution of that overhang is unlikely to happen in the next month or two. It is going to drag on for a while and clarity is not imminent.
The second concern is the growth rates for these companies once the country walk past the regulatory issues and there is hope that any sort of a growth revival in the US leads to an acceleration of growth for IT companies but at the moment, the commentary is very tepid if I understand it correctly.
So the combination of the overhang, the slowing growth environment makes us underweight and we stay cautious on that space.
Discretionary – my argument is very simple. It is likely that the effects of demonetisation are not fully digested. Our surveys that we have conducted earlier in the year have suggested that upto 40 percent of consumers have deferred their purchases of many items and that is likely to show up in volume numbers for discretionary companies more than they do for staples.
On the argument that growth is not recovering as rapidly as people are now pricing in, we are underweight the discretionary space.
Sonia: Overall on the market, I heard you say that the upside from these levels does not look like too high but what about the earnings growth because we are getting into a season where you do not know what kind of earnings recovery we will see post demonetisation. What are you factoring in now and how does that tie in with the valuations of the market?
A: Again here, arithmetic is the saviour because of the low base from last year. You should see at least double digit growth in FY18. We are counting on at least 12-13 percent outcomes but irrespective of the cuts that I expect, you should see an acceleration in the growth trend from the last three years which have been low single digits. So there should be growth, this will be supported by financials and materials by Y-o-Y basis and we are hoping that FY19 and FY20 beyond that tends to be a little better.
The reason I am optimistic if you are willing to take a longer investment frame is because the Indian business cycle looks to be turning. If you look at data from the Reserve Bank of India (RBI) on aggregate industrial utilisations, it is clearly indicating that utilisations have stopped falling and have started to tick up.
This is very simply a lag effect between demand and supply. Capex peaked in FY08, demand chugs along at a steady rate every year and with time, utilisations go up, creates a business cycle which drives earnings. So looking out, I am hopeful that your earnings growth will accelerated from 12 percent I expect for FY18, which is probably what the market is reliant upon at these multiples. If there was any risk to that then you should see some downside.
Anuj: Is that the overall risk to your 29,000 Sensex target as well because we have seen in the past the liquidity can do various things to market?
A: That is true. These things are extremely difficult to predict and the flows into the domestic funds has been extremely strong. Last year 2016 calendar primary issuances were pretty weak. There is good prospect this year and if you see demand for equity match the supply of equity then valuation should not rerate. However, if for any reason that supply does not come through then there is upward risk simply because of the flow.
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