Earnings, reforms will be next drivers for market: Experts

Neelkanth Mishra feels the RBI today did the right thing by keeping rates unchanged. He said the RBI cannot afford to cut rates now and regret it later, he said. The market had to be cautious about the implications of falling commodity prices, since 56 percent of Nifty earnings was now dollar denominate, Mishra cautioned.

“I will not be squeamish about valuations,” says Mishra, adding “if the world is worried about deflation, it will throw money at it.” Mishra feels large dollops of this liquidity should find its way into markets like India which are growing at much higher rates than the rest of the world.

Desai is betting on good quality banks and good quality FMCG companies. He is more bullish on midcaps, which he feels will outperform the large caps over the next few years.

Laijawala is bullish on consumer discretionary, financials and logistics shares. He is particularly bullish on financials, as he sees a transformational shift, as investors switch from physical assets to financial assets.

He says this is a good time to be betting on some of the PSU bank stocks, where the risk reward ratio is attractive.

Ratnesh Kumar sees a compounded annual growth rate of 20 percent from equities over the next 2-3 years.Below is verbatim transcript of the discussion:

Q: The commodity super cycle, I am beginning with that question because all of you are heading foreign brokerages and in a sense are on the cusp or are on the borders of the foreign view of India which is why I want you to delineate the global scenario for us and whether that will remain as clement to India and to Indian equities as it has been over the last 13 months. Would you say that this commodity super cycle which is perhaps at its lowest ebb compared to the last 10 years, will continue that way for another 12-18 months?

Desai: It actually doesn’t need to. See if you go back to 2003, net commodity imports for India ex gold were 1.5 percent of gross domestic product (GDP). That number by 2012 was over 7 percent. So for the Bull Run in commodities which was led largely by China, we paid 550 bps of GDP that is the cost on our current account, that is what it cost us to inflation and it cost us about 125 bps to growth even while we average 7 percent GDP growth. So without the commodity Bull Run we would have averaged over 8 percent.

Now that number has already come down to 4.5 percent, at current commodity prices it would be at 3.5 percent in the next 12 months. So even if commodity prices don’t go down, I have to give back 350 bps that is going to drive up growth by 75 bps, it is going to bring down inflation by 350 bps and we are not seeing that full picture right now, it will bring down our current account deficit (CAD) by the same number.

So this is that disruptive positive change for India. Forget about what the government is doing, forget about the growth cycle. This is such a big change on its own and I don’t think it is fully priced.

Q: But do you at least expect it to plateau here for the next 12 months?

Desai: Even if it went up a bit, okay I will get 300 bps, it is still a big change. Now the likelihood is that it may not. There was a question here about global growth. So I am actually happy to see global growth where it is. I don’t want the world to come back, commodity prices will go down, it is good for India. So I don’t think you have to worry about global growth.

We have to worry about China coming back but it is difficult. China has built up so much of leverage, it has to unwind its debt. It is unlikely that we are going to see that type of demand on commodities that we saw. Infact India will be one of the biggest consumers of commodities in the next 10 years but it is unlikely that commodities go up like the way they went up in the last 10 years.

Q: Would you agree that we are going to have another very benign year of positive commodities that is bearish for us?

Laijawala: We do believe that, I completely agree with that and I agree with Ridham that that itself sees India’s virtuous cycle. India’s vicious cycle had started with the commodity up cycle and particularly in the last two-three years it was really the high commodity prices which ultimately translated into all our problems leading to the fiscal deficit and higher inflation. So completely concur that the sedate commodity cycle is going to be very positive for India.

Q: What is your view on so many views expressed on the credit policy? Rakesh believing that Raghuram Rajan in future may believe that he could have cut rates in December itself, was it wise to have waited and more important than that, is it really going to change the foreign view, the big investor view on India itself or will that view be strengthen that the rates are being held where they should be?

Mishra: I think this rate cut whenever it happens is not any other rate cut. It will be an inflexion point which is something that the governor mentioned in the policy document as well. You cannot take that lightly so you cannot cut rates and three months later say ‘sorry I was wrong, I am going to maintain rates or raise rates again.’ So it is much better to be prudent.

What had happened from July to November, very few of us do our vegetable shopping ourselves but if you do that like I do, there was a very sharp spike in vegetable prices. Tomatoes went from Rs 15/kg to Rs 80/kg from July to November. In India there is very high concentration of vegetable production. So if you have weather disruptions in one area there is big disruption, so all of those reasons led to a big spike from July to November. From about first week of December we saw a very sharp decline in vegetable prices as supply came into the market.

This year if we don’t see that, we will see CPI going back to 7 percent and so it is important that the governor and the RBI wait two months and see if they are going to see a repeat of that before they embark on a rate cut cycle. So he signaled very clearly that he is very comfortable with the price of oil coming down but I think it is much better to be prudent.

Q: In your animal farm series you have looked at milk, meat, eggs and vegetable prices very closely. Do you think the back of inflation has been broken? I mean this time despite the bad monsoon we did not see 12-13 percent cereal inflation. Last year with a record monsoon and a record kharif we saw 12-13 percent.

Mishra: Some of our anchors that we are using for the economy are wrong and I don’t think commodity prices and global commodity prices are – I think it will be good for us as we are growing in the next 10 years to have low commodity prices but I don’t think they matter that much. What matters is that half the households in India who cook on firewood should work with gas or with electricity. The 40 percent of households don’t have drinking water should get drinking water and so, they save three-four hours a day, it is a massive jump in productivity.

We are like a sub Saharan African economy with a developed world political system and those are the things to be excited about. The state government suddenly will change but we need to be very cautious on how we interpret commodity prices. There are three implications in commodity prices, the balance of payment.

We only look at the current account, we don’t look at capital flows, where was capital coming from. The capital was coming from oil exporters. If Norway doesn’t have surpluses, if Kuwait doesn’t have surpluses, if Abu Dhabi and Saudi Arabia doesn’t have surpluses where is the capital going to come from.

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Q: China, it has got a huge sovereign wealth fund.

Mishra: China when they want to invest they will invest with a lot of control, if you don't give them the control, they come and say give us this role and you say no you come and bid for it, they won’t take that role. So, their ways of operation are very different. So, on the balance of payment side I don't think the weak commodity prices are going to be that great. On the CPI side just two percent of our CPI is petrol and diesel and even that is not coming down with the government prudently hiking excise duties on that.

The second order transmission is being prevented by or slowed down by the fact that after four years you are seeing a recovery in the transport cycle. So, for three years the freight operators were absorbing diesel price hike. For the last 10 months they have been seeing a hike in freight rates, they are not going to pass on everything. So, yes, there will be a tapering because prices are not going up anymore. Over a period of time you will see a slight slowdown but I don't think it is going to be as big as we made it out to be.

Q: The 4 percent inflation which appears to be given for Ridham and Rakesh is not a given for you?

Mishra: It is too early for me to take a call on that. I would wait and see how vegetable prices move because milk prices are still high. Milk powder prices globally have come down. So some companies will tell you that it is great, milk prices are coming down, but milk prices and CPI, milk prices year-on-year (YoY) the stuff that you buy, I don't think they are coming down.

So we need to wait for another 2-3 months and see if the back of the food inflation has been broken. Most of it came from animal products and fruits and vegetables and then we can take a call whether 6 percent is right for the next year.

Q: Does the rate cut really matter for foreign investors investing in India? Is it such a big signal?

Kumar: As Neelkanth Mishra mentioned that because this is going to be a turning point so to speak in terms of the trend and the policy stance, to that extent it is important. However, if you are looking at the market, equity as a long-term asset class, whether it happens in December, whether it happens in February or whether it happens in April, I think the direction is clear and to that extent may be governor Rajan has succeeded in one thing, he has got everybody talking lot more about inflation than they ever did. So that is one objective successfully done.

But from an equity point of view what I look at is from interest rate point of view, the important thing in India is when do you get the whole investment cycle going and will the interest rate cut of 25-50 bps today or in February or April, is that going to have a meaningful implication for when the investment cycle is turning? Probably not in the longer term horizon because ultimately you make best amount of returns from equity when for least amount of investment you get maximum amount of profit which in economic terms you call incremental capital output ration (ICOR). So that is what I am focused on.

You have whole lot of capital which is already invested in India earning zero or negative returns today. When that begins to produce returns through removing some of the problems which might be there in terms of bottlenecks or regulatory problems, the kind of fillip that it can give to growth and productivity. Similarly on the other aspects of inflation which we talk about I think India is all about efficiency gains. Even inflation the way I look at it it is a story about efficiency gains.

If we have efficiency gains, inflation problem is taken care of. If we don’t have efficiency gains then we are victim of commodity cycles. So by efficiency gains I mean investments whatever happens in terms of supply chain or like this time you saw from the government, very proactive actions to take care of certain vegetable prices etc. So those things are what I call efficiency gains. To my mind in the longer term they will play a far greater role in controlling inflation or managing inflationary expectations than some of the near term volatility.

Q: I want to ask about the inflexion in growth. When is that turn in the quarter coming, that 2003 fourth quarter that we saw when you saw a sudden change and thereafter it became a virtuous cycle. When is that quarter?

Desai: In 2003 the recovery was V shaped, right now it is U shaped and it has already happened, the bottom is behind us, it was December 2013. Broad market earnings growth was minus 5 percent, today it is in the teens so we are already actually on our way.

I think in the next four-six quarters we will probably hit 20 percent earnings growth. So my estimates for FY17 on the Sensex are 20 percent ahead of the street and I think there is upward risk to my earnings estimates because we have not fully factored in the decline in commodity prices.

I think the street models this on an excel spreadsheet but in reality earnings don’t work of excel spread sheets. So I think we will get the earning cycle that we are looking for. I think it is underway. In the next three-four quarters it will start getting visible and in the next five-six quarters we should hit the 20 percent mark.

Q: Why don’t you tell me what is your Sensex earnings FY16, FY17 targets?

Desai: The street is at Rs 1600 EPS today for FY15, take it forward my number for FY17 is Rs 2500 EPS approximately.

Q: Do you think that is the underestimation?

Desai: I think there is upside risk. I mean it doesn’t assume any major policy reform from the government, it doesn’t assume a major rate cycle, it doesn’t assume oil even at USD 65/barrel, it assumes oil at USD 90/barrel.

Q: Better than the base case?

Desai: Yes and so, I think there is risk to the upside here both on equities as well as on earnings which probably plays out and of course there are risks, it is not without risk. You have to worry about the world in the near term. I don’t think the world is a settled thing. I would worry about geopolitical risk, I would worry about interest rates in the US 12 months from now. I would be very worried about China, I think China could be disruptive. The biggest risk is its export deflation to the rest of the world.

Q: Are you worried about the Chinese slowdown rather than a Chinese pickup?

Desai: Well I am actually worried about Chinese currency moving in order to promote Chinese exports and therefore export deflation. So those are risk factors that could play out in the next 12-18 months. But big picture I think India is on its recovery path for growth and it looks like we should do quite well in the next four-six quarters.

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Q: How does Rs 1600 FY15, Rs 2500 FY17 square with your calculations?

Laijawala: Very similar, we are expecting a similar 16 percent earnings growth this year and 16 percent earnings growth next year so very similar. Infact our expectation is that growth really starts to pickup probably from the second half of the next fiscal year and perhaps this is going to be driven more from the reorientation of government capex towards investment from consumption.

Our view also is that the private sector is probably not going to be as quick to return to invest as everyone seems to be thinking and therefore the onus of investments will have to be taken by the government and we expect to see that reorientation in this budget where the government is consciously shifting from the previous governments bias towards consumption, towards allocating higher towards investments. Here I guess we have to see faster progress on the corridors, we have to see faster progress on many of the infrastructure projects.

Q: Would you agree with such valuations and if this is the kind of earnings growth and if yours squares with these would India be expensive at all at current levels?

Kumar: The way I look at earnings forecast is that in any case market leads the earnings forecast by six-nine months. So in the event whatever the EPS which comes six-nine months before market would try to discount that ahead of time.

The other thing which I look at our own history, when you have an inflexion point in the economy, there is operating leverage at work and historically we have seen that the actual earnings have substantially positively surprised whatever the estimate which might be there.

I am expecting operating leverage to start working through as my expectation is that the growth recovery on the top-line basis will be better than what the current average forecasts are and as a result the operating leverage benefit will be stronger than the forecast. I mean which bull market have we had in India where we haven’t had couple of years of 25-30 percent of earnings growth if you think about any bull market.

So those sort of numbers are not in forecast because there is a big chunk of the market where the assumptions may be rightly so today are extremely pessimistic whether you take banks or infrastructure or those kind of sectors. So I am currently at this point in time my stand is that let us not have too much of – if we have linear thinking at this point which is should it be 10 percent, should it be 15 percent, we will all be wrong. I think we are at an inflexion point, when the turn comes there will be a year or two when growth will be in excess of 25 percent. That is my view which is obviously not in any forecasts or models.

Q: It is still in buy mode, you wouldn’t think India is expensive if you are expecting that kind of an inflexion in earnings growth?

Kumar: No I mean in valuation basis if you look at even current forecasts which are there I think you are probably one standard deviation above the mean and in my view the current one-two year forward forecasts which are there, if everything goes right what is happening, all the other things which are being talked about in terms of 4 percent inflation or whatever else, I think earnings will surprise on the upside.

Q: But your analysis is not predicated on the 4 percent inflation?

Kumar: No, it is not.

Q: So, that would be icing on the cake.

Desai: The market is trading at 11 times FY17. For an economy that will grow 12 percent topline for the next 10-12 years without trouble forget 18 percent which Rakeshji was talking about 15 percent take earning growth, what is the problem at 11 times for 15 percent earnings growth two years forward.

I don’t think valuation is a problem and we are not even taking interest rate cuts into account. Bond yield was 8.1 percent and now it is 7.95 percent. In Morgan Stanley’s top 15 global trades for 2015 there are two Indian trades there and it is not equities, local bond and the currency.

Q: What is the call on the currency then?

Desai: Against the euro not dollar, we are expecting it to go from 77 to 69 against INR-euro cross and the bond yield when we published the report it was 8.1 and we said 7.5. Two top trades in 15 I have not seen that happen in my life. We had a bull market even before but we have never seen two non-equity trades in the top 15 Morgan Stanley’s.

Q: When is this 69 to the euro?

Desai: This is for the next years.

Kumar: Let say we quibble a lot about what should be the EPS or earnings growth. Whether it should be 10-15-20 but the biggest delta for the markets comes from risk premium.Adjustment of risk premium which reflects in your bond yields which is derived by growth expectations and inflation expectations etc. So, we have a lot more ways to travel in terms of contraction in risk premium being attached for India and as the growth recovery comes back, as the rate cuts cycle begin you will see the risk premiums further contract and that will cause more upside to the valuation.

Q: Are you comfortable with these valuations but more importantly how long will India be the cleanest shirt in the global laundry? We have had this 35 percent rise in Sensex and Nifty and this USD 30 billion come? Also because others have done a damn bad job of their own economies or their polities, do we continue to be the best shirt in 2015 as well?

Mishra: It is a game that we will have to strive hard to lose. When we compare ourselves to other emerging markets we are fooling ourselves; Mexico was at India’s current level of prosperity in 1976, Brazil was at India’s current level of prosperity on 1983, Turkey in 1983 and South Africa in 1992. We are not comparing ourselves to the right benchmark; we should compare ourselves to Nigeria, we should compare ourselves to Borneo.

From a growth perspective we will continue to grow. I am not as constructive on earnings. I think market is not a true representation of our economy. Around 56 percent of Nifty revenues are in dollars which means that they are linked to what is happening in US economy or elsewhere. Out of the remaining 44 percent which remains in rupees, a lot comes from banks who have lent money to these companies.

If you see a steel company blowing up you will see that effect in bank earnings. So, I am not as constructive on a 20 percent earnings growth anytime in the next two to three years. However, I do think that the PE multiples will support us.

Right now almost two thirds of the world economy has zero percent interest rate and more than 45 percent is actively printing money. In the last five months, China has printed USD 250 billion which at the peak of the US Fed quantitative easing (QE) was three months of QE. China is half the 60 percent of the nominal US economy. Japan is doing QE, the Europeans are going to do QE.

Economies that were considered to be bankrupt three years back have 10-year bond yields at 300 year lows or 200 year lows. So, the world is desperate for growth, India provides that growth.

I am far more constructive on the PE multiples holding up or even marginally going up from here in order to deliver maybe a 20-25 percent return or maybe a 30 percent return over the next two years all of that coming from 10-12 percent earnings growth which is what we have been delivering and marginal expansion in the PE multiple.

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Q: Since you have spoken about 56 percent of Nifty being dollar denominated or blessed with dollar earnings, what would you invest in? Would you therefore, stick with the likes of TCS, Infosys and the banks which do not lend to the steel companies?

Mishra: Very hard to find banks that do not lent to steel companies but I would stay constructive and I fully agree with what Rakesh said that it is important to look at companies, not sectors because you can be in the right sector but you can choose the wrong company. There were five competitors to Infosys in the late 1990; depending on what you chose you made your money or you lost your money. You could have chosen the sector right but you can get the stock call wrong.

I think there are still companies that will deliver 20 percent earnings growth over the next three years CAGR still trading at valuations which maybe high compared to their past trends but given what is happening globally, the market will be willing to pay for that. I won’t be squeamish about valuations right now given what is happening in the world.

If the world is worried about deflation they are going to just throw money at it and then all that money is going to go and stick at anything that delivers earnings growth. Anything that delivers more than 15 percent earnings growth, I would be a buyer.

Q: Do you think that the dollar earnings sectors are the better sectors?

Mishra: Not necessarily, we are overweight on pharma and I have been a pharma analyst and four years back I used to say it is a 10-year story; there is still five years left, maybe more. I still like it, there are times when a pharma stock can give you three years of return in one year and for two years it will tread water. So, there are some stocks like that as well. There are some stocks which are exposed to emerging markets like Russia, Brazil or Venezuela.

Q: Which ones should be avoided?

Mishra: Where you will see earnings cut. So, news flow momentum won't be as positive but I think that sector is a good area to look at. IT there are some stocks that we still like. Consumption I am still constructive on; I think it will still surprise. I am again not very positive on the investment cycle reviving anytime soon.

Q: You are not touching any of the public sector banks, not any of the infrastructure companies, not any of the metal companies?

Mishra: Selectively on the cap good side, the small sector capex, that cycle is starting to turn. I think that there are some opportunities there but otherwise in terms of the power sector capex reviving, the metal sector capex reviving; not confident.

Q: Since you spoke about Rs 2500 as your FY17 earnings, what is your Sensex target for FY17 and walk backwards?

Desai: Our public forecast for December 2015 is 32500.

Q: That is modest, isn’t it going by the kind of earnings growth you have in mind?

Desai: That is to be seen in the context of what we expect global equity returns to be. So, it is not in vacuum and is going to be quite much more than what we think the SPX is going up or what the euro index or probably in line with what the topics will do but it has to be seen in that context.

Q: But would you bet that another 15 percent growth in FY16 also cannot be doubted?

Desai: That can happen, our bull case is a much bigger return and I am attaching a 40 percent probability to the bull case. So then we are talking 40000 Sensex, on a 10 year view we have a far more optimistic view. That was the report we published in early May so it is outdated now. Oil was USD 100 then, today it is USD 65/barrel.

Q: What would you ride on, would you touch some of the infrastructure stocks which are stuck, would you touch public sector banks which are saddled with these kinds of loans?

Desai: Thematically I think you want to buy three sectors in India, you want to buy financial services, consumption and a bit of new stuff that is going to happen which will come out of reforms like GST. So GST will have a meaningful impact on say logistics or digital may have a big impact on logistics. So the frontend is not available to buy.

Q: What is the new theme from now till the next five-six years? Would you say it could be logistics because GST could make it a multi bagger?

Desai: I don't have a clue. I think you want to buy good quality banks, good quality consumption companies; those are reliable places where you can put long-term money to work. Those should work out quite well but this is a bottom-up company specific theme. When you ask sectors that is okay for institutional investors. For retail investors it is about selecting the right stocks.

Q: Are they depending on you to tell them?

Desai: Otherwise just do SIP, best, don’t worry about it. Every month put 25-30 percent of your savings into equities.

Q: You expect the Sensex in one year to be 32,000. What do you expect the midcap index to be?

Desai: I don’t have a forecast for midcaps. But I think the midcaps will do much better.

Laijawala: We are most positive on financials and consumer discretionary. We believe that we are going to see a transformational shift for financials particularly the big transition that will happen from physical to financial savings and the conduit of that will be through the banks.

Q: Financials is only private sector like most of you think?

Laijawala: No, we believe that the time has come to take risks on public sector banks and this is something that we have been highlighting. We think that the risk reward is far more compelling today for the public sector banks. So yes, we like the private sector banks but in terms of the risk reward, it is beginning to look extremely compelling. So far this has been one sector that has been shunned but we think that is exactly the reason why investors must look at it. So we are going to be very selective in public sector banks, I am not saying buy the whole space but selective public sector banks that is the best trade for 2014.

Q: The other two sectors?

Laijawala: Consumer discretionary and I agree with Ridham Desai that the next drivers will emanate from the reforms particularly the beneficiaries of the goods and services tax (GST). So I think logistics is going to be one sector that is going to look very attractive. Unfortunately, valuations are beginning to run over there.

Q: Names?

Laijawala: No names. I am held back by my compliance.

Q: What kind of targets have you given for end of year, Sensex and Nifty for 2015?

Kumar: The convenient answer is there is no one year target that I have, which is given out but if I look at equities per se whether it is for retail investor or institutional, you have to have at least two-three year view and if I am looking at next two-three years, I am expecting to have 20 percent type of a CAGR from the market or portfolio stock whichever way you look at it.

Q: 20 percent CAGR?

Kumar: Yes, it will be at least about 15 percent of earnings growth average and balance is a further rerating, which I expect, which is a fairly healthy sort of a return. It may not be even 20 percent type of return but I think next two-three years, all the factors are aligned to see that kind of a return for a broader market within which obviously there would be greater upsides from some segments.

Q: Would you also believe that the midcap bet would bring more mullah?

Kumar: It always has both on the way up and the way down. So they have a higher beta which is natural. So obviously if my expectation is that if broader market gives you 20 percent, midcap index will give better.