Will Q4 be start of the end of earnings downgrade cycle?

In the same interview, Rakesh Arora of Macquarie said an earnings recovery is already under way, except for commodity and bank sectors.

He forecast a growth of 14-15 percent for FY17 and expects it to improve further if crucial reforms like the bankruptcy bill and GST are passed in the second half of the Budget session.Below is the verbatim transcript of Rakesh Arora and Gautam Chhaochharia’s interview with Latha Venkatesh and Anuj Singhal on CNBC-TV18. Anuj: I am reading your report and you believed this quarter while we may not see earnings growth, but it will show signs of underlying growth pick-up. What do you mean by that and what you are pencilling in as we head into the earning season. Q4 not too many fireworks are expected but could this be the start of the end of downgrade cycle. Chhaochharia: So Q4 specifically the headline number will look better than what we have seen over last 3 quarters and also given the base of last year’s 4Q where we saw decline in earnings in double digits, so just by that logic the headline numbers should be more optimistic, so we look at street forecast is around 7 percent earnings growth for Nifty as a whole. But the question is as you rightly said in the beginning what happens to the downgrade of credit cycle and there again the story is still not good from analyst expectations, if I look at bottom-up street expectations for FY17 they are still expecting 19-20 percent growth for Nifty, which is far too optimistic in our view. Our top-down framework suggests more like a 10 percent earnings growth which will anyway be a recovery compare to say a 2 percent earnings growth likely in FY16, but there is definitely some downgrade left out there. Latha: Will the downgrades be more than the upgrades. Chhaochharia: Even in last two years we have seen stock level upgrades of positive surprises. But we moved down from 20 percent earnings growth expectation to a realistic 10 percent earnings growth for next year. It will still be a kind of drag on the market but having said what’s also interesting is when we talked to investors globally specifically over the last 2-3 months, their expectations are far more realistic than sell-side analyst expectations, so that’s kind of positive for the market. Latha: This 10 percent earnings growth or 11 percent that you spoke about excluding some sectors is that also only because of a low base? Chhaochharia: Low base and obviously some recovery or normalisation in the economy or some normalisation in terms of the nominal negative impact which you saw this year. So, on one hand you will have the nominal headwinds going away in terms of WPI picking up in FY17 but on the other hand you have to also remember that the EBITDA margin tailwind which we got in FY16 because of lower commodity prices will also dissipate in FY17. So, net-net that is where we end up with coming at a 10 percent growth number next year which would still be better than this year. Latha: Varinder Bansal was telling us that we will get fourth quarter earnings growth of about 3 percent but that will be largely because year ago the quarter was a dismal one with a 11 percent contraction in earnings. What are you going with for this quarter? Arora: Two things have been weighing on earnings pretty heavily for the current quarter also. While last year the same quarter was weak but this year also commodity prices have come down sharply. Secondly banks are seeing a huge losses because of provisioning that they have had to make on asset quality review. So, those two things, reported number may not really look nice but if you look at the underlying growth, if you remove banks and commodities, this growth in FY15 was around 4 percent. In the first 9 months it was around 7 percent and in Q4 it is going to be around 10 percent. So, apart from banks and commodities there is already a recovery which is happening. I agree Gautam that the underlying growth is around 10 percent but as things improve on the front of commodities and banks from next year, most of the houses are forecasting more than 100 percent growth in these two sectors. So, probably I would tend to think that FY17 growth would be more like 14-15 percent above the trend line rather than below it. Anuj: The other thing that market would want to know is or market participants would want to know is that what should be the multiple given to this market because now we have the added news of may be a normal monsoon. Do you think that will change things a bit and going forward from markets point of view, with the kind of numbers that you have for FY17 and FY18, we might need to reassign slightly higher price earning multiple? Arora: Assuming a 15 percent earnings growth both for FY17 and FY18, market is trading at about 14 times FY18. Historically 10 year average is around 14.8. So, there is still some scope for market to go up even without breaching the long term averages. I think what is more important apart from monsoon is going to be the second half of Budget session of parliament which is starting from April 25. If we can get bankruptcy bill and may be some progress on GST, markets can get easily rerated to 16 times PE multiple also. So, it is more driven by reforms than just the expectation of monsoon. Latha: What would be your stand out sectors in Q4? What would you watch out for in terms of sectors? Chhaochharia: I think the stand out sector in our view would be pharma because of visibility on specific products across companies. So, it should be a very strong quarter in terms of year on year earnings growth. Specifically in terms of what has been happening to that sector recently in terms of negative shocks around FDA etc, so that sector stands out for us. Obviously for the market sentiment, broad macro sentiment also what would be relevant is what banks do in terms of provisioning in Q4 and more importantly what is the guidance they give for FY17 in terms of whether they have completely cleaned up, there is more left on the table etc. Latha: What is your pick of the pack in the banking space. Arora: We are going with the safe bet, HDFC Bank, that is our pick and if somebody wants to add a little bit of risk, Yes Bank is the other one. So these are the top two ideas that we are pushing not just results, but also over of next 5-6 months. Anuj: We have seen a big rally from the recent lows that is for the likes of ICICI Bank. Of course, Indusind Bank has been a different story altogether that’s had a new lifetime high, but from this point on do you think the bank rally will go on regardless of the reality check that we might see in Q4. Chhaochharia: Again, selectively it can but broad sector is more a correction of the over pessimism we saw a couple of months back. The key element here would be both what happens to the macro data points over the next six months in terms of growth recovery as well as comfort investors get out of the banks’ disclosure in terms of the stressed assets, so we are still hoping and trying to get a sense whether they have cleaned up the books enough or not. So one thing is what banks tell in their quarterly calls, second is also whether RBI backs that up in its own commentary and third the data points coming out in terms of assets sales, some assets coming back on track etc. These are the things which will determine them. So in a nutshell we are still sticking to our preference for retail focussed private banks and non-bank financials over the corporate lenders where will still remain underweight. Latha: Would you still not even touch say a bank like Axis which largely recognised most of its problems, loans or at least those pointed out by Reserve Bank in the third quarter itself. Arora: Axis is a more forthcoming in terms of expressing what is there on their books. Though, fourth quarter they might be revealing more about those eight accounts which are not yet classified as stressed assets. So that will go a long way in clearing up the air on Axis. Axis stands out amongst those banks which have been beaten out of shape probably the first one which should recover going forward and it’s also a decent play on government infrastructure spending so we may not be averse looking at Axis Bank at the current levels Latha: Any of the economy facing banks. You spoke about Yes but that’s still a small player. Axis, ICICI, SBI, BOB any of them. Are you L1 with any of them. You might take a look in after a quarter. Chhaochharia: Can’t really comment on any individual stocks per se, but corporate facing banks still underweight till we get a better clarity. Anuj: IT is going to be key this time. Traditionally Q4 is weak but we had a weak Q3, so, the base effect becomes favourable. What would be your top bets as far as IT is concerned? Is it a sector that you prefer and secondly the kind of stocks that you would want to play? Arora: IT has been one dog of a sector despite having reasonable amount of growth coming through. The expectations will be set by Infosys results. 11-13 percent is the expectation, Nasscom is at 10-12 and Infosys has said they will do better. So, 11-13 kind of fits in. They can even increase that range to 10-14 percent. However I would tend to think that Vishal Sikka will be more optimistic and that should really set the recovery process in the IT space. We like the top 3 Infosys, TCS and HCL Tech. HCL Tech has become very cheap at 13 times. TCS and Infosys are also at around 17 times. So, I think the sector is kind of near bottom and if we can get the right guidance there could be some activity. If markets have to go up further I can't think of markets going up without IT or banks performing at all. Latha: What your preferences in the IT space, midcaps, Large caps. Chhaochharia: So we still remain underweight IT from a portfolio perspective and there is not a single buy-rated stock among the Indian IT services companies. Given our concerns on the shift to digital and how it will hurt their growth prospects and in that context we still don’t think valuations are necessarily attractive here despite the last couple of quarters of the performance. This quarter the headline numbers should be better than what we have seen in last few quarters. Primarily again you have to remember that this quarter is a leap year and leap year itself adds one day which in the context of when you are talking about 1-1.5 percent one extra does make a difference. That’s hold for macro also but definitely for IT services companies also. So headline numbers should be fine. Guidance will be critical in terms of the stock performance. Latha: Only looking at consumer staples where do you stand? Staples are normally seen as a late cycle stocks, stocks that come in the later recovery cycle, are you touching them at all now? Chhaochharia: We are neutral from a portfolio perspective. There are individual stock specific opportunities but sectorally we are neutral. The main stocks there have not done badly even over last few quarters in terms of earnings because that is the nature of the business, you see less volatility there. That should continue in this quarter because they continue to benefit from lower input prices in terms of margins. Again for these companies the recent commentary around monsoons is raising some hopes for the next year and that is where the management commentary around the quarterly results will be critically tracked. Anuj: Puzzled by this conviction sell of yours United Spirits. It has already been the dog of a stock, has fallen some 40-42 percent. What explains this conviction sell and any buy ideas as well in FMCG ahead of earnings? Arora: You must have heard of Tamil Nadu both opposition parties want to ban liquor and government has done everything to stop smoking. Then there is Patanjali to worry about. We would remain away from this sector for some time, at least till the time we have some clarity. Latha: Would you look through the bad numbers in Q4 or the mediocre numbers in Q4 in anticipation that rural growth will mean a better FY17 for any of them? Would you buy them in their distress hour? Arora: I would tend to think there are better opportunities to play the rural theme. Today we saw what Mahindra & Mahindra has done - 7 percent up. So, we would rather play stories which are more specific to rural and avoid FMCG for the moment. Valuations are becoming moderate but not attractive enough. Anuj: Any think like Marico may be which has hit a new lifetime high and has been a strong stock? Chhaochharia: Can't comment on individual stocks.