Indian equities overvalued; focus on rupee: Sanju Verma

In an interview to CNBC-TV18 Sanju Verma, managing director of Violet Arch Capital said Indian equities look overvalued.

"Keeping the S&P 500 rally as a benchmark, and assuming the Sensex at sub-19000, Indian equities are giving an earning yield of just 7 percent. Considering the risk free rate (yield rate on Government Securities) is 8 percent, the equity risk premium for Nifty companies is a negative 0.86. This is a proof of equity as an asset class being grossly overvalued," explains Verma.

Also read: Late FII selling on April 3 triggers outflow concerns

However, she is bullish on the market and hopes that macro issue like current account deficit (CAD) may come down to 3.5-4 percent from the existing 6.7 percent. "With gold prices coming down leading to a decrease in gold import expenses, CAD is likely to come down in the coming six months," she added.

Investors should consider investing in the currency market instead of equities. Despite the negative newsflow, the rupee has held steady. Once forward premiums and hedging costs come down the rupee will appreciate and give a boost to the next phase of equities rally, she elaboarted.

Below is the edited transcript of Verma's interview to CNBC-TV18.

Q: Do you think we are headed for a big waterfall slide in the market and if yes what could the extent of the correction be?

A: We need to take a hard call and look at fundamentals on the ground before we decide to be bullish or otherwise. The screen is screaming red at this point in time. It is a sea of red. I may be called a brave heart to give a bullish call.

The macro scenario is certainly not looking rosy. The only reason S&P 500 has moved up at today’s levels is because the S&P is trading at something like 16 times giving an earnings yield of 6.25. Given that the risk free rate in the US is just about one percent or even lower, it basically means that the equity risk premium for the S&P 500 set of companies is just about 5.25.

This indirectly means that equities in the US are grossly under-valued because the higher the equity risk premium, the more under-valued the equities class for that given geography. If I use the S&P 500 rally as a benchmark and extrapolate the workings into the Indian context today at sub-19000, the market on one year forward, assuming that the EPS for FY14 will be in the region Rs 1300 or Rs 1325, the PE works out to something like 13.5-14 times which gives an earnings yield of just about 7 percent.

If I were to compare the 7 percent earnings yield with our risk free rate which is the government securities (G-Sec) rate which is close to 8 percent, then the equity risk premium for the Nifty set of companies is actually a negative 0.86. This means that equities as a class in India are grossly overvalued.

It needs to first get into the positive territory with respect to equity risk premium even before calling for a buy on Indian equities as an asset class. That’s the absolute bearish view which takes into account all the negatives; be it with respect to the current account deficit (CAD), poor earnings trajectory and a macro which seems to be flip-flopping between the good and the bad.

However, I am of the firm belief that USD 25 billion that we made through FII inflows last year had nothing to do with macro. It had even lesser to do with earnings. What it had to do with was just liquidity and liquidity alone fueled the 20 percent plus rise in dollar terms that we saw in the broader indices. So, the question that we should be asking is will liquidity continue to flow in or will there be a stop there for good.

We have pulled in on the equities front more than USD 8 billion in this calendar year. Will it continue? I think rather than getting carried away by the stock market, one should look at the currency market. I have always maintained that currency markets are nimble footed and a precursor of things to come in the stock markets. I am surprised that despite a 6.7 percent CAD number for the December quarter, the rupee has by and large been steadfast. Even in the non-deliverable forward market, rupee is trading at just about 55.25/USD or 55.35/USD at the worst. I think that is a positive.

Over the last one year, on a year-on-year (Y-o-Y) basis, rupee has depreciated all the way from 50/USD to 54/USD which is a depreciation of 7 percent. Over the last two years, rupee has perhaps depreciated by more than 20 percent but the point is that despite huge amount of negative news on the forex front, the rupee has held steady which means that there is something that you and me don’t know.

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What the strong rupee is telling going forward is that forward premiums are likely to come down. Going forward, hedging costs which have inched up all the way to 7 percent are likely to come down. Once that happens and the rupee appreciates, that itself will give boost to the next phase of equities rally as and when it happens. Why I believe that forward premium on the rupee will come down and hedging costs will come down is purely because I believe that forward premium is at the end of the day a function of domestic liquidity. Last year, the liquidity deficit was to the tune of Rs 84,000 crore on an average on a single day throughout the last fiscal. This year, the liquidity deficit will be in the region of about Rs 70-75000 crore which is a far more benign number.

While the CAD number at 6.7 percent scared away people in February, the trade deficit was just USD 20 billion whereas in January that number was USD 15 billion. So, let’s not look at the past numbers, let’s look at what the CAD will be in March because there is so much of debate around that. I think that number will be lower than 5 percent.

If gold prices come down to USD 1500, then we can easily save USD 15-20 billion on gold imports alone. Saving USD 15-20 billion on gold imports alone will bring down the CAD to more benign levels of 3.5-4 percent. So, it might seem impossible now but its not impossible six months down the line.

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Q: Having looked at the screen, there are some mouth watering levels at which stocks can be bought at. Would you advice nibbling into the market at this point and if yes are there any particular stocks that you are looking at?

A: We have just recently released a buy report on IndusInd Bank. We are calling for price target of Rs 497 which is our base case price target translating into more than 20 percent upside from current levels. The banking sector has been under a bit of a cloud for largely wrong reasons. That said, the story in IndusInd is pretty much well known. It has been well flagged by a host of brokers but what is important that it is a misconception that IndusInd is primarily into the CV financing business.

What one needs to understand now is that the whole business mix has changed dramatically while peers are focusing on fleet financing which is highly vulnerable to how the CV market overall does. What IndusInd has done is very smart. They are actually now focusing on small road transports operators (STROs). While the margins and growth in this business are lower, this is a less riskier business and that is what we are particularly assured by.

Infact, in a bull case price target for IndusInd, we are calling for a price target of Rs 613 where we are assuming that the net interest margins (NIM) will not be 3.8 percent but perhaps inch up all the way to 4.1 percent. The incremental slippages will not be 0.8 percent but may fall all the way down to 0.5 percent and credit growth will not be 25 percent but maybe 29 percent.

There is a reason to believe that our bull case assumptions will actually be met. This is one story that I am particularly bullish on. However the big disclaimer and caveat here is the fact that the banking space is also vulnerable to government diktat.

While the government may have done wonders for Adani Power's stock price yesterday, the company has very little to show by fundamentals having posted Rs 500 crore loss in December. Nobody is bothered to find that out. The government is telling Adani to engage in compensatory tariffs so that their net worth is not eroded over the next two years and it gets to sell power at a slightly higher tariff than the Rs 2.5 odd that one would have otherwise sold in places like Gujarat and Haryana. So, who will bear the additional tariff hike? Certainly not the consumer, given that we have a general election maybe this year, maybe not this year but next year for sure.

Are the state electricity boards (SEBs) in Gujarat and Haryana going to bear their additional costs? If yes, then what about the lending consortium that has lend to these SEBs. Canara Bank has an exposure of Rs 22,000 crore to the Rajasthan SEB and Oriental Bank of Commerce (OBC) has an exposure of Rs 9000 crore alone to just the Haryana SEB. So, each time the government tries to give a sop to one part of the market, there is somebody else who is bearing the rough end of the stick.

These kind of ad hoc measures are something that are very scary. Yesterday's decision on compensatory tariffs by the Central Electricity Regulatory Commission (CERC) could have far reaching implications. Its implications will not just be on power sector, which could albeit be positive, but it could also have negative implications for the banking sector. These are the kind of ad hoc measures that I am concerned about.