Bank of America Merrill Lynch (BofAML) is cautious on the market going forward, albeit with no change to its risk metrics. “Much of the rally is based on the global equity upcycle. This rally could correct and it is difficult for us to recommend risk at these prices,” BofAML's Director-India Equity Strategy Sanjay Mookim told CNBC-TV18 in an interview.
The bearish tone was evident as BofAML chose to stick to its target of 30,000 for December 2017, implying a significant downside from the current level on the index.
Mookim said the market is expensive in general at the current valuations and there is a struggle in finding overlap between value and growth.
On goods and services tax (GST), he said the numbers indicated a softness in the economy and the next two quarters on the earnings front could be weak.
Mookim also observed the earnings delivery of midcaps has not been differentiated. “Earnings performance has not stood out from largecaps in any way,” he told the channel. Much of the performance has been multiple-led, he added.
This could be the end of the re-rating cycle. Midcap premiums have expanded a lot and usually returns from value buying is only finite, he added.
Among sectors, he said he continued to prefer private banks, especially those focused on retail sector. Pharmaceuticals, meanwhile, still continue to see pricing pressure in the US. Having said that, he is slightly positive on real estate, and its cycle could start in the next 9-12 months.
Below is the verbatim transcript of the interview.
Anuj: Market still trading above your fair value or above your Sensex target for the year end. Do you get a sense that liquidity could continue to triumph valuations and market could head higher or you sticking with your Sensex target for now?
A: I am sticking to my Sensex target for now. Fair value is what I think is fair value and the market can obviously be higher or lower than that and that is why you get opportunities to make money. Like I was telling somebody else yesterday, at top, people don’t see why the market should fall, and when it does, people don’t see why market should go up. So keeping a level-head at these times can be fruitful, but you need to be a little bit patient I suspect.
Much of the rally that is happening and while sitting in India we like to talk about India and the growth and why that is very attractive in the long term and all of that is correct, but what is happening right now is purely global equities upcycle which can correct anytime and it is very difficult for us to pin-point why that would correct and when. However, all I can say is that it is very difficult for us to recommend risk at these prices; because risk is very expensive as reflected by prices and multiples, we should not be adding that at these prices.
So, yes, I will keep my cautious tone, the risk levels have not changed. I just don’t know when and why the market should fall.
Surabhi: Is the impact of Goods and Services Tax (GST) on earnings in maybe Q1, Q2, is that built into that 30,000 target and what do you expect in terms of actual hard corporate numbers in the first and second quarters?
A: No, it isn't because very simply it is very difficult to anticipate. I don’t think any analysts on the bottom-up basis has forecasted this adequately. We have obviously seen most companies come out with commentary, we have seen the retail numbers as well. That does indicate a bit of a soft patch, not just in June, but I argue possibly in September as well.
This is already leading to downgrades and unfortunately in India downgrades are not a new phenomenon, but we are continuing to see that for FY18 as well and I do think that there is much more to go in terms of number cuts. In that environment, I argue that at least for the large index related stocks it becomes very difficult for you to push up further upside in this market. However, yes, the next two quarters are likely to be, reporting seasons are likely to be weak.
Reema: Your Sensex target of 30,000 by December 2017 implies some downside from here on. Which are the sectors which are most at risk in the second half of this calendar year according to you and the reasons for the same?
A: The answer to that would be whatever has gone up the most really because what we are calling for is not a very alpha short, it is not like something in specific is wrong with India, but it is more of a beta call to say that look the market is expensive in general. We struggled to find an overlap between growth and value. Either you buy growth with extremely expensive prices, or you buy value which is doing nothing. There so no real overlap at the moment. So if the market has to crack, I suspect everything will have to fall.
However, what might be at risk therefore or what is a better indicator of risk is smaller caps where there is a liquidity problem and companies where the operational delivery is not visible yet. So, in this environment, people are plumbing the depths of the market looking for stories, to find out changes, where there is some potential for improvement. I think that is the kind of hope trade that reverses once a bearish sentiment trade sets in. So, what we recommend to our clients, is not like I said to add risk, both operationally and from a liquidity perspective.
Anuj: In terms of midcap action, we have seen huge run for broader market in India and that has been the global trend as well, but off late we have seen breadth narrowing a bit. At your end are you also finding that the opportunities are getting scarce now, limited now in the midcap space, is the risk reward turning unfavorable in the smaller and midcap space?
A: We have been saying this for a while that the earnings delivery of midcaps as a basket has not been particularly differentiated and obviously there are companies which stand out in all categories of stocks; some which do phenomenally well year after year and some which don’t. However, if you were to look at midcap baskets, the earnings performance has not stood out from the largecaps in a big way anyway. It is largely been a rerating.
If you look at the top 900 stocks today, anything with market cap more than Rs 100 million, the average trailing P/E, unweighted, unindexed is now twice what it was in the January 2008 peak and remember January 2000 was the last excess of the equity market. We are already twice of what we have seen in the previous excess. So, clearly much of the performance is been multiple led and until the earnings start coming through, the valuation expansion is only a finite deliver of returns and has to stop which is where we think we are at like I said elevated levels of risk.
Surabhi: Do you see pockets of froth in the midcap universe and if you do, if you could point them out to us, whether it is tyres, whether it is couple of these apparel stocks, innerwear stocks, do you see too much excess in this part of the market somewhere?
A: There is never too much, that is the unfortunate part. The timing of all of this is extremely important but very difficult. Of course I am handicapped by the breadth of our coverage in answering very sector specific questions that you have. So, I can’t unfortunately do that. However what I will say is that as a basket, midcap premiums have expanded a lot and over the month and a half they have stopped doing that and the market has thankfully starting to become a little bit more differentiated. However I do not see any further reason for this to continue.
Like I said, returns made out of valuation expansions are finite and they have to stop. We buy equity for earnings growth year after year which can continue for a long time really.
I do think that it seems like that we are at the end of rerating sort of a cycle.
Reema: Have you changed your view on the banking sector whether private or PSU banks in the last month or so on account of the recent news flows surrounding debt resolution?
A: No we haven’t. We continue to prefer the private banks, especially the retail focused ones because our thesis is that while the market may have very well understood the problems on the balance sheet, it is the topline which is the income growth that will drive bank stock performance and income growth or loan growth is very linked to consumers. So, whichever banks are able to grow, who do not have capital constraints and are willing to grow and lend to Indian consumers sort of space will be our favoured space within banking.
Anuj: We keep talking about this being a liquidity driven market but the space that has led the market, remains the low beta space and we have seen high beta underperforming. There have been phases where high beta has also done well but it is consumer discretionary which keeps getting higher and higher valuation which keeps moving up. Do you think it is time to introduce some beta in portfolio or do you stick with non-risky sort of high valuation stocks?
A: I don’t think it is time now to add risk to portfolio. That is what I have been saying in all our notes for the last couple of months now. To your earlier point of consumer discretionary rerating, again I will highlight that this is not specific to India. If you look at the chart of EM discretionary multiples and India discretionary multiples, they are the exact same chart. India trades at a premium but the rerating is a consequence of an EM rerating. It is not because investors have specifically discovered the Indian growth potential as it were. That is the risk because it is not something that we control, it is not an Indian economy phenomenon, it is driven externally and it could correct externally as well.
Surabhi: Finally, sectors like pharmaceuticals, where there is a big debate going on, even this morning I am seeing some price action on, for instance, pharmaceutical stocks. Is the worst over? What is your sense here?
A: We are not so sure. Unfortunately, we do not currently have coverage on pharma, but as far as I can recall, most companies still have issues with pricing pressure in the US, with operations really and the approvals they will get. The call that investors would try to make is on valuations rather than an operational turnaround. I do not think that is visible yet. Many people are trying to suggest that prices have fallen enough which is always a bit tricky to my mind.
Reema: Finally, an open ended question. Give us some themes where you still see some growth available at reasonable valuations where you would look, where Bank of America Merrill Lynch would look to add position at current levels given the entire market backdrop and secondly, from which sectors would you take money off to invest in these sectors.
A: I excuse myself from answering the reasonable valuation part. Unfortunately, there are not any. But I do think and we have been highlighting that the real estate cycle should start over the next 9-12 months. Obviously, that is a very generalistic statement to make.
Real estate is a very micro sort of a market, but all the ingredients are falling in place. You are getting flat to weak prices, you are getting falling mortgage rates, RERA is conducive to demand and of course, the government policies are supportive for affordable housing with whatever subsidies are available.
Give it some time, real estate activity in India should pick up and this is important not just for the real estate exposed companies, but also for the economy because what we are lacking at the moment is aggregate capex and real estate activity can drive that capex up over the next 4-5 quarters. So I am hopeful. I forecast that the real estate activity should start to improve.
The other more tactical theme that could possibly work is a strong December quarter. We are already seeing a lot of destocking happening in the country at the moment, we have crossed the GST chain, there is no stock anymore. But looking to the Diwali season, you are going to get strong seasonal upticks, you are going to get consumer demand going up because prices for many discretionary items have come off a little bit and this growth will happen at the base of a demonetisation quarter.
So optically, the December quarter, many companies are likely to deliver very strong year-on-year numbers. Ideally, this should not matter, but if the bullish sentiment remains then may be it affects stock prices.
Anuj: From what I am hearing, do you get a sense that the risk for this market is also global in nature because as you have been pointing out, all the rallying aspects have also been global in nature whether it has been the profile of stocks, whether it is the nature of rallies, so are the risks also more global in nature than domestic and what are those risks?
A: Yes, you are right. There is absolutely no decoupling of India however much as strategist we would like to justify our jobs by talking about long-term growth. There is, at the moment, no decoupling at all and therefore, any risk will have to emanate from somewhere overseas. There are many candidates for it. There is financial tightening happening in China, there is potential Trump trade unwind which already seems to have started, there is tapering talk.
We will know in hindsight which if this actually matters. I can only point out candidates at the moment, but there are several issues which are under the surface bubbling around which might effectively lead to a correction. But like I said, we will only know in hindsight.
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