Consumer, pharma, IT to outperform over 1 yr: Credit Suisse

Neelkanth Mishra, Head of Equity Strategy India, Credit Suisse believes that there is a lot of optimism outside India, far more than what is actually seen. "FII investors that you meet outside India are quite excited about the prospect for change in India, which is reflecting in a lot of fund flows into India," he said.

While this is just a temporary phase with the market getting excited because of announcements, Mishra feels that once the surge of inflows has stemmed, people will go back to earnings. That is when a lot of the rallies will start trending down again. Also Read: Dimensions Consulting sees Nifty at 6000 by December  "It is very hard to say if this rally is done. But yes, six months to one year from now, I think the market will again be focussed completely on how earnings are moving, how are fundamentals changing and we will see a reversal of the rally that we are seeing right now," he anticipates. From a sectoral perspective, the outperformers, over the next twelve months, will be the consumer and pharmaceutical names, maybe even IT once the depreciation in the rupee has stemmed and started to reverse, he added. Below is the verbatim transcript of the interview Q: We have had a 10 per cent rally since early September perhaps on the back of news flow from New Delhi. Are you seeing this as a sustainable upmove? A: No. We have recently put out a note explaining why India has been consistently seeing FII inflows for not just the last few months or last year but actually for the last 15 years. Its share of emerging market fund flows has been far in excess of its MSCI emerging market weight. This is just the other side of the coin of global trade flows. There is a lot of capital getting pushed away from the developed markets, which is really desperate to get invested somewhere. India is among the emerging markets. India is the only one, which has raised its hand and said, ‘we can change things.’ So there is a lot of optimism outside India, far more than what you see here. FII investors that you meet outside India are quite excited about the prospect for change in India, which is reflecting in a lot of fund flows into India. All that has been done so far, and even if the bills that have been proposed were to pass, there is unlikely to be any meaningful impact on fundamentals for the next several years. What the market is eventually going to move on is earnings and multiples. We have seen long periods in the past; to give you a perspective, from 1994 to 2003, India saw USD 50 billion of FII inflows in dollar terms and Nifty was unchanged. Once this surge of inflows has stemmed, people will go back to earnings and they will go back to worrying about which power plants are going to survive, which steel plants will become NPAs and then you will see a lot of these rallies actually trending down again. Q: You believe that this is just a temporary phase but the market got excited because of announcements. But do you think fundamentally higher levels or a rerating cannot be justified? A: Yes, it is very hard to take a call on whether this is where we stop or this rally can have another few weeks to go. There are lots of things changing globally, which we must take stock of; QE3 is very different from QE2, QE2 was a specified quantum of capital to be injected into the markets over specified period of time. QE3 is potentially unlimited. Various estimates take it to four-six years of USD 540 billion every year being pumped in by the Fed. Now all of that capital has to get deployed somewhere. It is very hard to say if this rally is done. But yes, six months to one year from now, I think the market will again be focussed completely on how earnings are moving, how are fundamentals changing and we will see a reversal of the rally that we are seeing right now. _PAGEBREAK_ Q: The general perception on the market seems to be that we have put a firm base behind us and downsides in the context of such global liquidity will be much limited. Therefore, you can make returns from equities unlike in the last five years, would you contest that view? A: No, I would not. Over the past six months or so, as we have begun to understand the scope and nature of these flows, we have also realized that it is, after all, an asset class. An asset class will have returns on a relative basis. You are likely to see perhaps the market being supported higher than the levels that we had sought was likely maybe late last year. But I would like investors to focus on relative returns on which sectors will do well, which sectors have potential for earnings growth, which sectors are likely to see disappointment, which sectors are likely to get derated. Irrespective of where the broader market is, there are very few people who trade the broader indices. From a sectoral perspective, the outperformers, over the next twelve months, will be the same old boring consumer names, pharmaceutical names, maybe even IT once the depreciation in the rupee has stemmed and started to reverse. Q: Do you think earnings have troughed out and we are on a reacceleration path? Do you see any evidence of that coming through in this earning season or the next one? A: Not really. We have to look at things from a sector wise perspective. In the past seven quarters, the broader operating margins have been trending down. They will be in a mix of very sharp correction for the more cyclical sectors like materials. But at the same time, there has been margin improvement in sectors like IT and consumer. On a broader mix, there are disappointments in infrastructure, capital goods and materials. I think these are likely to continue. The improvement in margins in some of the sectors like consumer staples will continue again whereas you will see some weakening of profit growth in sectors like banks. Our preview note put out today shows that while the net interest margins may improve slightly, the weakness in the free income and the loan growth is likely to keep profit growth quite neutral. I don’t expect any reversal in profit growth to start materializing in the next one-two quarters. Q: The counter view to that for a lot of people who are more optimistic seems to be that now, we have got a very tepid earnings trajectory of around 10 per cent growth. May be as we get into next year, that does not fly off to a 20 per cent plus growth as we have seen in the past years but may be gets up to 14-15 per cent. But that would still be an improvement on the margin enabling some degree of rerating on the way up. Do you think that is unlikely? A: Extremely unlikely. Optimism is what everyone in the market, including us, thrives on. Every year, we have started on a very optimistic trend and we have only seen disappointments. Some of this optimism is also fueled by inflows. Early in the year what happened in the market and we kept flagging it, was a mean reversal rally driven by a surge in global flows. We wanted to keep ascribing reasons to it. We said the UP elections are going to do this and that. Reforms will change things but nothing happened. Now, we have seen the government wake up very luckily at the right time. I am very happy they have, and again, fund flows have started. We are now trying to see reasons to justify why the market should go up. My sense is that we are in for a high single digit at most earnings growth for the next couple of years. I think earnings upgrades going forward will be very unlikely. _PAGEBREAK_ Q: What could be the trigger for reversal again, in the next three-four months can you think of possible things which can reverse this mood of optimism which has crept in once again? A: Absolutely. The thing about capital flows and their impact on the rupee is that there are two moving parts, which in my view determine which way the rupee is headed. One is a very steady state current account deficit driven by a very high trade deficit. That is something which is like an upward incline or downward incline negative throughout the year. Then you have a very volatile capital flow line, which keeps moving up or down. Right now the capital flows increasing or accelerating has helped the currency, it has helped the broader markets. There is a prevailing mood of optimism. Once the capital flows stem and I expect that to happen maybe in the next couple of weeks, you will see the rupee starting to weaken because it cannot clearly hold on to these levels. Then all the optimism, the circularity around balance sheets getting repaired due to the beneficial impact of a stronger rupee, all of those things will start to reverse. I think a lot of people would be forced to dismiss this quarter’s earnings season as somewhat of a lagging indicator. But, once the December quarter results start to come out and we start to see disappointments again you will see the market starting to trend down. Especially, I would say in particular, the sectors which are likely to see most of the downgrades will start to trend out again. For example, something like steel. I think the fundamentals are driven mostly by what is happening in China, which has very little to do with what India does or does not do in terms of reforms on pensions or insurance. I think there is no reason for the stock to go up because the stocks have gone up as much as they have and as earnings and fundamentals start to show up maybe in the next couple of months, you will start seeing them trending down. I do not expect a collapse. In this kind of a surplus global liquidity environment, I do not expect the market to come crashing down. Q: You were not in that camp which believes that we are in a multi-quarter uptrending market now which will eventually hit all time new highs sometime in the next six-seven months? A: Whether we hit all time new highs or not are two different things. If this rally lasts, who knows. If people keep putting money in, in the hope that these reforms are a precursor to much stronger action by the government and that a lot of things will fall in line for the government, the reshuffle happens and some critical ministries are given to the right people, there are going to be some new inductions into the ministries and some known people who are good at execution could be brought into the right ministries and if they start doing the right things over the next one year, you see a lot of the bottlenecks in the government opening up. If those things start to play out, which is what the market seems to be implying then maybe yes there can be new highs. But if people keep getting excited, keep getting pushed out of all markets like what you see in Brazil, they are trying to push away capital to protect their currency. India seems to be the only shining beacon with any sign of hope for the next three-five years. So who knows whether the new highs are made in the next month or two months or in the next six months. But, that is going to be driven by capital flows. Fundamentally looking at various sectors in earnings, I think six months from now, we will be focusing again on the old boring sectors and worrying about asset quality issues of banks, on steel companies which are going to survive in the next cycle or which power companies are going to get coal. That is something which people have completely forgotten right now. I think in the next four-six months, that will be again top of the mind and we will be worrying about a weak currency and whether the RBI can cut rates further or not. That is the way I would approach it, whether broader new highs for the markets are reached or not is something which will be determined from fund flows move, maybe it can happen in the next two months. Q: Why do you think global liquidity flows might peter out because as you said yourself the Fed has almost written a blank cheque, ECB will start buying bonds soon. But you believe that this kind of liquidity will abate in just a few weeks time? Why do you think what kind of risks do you see popping up which might lead to that reversal? A: We have to understand that initially equities move on hope and you want to be linked to the rally. For example, people who did not participate in the January rally would have made no money this year. While the markets are up from December, at least till a month back there would have been no money making opportunity if you had not really participated in January. People move very early. They shoot from the hips so to say and then you wait for fundamentals to change. We only need to look at the correlations between FII flows. I am not saying FII flows will slow. I think the pace at which they are coming will slow. People at the margin who covered their shorts, people who have gone marginally long, people who have gone marginally overweight on India or rather have started to cut their underweights, are people who will then start to think twice once all the fundamental starts to deteriorate again. And I must reiterate that from 1994 to 2003 we saw up to USD 50 billion of FII inflows and the Nifty didn't budge in dollar terms. We are conditioned by the high correlation between the Nifty's move or MSCI India's move and FII inflows between 2003 and 2010. I mean they all seem to be very highly synchronized. But, if you just stretch that time window a bit and include 1995-2012, you see that for the period outside of 2008-10 there are absolutely no correlation between FII flows and the broader markets. We need to be cognizant of that and equity markets in the short-term may move on optimism but, over 6-12 months you need to have earnings and even earnings growth prospects backed up. I have heard from several investors that prospects for earnings growth are changing and I fully agree with that. I am very excited that the government has started to take some steps. Unfortunately, I don't see the steps that are even being proposed really changing fundamentals for the listed stocks for the next several years. That is why I think that once the earnings trajectory starts to become more visible, you will see the sectors that are getting hurt start to come down again. _PAGEBREAK_ Q: We have seen a pullback in infrastructure and BHEL is up 30 percent over the last one month or so, L&T has had a good ride. I see Voltas in your underperform list at Credit Suisse. Would you still use this opportunity to lighten up in infrastructure? A: Absolutely. I think this is a great opportunity to cut weights. What happens in these rallies and continuing with the theme that was harping on just before this is that you have no idea what is going to change. It is very hard to identify which stocks are going to benefit. There are reforms but, one very senior bureaucrat very amusingly corrected reform for a journalist and said, diesel price increase is not reform. If you just have to go through the list of reforms that happened in the early 90s, maybe some time in the late 90's and early part of last decade, those were serious reforms. You brought down weighted average import duty from the mid 70s to 7 percent now and you removed a license raj, you opened up several industries for large scale investment which were earlier reserved for the small and midcap. Those were reforms. I think SEB restructuring or raising the price of diesel is certainly not reform. There is absolutely no visibility on what's going to change. The markets are running up on hope that more such change is going to happen going forward, which I think will be great if it happens. At this point, you have no idea which reforms will get passed, what steps will be taken by the government. The market only can react to prior price performance. That is the only information available in the market. In the early stage of any rally like this you will see strong mean reversal. The stocks that sell the most will rise the most. If you are a big holder, you were a big believer in BHEL or any infrastructure company and you are stuck with that position. This is a great opportunity to trim, I fully agree. Q: The one thought as you were outlining just now has been that this time when the rally progresses you will see many of those high beta kind of sectors or high risk sectors doing well. You think it makes sense to stay with high quality defensive natured kind of names, good balance sheets and not get tempted into buying low quality names which give you more bank for the buck just in the near-term? A: It is very hard to give a yes or no answer to that. I think it has to do with people's risk appetite. There are people who are confident of predicting stock price moves over the next 2-3 days or five days. For those, I think getting into the high beta names and those who can do it successfully can try to take advantage of this rally because sometimes these rallies can be self perpetuating. Once some company with a broken balance sheet sees its stock go up a 100 percent then on the potential of its balance sheet getting repaired, if there is a primary issue those are again things that start to drive the stocks further up. If you can time it that well, I think yes why not. If your time horizon for investment is still 6-12 months and you have the ability to withstand a pain of underperformance within the next month or so, I would advise to stick to the companies with good earnings momentum and decent valuations.