Things will be 'different' in 2013, says Morgan Stanley

Moneycontrol Bureau

The year 2012 was all about defensive and quality stocks. However, according to Morgan Stanley, things will be different in 2013. "We think that earnings growth is likely to improve over the next 4-6 quarters. Therefore, we believe, the earnings revisions breadth will also rise and that is good for share prices. However, the recovery in earnings is likely to be at a steady pace unless there is a major positive change in the investment rate or the current account," the broking firm said in a report.

Morgan Stanley believes profits have grown significantly slower than nominal GDP due to compressing gross margins and rising rates over the past four years. This happened mainly because of two reasons: 1) The fall in the investment rate relative to household savings (implying falling utilization of capacity) and 2) the rising current account deficit (implying loss of production to the world), offset partly by rising fiscal deficit or lower public savings were key explanatory factors.

What has changed?

Morgan Stanley says revenue growth outlook is improving since M1 growth has seemingly put in a firm base at the end of last year and it leads revenue growth by about two quarters. The base effect is favorable for EBITDA margins. Gross margins have started to rise from decade lows (helped by slowing pace of commodity prices increase) and improving operating leverage will help margins. Moreover, interest rates could have peaked as the YoY fall in CP rates suggest and interest costs are unlikely to rise at the same pace as seen recently.

From a top-down angle, the broking firm said, the shift in terms of trade could be the inflexion point for corporate margins in the coming months. The shift in terms of trade is sourced from a currency that is no longer overvalued and moderating global commodity prices. “The other macro support for profit margins comes from the recent uptick in public investments,” the report said.

The key risks, according to Morgan Stanley on earnings include an increase in commodity prices, a serious global risk off with negative implications on India’s BoP and interest rates and another leg down in the investment cycle or a fiscal cliff.

Morgan Stanley economists forecast neither a big investment cycle nor a sharp fall in the CAD – so this is about a trough formation rather than a boom in earnings.

"Thus, our Sensex forecast is for 26% upside. For a full-blown bull market (our bull case), we need bullish steepening of the yield curve and significantly better domestic liquidity (in the form of lower short rates). Our bear case is anchored to global developments," the report concluded.

Morgan Stanley Outlook 2013

*A new earnings cycle -- A steady recovery in broad market earnings growth to ~20% by end-F2014.

*26% Sensex upside -- largely from earnings progression, not multiple expansion.

*An upcycle in earnings, strong global liquidity and supportive valuations are helping the market. Domestic liquidity and flattish yield curve are still impediments.

*Preferred portfolio strategy: Growth over quality (high FCF, high ROE, low capex), cyclicals over defensives, active sector positions vs. stock selection.

Also read: Moody's says India's rating outlook stable