Macquarie sees Nifty at 5500 by yr-end; suggests buys

Despite sagging economic growth, policy paralysis and a downturn in investor sentiment, Rakesh Arora, head of research at Macquarie Capital Securities, says that Nifty could touch 5500 by year end.

In an exclusive interview to CNBC-TV18, Arora explains that the market is currently undervalued because it is discounting GDP growth lower than the street consensus and because there is a change that earnings look achievable. “If interest cuts do happen slightly more aggressively, there is a chance that earnings might see support from the lower interest cost,” he added. Arora says that the market is factoring gross domestic product growth of 4.8-5.6%, and earnings growth of 11%. However, he does say that two factors that have to be watched are the rupee and government action. The Indian currency has been on a spree the past few months, breaking new lows against the dollar with ease despite Reserve Bank intervention. Adding fuel to the fire is the lack of policy action from the government. Both these factors in turn impact investor sentiment towards India. Close to Rs 3400 crore foreign money left Indian markets in April and May on post-Budget tax worries, the pace of rupee depreciation and the lack of any significant policy action, and has only recently made its way back into the market. Arora advises investors to see the current market scenario as a ‘buy on dips’ opportunity. Arora advises investors to see the current market scenario as a ‘buy on dips’ opportunity. His top picks are Maruti Suzuki, Larsen & Toubro and NTPC. He is still cautious on banks though, as concerns of non-performing loans still cloud the sector. Below is an edited transcript of his interview with Udayan Mukherjee and Mitali Mukherjee. Also watch the accompanying videos. Q: You track cement quite closely. What have you made of the order and its likely impact on the frontline cement names? A: The penalties are much stricter than what was anticipated by the market, so that should come as a negative surprise. If you read through the whole judgement, it is largely based on circumstantial evidence so cement companies would be hoping that they get some relief from the appellate tribunal. I am pretty sure that they are all ready to go and appeal in the next two days. So in all probability they should get a stay order and should not have to pay the penalties till the case is finally decided. That should give them some breather. But two things are very clear; we are heading for a de-rating in the cement sector because you are not sure how much of this profitability the companies will able to maintain. Secondly, consolidation in the sector is going to be more difficult primarily from the fact that now all merger and acquisition applications have to be processed through Competition Commission of India (CCI). So anybody trying to buy companies in their own regions is going to be difficult. Most largecap cement companies are trading at 17-18 PE, but that seems extremely expensive and they should de-rate to more like 12-14 PE. Q: How have you done that devaluation exercise? Where is it that you think it will get lopped off first? A: We were expecting these penalties to come in so we were already building 15% discount to our discounted cash flow (DCF) value. We had a sell call on most of the cement names already, so for us it’s already built in. Q: India seems resilient for the last couple of days, but do you see it outperforming other global markets now even if a correction ensues? Also, how much of that would have to do with the price of crude and the way it has slipped off? A: Falling energy prices do augur well for Indian markets and that is playing out. If you look at the equity risk premiums, India has the lowest so market participants do believe that India is largely insulated from the global markets. That’s why India’s premium over emerging markets is now stretched to around 33%; it was 25-26% few months back. So that point is already well reflected. The question is how the currency behaves and how much of benefit of the oil prices we can sustain. Government policies would also decide where India goes. We are slightly more hopeful, we think that some activity on the infrastructure side has picked up and it is a matter of time before interest rate cuts happen so India may not have too much of downside from hereon. Q: So you are comfortable with that 5,500 Nifty target that you are working with right now? If yes, how would you approach the second half, is this a buy on dips kind of market? A: Yes, that is what we have been maintaining for almost a month now; it is a buy-on-dips kind of a market because things are likely to improve in the second half. Our expectations are extremely low; we think the market at current levels is discounting gross domestic product (GDP) growth of around 4.8%-5.6%, which is well below what all economists are thinking. So clearly the market is already factoring in a much lower growth environment. Secondly, if I look at the earnings estimates, they have fallen quite a bit. FY13 consensus is projecting only around 11% growth, which looks reasonable and achievable. In fact, if interest cuts do happen slightly more aggressively, there is a chance that earnings might see support from the lower interest cost. So for the first time in two years, earnings are looking achievable. Also there is a slight chance of an upgrade also. So in that context, I think the market does look reasonably undervalued at the moment. Q: Any worries on the monsoon front for the market or do you think it is a side issue? How do you see that and the inflation situation panning out for the next six months? A: Monsoon remains one of the critical things apart from oil to watch out for. I don’t think anybody is estimating very high contribution from agriculture on the GDP, but there are ramifications on inflation. RBI has made a tacit turn and has started looking at wholesale price index instead of core inflation, so clearly inflation on the food side becomes more critical. So having around average monsoon is a very critical for India to continue to rerate upwards. _PAGEBREAK_ Q: What would you do on metal complex now because commodities are collapsing globally? How do you approach names like any of the frontline metal stocks or even some of the upstream companies like Cairn in the light of fall in crude? A: We are hopeful that China demand would recover in the second half and already we are seeing signs of increasing copper imports into China, given that LME prices are lower than the Shanghai prices. We also believe that US would see the third round of quantitative easing (QE3) by September or so. Both these things point to a stronger second half, so we are not so bearish on the commodities complex per se. For the Indian names, given the rupee depreciation there has hardly been any change in the realization. I would think that the price fall that we are seeing in some of these stocks maybe unwarranted until and unless China recovery becomes doubtful, I think things should be okay. Q: Specifically though what is happening with the Sesa-Sterlite combination because there is a lot of negative news flow that we hear in terms of the merger, the kind of dissidents that’s happening over there? A: It is touch and go situation regarding this merger because in Sesa Goa you have one major shareholder who controls close to 14% and has been negative on this deal. But from our reports, the voting has not been large enough to make an impact and this deal would go through. The gap between Sterlite and Sesa is widened largely due to the fact that some of the existing shareholders have been exiting, but nothing to do with the deal not going through. So probably on Monday before the market opens we will have the final decision on this and the gap should narrow down. Q: Even if you are holding with your 5,500 target, do you get the sense when you speak to global institutional managers and people running the money that there could be another sharp cut coming for the market deeper than what we have seen in the last few months? A: Talking to the global investment managers, most of them are hugely underweight India, so I don’t think there is any major selling to be done by the global fund managers. Given where the rupee is, it brightens up the scope of making 15-20% return from the current levels at least in dollar terms. So I think Indian market is appearing more lucrative and we should see a pick up in foreign inflows in the second half. Q: What do you expect to see in earnings for the current quarter when the July results come out? Do you think the market will have any kind of problems negotiating that because of any ugly surprises or we should be okay? A: On the operating level we should be okay, but there would obviously be foreign currency losses and mark-to-market provisions which the companies will have to do. So yes, there would be this element of exceptional items which I think street should be able to look through. Otherwise no real major surprises. I think Q1 should be equal or slightly better than Q4. Q: Just going through your report, you have got stocks like L&T, NTPC, Maruti as your top key picks, but don’t see too much from banking. Are you still staying clear of that or not particularly bullish on that space? A: We think that the non-performing loan (NPL) cycle is still playing out and the restructuring is still going on, so probably we are one-two quarters early from going all out on banking. Though we have reduced our underweight on banks and have brought in State Bank of India (SBI) into our top-30 ideas, we have not gone ahead and made an outperformer or overweight call in banks as yet. So I think in two quarters time probably things will be better for banks. Q: What is keeping you positive on Maruti though because there has been a lot of concern, both about a dip in petrol car demand and of course what’s happened with the currency? A: We think that the petrol car demand is largely a Maharashtra phenomenon and most of the investors from Mumbai are influenced by it. But rest of the country seems to be doing well. We are also encouraged by Maruti’s new product launches which are doing very well. The adverse reaction to yen strengthening is pushing the company into increasing its India operations much faster, so we believe that two-three year story for Maruti is very encouraging. In the near-term, the new model launches will keep the things going up. Also remember that it has a very low base effect kicking in, since last year they had many labour problems. So year on year (YoY) numbers would look much better this year. Q: The market has been quite wary of technology in part because of how disparate performances have been. What do you expect to see in the next quarter - more earnings damage or will it be the start of some kind of recovery, and how are you guys approaching IT now? A: Clearly there are demand issues and that is where their worries lie. But fortunately rupee has been helping the IT industry, so I don’t think there is any risk to the earnings. There probably could be an upgrade because of the weaker rupee, so we are still holding on to our overweight call. Probably QE3 happens and the demand worries might resolve itself, so there could be further upsides given where rupee is and QE3 possibilities. Q: Given that you are optimistic on the margin for the market, why is your upside target restricted to 5,500 because that is just about 6-7% from where we are now? A: The reason why we are not overly bullish is because we are getting into elections next year, and we think that government will be in a populist mode. Secondly we are not seeing any major signs of reforms happening, which can’t make us more bullish. So these two factors are the most critical thing which has making us believe that the market would remain at a slightly lower level than what historically we have seen. I don’t think anybody is forecasting GDP growth more than 6-7% for FY13-FY14. So clearly the PER band which used to be for the last six-seven years of 14-20 has shrunk to probably 12 to 17, so we are at 17 times PE multiple for FY13.