Financial services revival to be next big leg-up for India: UBS

The current market rally is global in nature and could extend some more but it is now going beyond fundamentals, says Gautam Chhaochharia of UBS Securities.UBS has a target of 8,600 for Nifty this year, which it has crossed already.“Fundamentally, the risk reward is definitely not attractive,” Chhaochharia told CNBC-TV18 in an interview, adding that the next big leg-up for the market would be comeback in financial services sector.Earnings estimates, which have broadly come-in line this time, could see some cut in FY17 as per UBS. Earning cycle upgrade could come in from a three years perspective, but this will happen only if the gross domestic product accelerates from its 7-7.5 percent level.UBS is positive on non-banking finance companies (NBFCs) and oil & gas companies, but not oil marketing companies.Below is the transcript of Gautam Chhaochharia’s interview to Sonia Shenoy, Latha Venkatesh and Anuj Singhal on CNBC-TV18.Anuj: What have you made of the recent market moves? Are you comfortable at current valuations? Do you think liquidity can still drive market higher from hereon?A: India is obviously benefitting just in line with what is happening globally -- nothing unique to India per se. Despite what we focus on locally here about goods and services tax (GST) reforms, etc, it is largely a global led rally and India is still not the best performing emerging market this year.Having said that, on an absolute fundamental basis the risk reward is definitely not attractive here. In our fundamental framework, even an upside case scenario for Nifty based on fundamentals and multiples is around 8,600. So, markets are above that. So, the risk reward is definitely not attractive here but we are living in a different environment altogether in terms of lower interest rates globally. And if the global rally continues, obviously India can still do well from here but fundamentally the risk reward is definitely not attractive.Sonia: When we chatted with you last at your office, you were telling us that hopes are very high from this earnings season. Now that we are almost through, what have you made of the earnings season?A: Earnings season, the expectations have been broadly met. There have been beats and misses as always. However having said that, what is interesting is the first quarter numbers looks like a low single digit earnings growth for Nifty while the same earnings estimate for the full year, for FY17, is 17 percent. So, we will see earnings cuts through the next few months. These expectations are definitely unrealistic.Anuj: The stock of the day right now is Idea Cellular. What have you made of the numbers? In your preferred picks you have Bharti Airtel, but if you have looked at Idea’s numbers and your thoughts on the space.A: Cannot talk on individual companies, but telecom -- the big hope for us is the data boom which should play out. So, there have been some speed breaks on the data boom for the listed incumbents recently. On the other hand, voice is surprising positively. So no change to our thesis.Sonia: The other big pocket that has moved lately is some of these fast-moving consumer goods names (FMCG) names like Britannia, Colgate, the companies that have credible managements and very high market share. Britannia is one of the preferred picks in your strategy note as well. I know you do not want to talk about individual stocks, but despite stretched valuations, do you see market continue to give a premium to some of these companies that have a great lineage and good earnings quality?A: That has been happening for a while. It is nothing new in this quarter, that has been happening for the last couple of years. That reflects the challenge which markets and investors face that while we are living in a broad macro driven low growth environment, companies which deliver growth and they have comfort on growth, they are willing to pay higher multiples. So, that is theme which we have been seeing for the last couple of years. And it can continue. So, again you have to be much more stock specific rather than making a broad brush argument because to extrapolate current earnings to the future is not going to be obvious for all the companies. So, that is where we come in, in terms of our stock preferences.Anuj: You have PVR as one of your top picks again. How do you justify valuations in some of these niche spaces, entertainment for example?A: When you look at higher valuation companies from any sector, the key elements for us is to remain comfortable at higher valuation would be two -- one would be the visibility on earnings growth versus both, history in absolute terms as well as versus what the street is expecting. So, if we see earnings to surprise positively possibly, then we would be comfortable with valuations. And second also, benchmark valuations regionally or their own historical benchmark valuations, that is also one of the other areas where we derive comfort for higher multiple based stocks.Sonia: As far as the market is concerned, in your note you say that your upside scenario on the Nifty is 8,600. We have already crossed that. We are at 8,700 now. By the end of this year, what kind of Nifty movement do you foresee and if you do see further upside, if that is your bull case, then where do you see the leaders of this market emerge from?A: Upside is 8,600 which factors in a stronger recovery than what we were looking at as our base case. So, for us to fundamentally justify anything more from current levels looks difficult.Obviously, markets can start looking much more forward than just the next one year perspective which does happen in the case of India. Specifically when the market rally up, you start looking two years out, three years out in terms of earnings, than just the next year. So, it is happening right now, that can help the markets.Having said that, the big next leg up for the markets, if you look at macro top-down and it has to be backed by a strong economic recovery then the only way it can happen is if we see financial services come back in a big way. When you talk about financial services we talk about state-owned-enterprise (SOE) banks, corporate lenders, etc because unless we see a big pick up in credit growth and that sector firing, it is difficult to see markets rallying dramatically from here.Anuj: Is there a case that right now we could be going through the 2004 kind of scenario rather than 2008 kind of scenario, which is that after a long hiatus, earnings start to grow and the market is pricing that in already, instead of the liquidity alone driving markets to crazy valuations and then seeing a correction. Do you thing we could go through a two or three period of big earnings upgrade, something which we do not know right now but market could be pricing it.A: Yes and no. Every macro environment or situation is very different. We cannot compare that simply with 2004. But yes, if you are asking a three-year view, then we will definitely have a period, maybe a year out maybe two years out where we see earnings upgrade cycle coming back and coming back in a big way where we could see earnings growth being much higher than the 15-20 percent, which analysts forecast.But for that, you need the economic growth to accelerate. So, what we have seen historically is that the trajectory of economic growth matters for earnings. So, when we see economic growth, the real gross domestic product (GDP) growth accelerating rather than hovering around 7.5 percent level, that is when you will see that kind of a year. In our base case view, we do not see that happening for the next one year at least, unless we see a dramatic change in policy stance by RBI and the government towards a more inflationary stance.Sonia: What is your view on non-banking finance companies (NBFCs) now? You do have exposure to names like LIC Housing. We were just speaking to an NBFC analyst a while back and he said that valuations make him a bit jittery now. Would you be in that same camp or do you think that there could be a big valuation rerating for the sector?A: There are pockets in NBFC where valuations are looking stretched even in a most optimistic scenario, but a large pocket of NBFCs still looks reasonable to us and that is why we stay overweight, both from the fact that the rates environment is supportive and we are still seeing the growth sustain.Anuj: The other space which has made a lot of money is the oil marketing companies (OMCs) sector. Huge gains in stocks like Hindustan Petroleum Corporation Ltd (HPCL), Bharat Petroleum Corporation Ltd (BPCL), Indian Oil Corporation (IOC), after years of underperformance, do you still see more value in some of these names?A: Overall from a portfolio strategy perspective, we remain overweight oil and gas sector, but our oil and gas analyst is not comfortable with OMCs at these valuations and after the rally. So we stay underweight in that part of the oil and gas space.