Ambit Cap sees big reallocations to India; suggests buys

Saurabh Mukherjea of Ambit Capital says the domestic political situation will be the biggest risk for our markets next year. He says Indian equities have had a decent run this year partly because of pro-reform stance of the government and partly on economic recovery in the US markets. 

"The 18 percent growth in Oracle sales year-on-year suggests that corporate America is spending properly. They are not waiting for the fiscal cliff to happen or not happen. Corporate America is back in business; we knew that consumer America has been in business for the last two-three quarters. But this resurgence in American confidence around consumer spending, around lower unemployment etc, is leading to a big jump in risk appetite," he told CNBC-TV18 in an interview. Nevertheless, he says, the risk of the fiscal cliff will remain an overhang on the global markets. Another risk, Mukherjea points out could be the blaze of IPOs and QIPs in the first two-three months of next year. There will be a lot of money raised that will obviously soak up some of the foreign flows and it will temper the upside for the market. "Whilst from January to March we’ll see lot of foreign money coming in, I suspect majority of that could well go into primary raises rather than coming into the stock market," he told the channel. Going forward Mukherjea expects to see big reallocations towards India. He says a lot of large foreign institutional investors (FIIs) will increase their India weights, which will lead to a fairly meaningful sum of money coming the country’s way. Below is an edited transcript of Mukherjea's interview on CNBC-TV18. Q: If you had to pick three-four names in the Non-Banking Financial Banking Companies (NBFCs)/ old generation private sector banks that might gain from this bill, which ones would be your top contenders? A: Amongst the likely recipients of a banking license, I would put Shriram City Union Finance at the top. It is a pretty small NBFC but it is good quality and the group as a whole is well regarded in regulatory circles. Mahindra & Mahindra Financial Services has strong capital position. They recently had a Qualified Institutional Placement (QIP) and strong branch network in the backward states. So, that gives it very strong credentials to press for a bank license. Remember, one of the criteria that the RBI will look for, is financial inclusion and M&M Finance on the back of that, can make a strong case for a bank license. So on the whole theses are my two favourite NBFC plays- M&M Finance amongst the larger NBFCs and Shriram amongst the smaller NBFCs. The other leg of the trade which is worth contemplating is some of the smaller private sector banks that might choose to roll themselves up with the new banks. This is clearly a story that will evolve over the next 18-24 months, but you need to look at the smaller South Indian Banks quite carefully to see which of them might do a role up play with the new banks. The two highest quality of the Southern Indian banks are City Union Bank and Federal Bank. Both of them have good branch networks, good loan books, progressive CEOs and there could be excitement around those stories as we move towards December next year and the five licenses are awarded. The smaller South Indian banks in particular City Union Bank and Federal bank could gain a lot of momentum. Q: Any thoughts on L&T Finance Holdings? It had a meteoric rise ever since it listed and the primary reason seems to be that banking license? A: I agree. It looks likely that they are a hot contender for the license, but my concern with that stock is, at close to three times book, already a lot of the economics of becoming a bank is factored in. Therefore it is difficult for me to highlight further upside. That is why I focused on Shriram City Union Bank and M&M Finance. L&T Finance also looks like a hot contender, but at three times book value, it is a bit too richly priced for me. Q: We have had our period of consolidation. What are you picking up from money and mood globally? Does it look like there is going to be a big late dash for the year? A: The big shift in the mood vis-à-vis India has taken place over the last six weeks or so. A part of it is the fact that the reform momentum in our country has continued and finally, we have seen action in Parliament after a year and a half. However, the other part of it is that there seems to be a pretty meaningful economic recovery in America. Oracle’s results, that came out yesterday is astonishing amongst the corporate spends. Oracle’s 18 percent growth in sales year on year suggests that corporate America is spending properly, they are not waiting for the fiscal cliff to happen or not happen. Corporate America is back in business, consumer America has been in business for the last two-three quarters, we knew that. However, this resurgence in American confidence around consumer spending, lower unemployment, Shale Gas, etc is leading to a big jump in risk appetite. My reading is that over the next four weeks, partly this year, partly going into next year there will be big reallocations towards India. A lot of large Foreign Institutional Investors (FIIs) will increase their India weights which will lead to a fairly meaningful sum of money coming India's way. _PAGEBREAK_ Q: What's the case for a correction from here on? Incase of a correction, where could the Nifty find a really strong base on which people should be buying into? A: There are broadly three risks that plague our minds when we see days like this where there is exuberance around and where our target of Sensex 23000 clearly looks achievable over the next 12 months. I have three risks that I worry about and the first of it is our own domestic politics. We have had a great run in terms of reforms and in terms of a progressive government action since September. However, you cannot rule out the beginning of the reinitiation of vitiated politics that we saw this time last year. So, our own domestic political situation is probably the greatest risk. My sense is things are moving forward with an election 12 months out. All the parties in the political spectrum have a very good incentive to play ball and to be progressive. However, one can't rule out the reinitiation of vitiated politics. The second risk that we cannot rule out entirely is the US fiscal cliff. If in the next two-three weeks, President Obama and the Republicans can't strike a deal, we will see a degree of slowdown in America. The underlying American economy is strong enough to deal with the fiscal cliff, but that clearly will lead to a temporary pull-back in global equities. The third risk I see, is there can be a blaze of IPOs and QIPs in the first two-three months next year. There will be a lot of money raised that will obviously soak up some of the foreign flows and it will temper the upside for the market. So from January to March we’ll see a lot of foreign money coming in. I think a majority of that could go into primary raises, rather than coming into the stock market. Q: You have a sell on HDFC. That is the perennial blue-chip which people do not want to sell. What makes you bearish on it? A: The main construct there is actually a structural change in the housing finance market. What has happened is over the last couple of years, the regulators made it much easier for customers to refinance their mortgages. So, if I am an HDFC Bank customer, it becomes much easier for me to pay remortgage with State Bank of India (SBI) or an Axis Bank. What that does is, it makes it much harder for a large incumbent in the home loan space such as HDFC to charge premium rates to its old book of customers and use that to offer very fine rates to new customers. That process of churn in the mortgage market undermines HDFCs comparative position. Hence, overtime it will erode its net interest margins by bringing down the price to book, which is at a very elevated four times. It will probably come down to more reasonable two times over the next year or so. So, it is a story about a structural change in the home loan space driven by regulation, heavy competition in the home loan space and HDFC in home loans is the biggest loser from that story.  Q: From your strategy notes, there is a camp amongst the FIIs that are interested in buying into companies with broken balance sheets looking for disproportionate gains. What kind of stories would that include? A: This is the big change over the last six weeks. Heavy FII interest in names such as Adani Power, DLF, GVK Power and Infrastructure; companies that FIIs really weren’t willing to even discuss meaningfully six months ago, are now on their watch list of stocks to focus on. There are two things that investors are looking at here. One is, can these companies do asset sales to deleverage? For example can GVK sell a stake in Mumbai International Airport Limited (MIAL) to bring its debt-equity down? Can DLF sell Aman Resorts to get its debt equity down? That is the first leg of deleveraging that the market is looking at. My sense is, that’s quite a sensible thing to focus on. Over the next three-four months,  we will see asset sales gather steam as private equity comes in and buy stakes in MIAL, Aman Resorts and so on. The second leg that people are focusing on, is the QIP market. There will be a lot of money that will be coming into India and a lot of the broken balance sheet companies will enter the QIP markets in February-March. The combination of asset sales in QIP could almost half the leverage in many of the broken balance sheet names and that’s where the re-rating potential lies in DLF and GVK and hence, the rising FII interest. These are stocks only for the strong hearted, for the seasoned investors. I wouldn’t recommend retail investors to dabble in these names, it is complicated. It is high finance and it could blow up with small changes in underlying economic conditions. However, I understand the FII interest and names such as DLF, GVK will have a very strong rally in the next 60 days or so.

_PAGEBREAK_ Q: How much of a role do you think the RBI in its action will play in helping the markets move higher going into next year?
A: In the last two RBI policies, the RBI governor hasn’t delivered what the market wanted to hear. However, yesterday’s message from the RBI was quite unequivocal that from this point they will be focusing on growth rather than inflation. Before the financial year ends, we will get 50 bps of rate cuts. Whether we will get anything beyond that, I am doubtful about, which is another reason why I don’t think financials is the main way to play the rally.
My sense is, the scope for rate cuts in the next three-four months is fairly modest- 50 bps at best. The RBIs bigger role in this recovery will be through the banking license route. The policies that it announces, the speed at which it proceeds and the bank license route is probably the more meaningful way for it to impact the market than the rate cutting. Scope for rate cutting is modest, 50 bps before the year end and hence my skepticism about the financials as a no-brainer play in this rally. Q: How do you think they will move with it? Do you go with consensus which expects to see action in January? Or do you think they will wait to see what the budget has to offer and come March, when their mid-quarter review happens, is when the cut happens. So basically the market actually shifts its big move to somewhere in the middle of the year rather than the early part?
A: My sense is they will move in January and there are few reasons for that. Food inflation traditionally soft in the winter months. Once you start getting out of the winter months and go into March April food inflation does tend to pick up steam. So, from that perspective, this is the best time. Secondly core inflation is at a 2.5 years low. Once we start moving into an economic recovery once again, there is a chance that core inflation could come back up.
Thirdly, obviously the need for rate cuts is greatest at the bottom of the economic cycle, which is where we roughly are. The final reason might be somewhat controversial- the government will borrow some more money probably end January- early February and hence, if the RBI doesn’t preempt and cut rates before that, it will look quite strange for it to then cut in March. So, all of that suggests that we will get something close to atleast a 25 bps, probably a 50 bps cut in January and then they will hold fire and see how the economy proceeds. Q: Not too many pharmaceutical names in your preferred list. Any aversion to this sector which has done so well?
A: There are two reasons. One is that at this juncture of the cycle, there is very little structural upside in those names. On pharma, FMCG, IT, we published a note this morning, cutting our sector weights on those quite heavily. The second reason is the domestic pharma landscape, with the cost regulations imposed on local drugs has become quite difficult for us to push companies, when in our home market your business has been undermined. We have names such as Dr Reddy’s Laboratories, Glenmark Pharma which have built successful export franchises. Those stories are quite well-known and meaningful upside in the next three-six months is difficult to see. So, we have got a great pharma sector, but I am afraid in the next three-six months I don’t see big upside coming from that sector.