India story looks extremely compelling amongst EMs: UBS

Below is the verbatim transcript of the interview:

Q: What you make of where we are in the markets right now in terms of the run up that we have seen through the course of this year? Has it been too hard, too fast how do you assess it?

A: We should step back a bit before we just comment on where the markets could go from here. If we look at the run up so far it should also be put into context of what the market did before the run up began which effectively means that we did almost nothing for about four or five years and actually came off on the Nifty and cam off much harder on some of the cyclicals.

Now with that context in mind what we have seen since December or since the elections is basically a mean reversal of that trend both on the Nifty and particularly much harder in terms of the some of the cyclicals which were really beaten down. So, we are well poised for the market to continue higher even from here. Our target is about 9,600 on the Nifty for December 15th which is about 15 percent upside from here and it is entirely possible to get there in that timeframe and then we see further compounding from there.

Q: What is the bases for the 9,600 what does it include, does it include further big ticket reform or are you saying that with the present cyclical upturn and the cleaning up that the government is doing or just the fact that you have business friendly government that will take you to 9,600 and anything done above that will take you to more than that? So what is the base that you are building the 9,600 on?

A: We are positive on the government and we are as hopeful as some of the other participants are on the reform potential that exist in India. However what we build into this 9,600 is the fact that the gross domestic product (GDP) growth could actually have bottomed out. So, we have put that up tad higher at about 5.50 percent and 5.80 percent for this year which moves up to about closer to 6 percent for next year. Along with data we have a big call which talks about how the interest rates in the system could come down by about 200 basis points in the next 18 odd months. So, we are talking about 6.50 percent 10 years yields and that is also premised on the fact that we think inflation would come off.

Now interest rates coming off, GDP growth getting to a slightly higher trajectory from here would effectively mean higher revenue growth and then margin expansion leading to much higher profit growth. Our profit forecast is about 15 percent for this year and 18 percent growth for next year. We think the valuations are quite middling at about 15 times currently. So, even if we don’t see the valuation uptick or a rerating further from here the earnings growth and compounding itself would take us to 9,600. So, any positive action from the government could lead to a further re-rating but we are not really baking that in to our numbers for now.

Q: That positive action at least at UBS has three touch points to it. I think you have identified it as the three arrows that is the use of Aadhaar, unique identification numbers; I am guessing this is for direct cash benefits, goods and services tax (GST) and dedicated freight and industrial corridors. On all three fronts, we are likely to see some very fruitful action only 12 months down the line. Is that in keeping with your forecasts for where this market is going to go?

A: These three arrows were identified as the three big things that we should expect from the government which could significantly transform the Indian economy over the next few years. So, that is not something that we were looking at with a six month or a 12 month theme because each of these projects is almost a milestone in the history of the Indian economy. The transformation potential of each of them is extremely significant.

We are not trying to get that into the picture here to sort of project an EPS growth or something but that is more a structural theme that we went into and came out with these three themes about what we could expect with a three to five year timeframe in terms of transformation for the Indian economy and the massive benefits which could flow through.

Q: In an effort to get to some of the more sector specific conversation let me start by asking you what your clients like at this point in time in terms of Indian equities. I know the financial space has been a heavily bought into one over the last couple of months or so. Are they continuing to buy into financials or does it seem that the price action has outrun itself so to speak. What are your clients telling you about what looks best in India at this point?

A: Financials still continue to be the flavour of the market and particularly private financials. If you talk to a lot of the FII clients they are more interested in the private side of the financials and even within that maybe the wholesale funded which is also our call. So, the way they look at it is the simplest way to play the economic growth and a leveraged way to play the economic growth would be to play it through financials and that is where the interest comes in.

Not to forget there is also a major component of the benchmark or MSCI that they are benchmarked too. Therefore, by default they would like to have an exposure which is commensurate to that benchmark.

Within the PSU space, the interest is building in but I would still believe that a lot more interest is into private financials.

Q: What about sectors like for instance consumer discretionary, your approach to that specific sector has changed over the last few months?

A: On the consumption side, we are more lukewarm as compared to some of the other participants in the market. This is based on the ground survey that we had done wherein we did this thing just before the festive season and figured out that there isn’t enough pent up demand in the system to sort of drive consumption.

On top of that one of the things that we have pointed out is that the income in the hands of rural population is growing at a much slower rate and even probably declining. So, to that extent the benefit from rural consumption side is going to be much muted as compared to what we saw in the last few years.

On the urban consumption side, we think it would ticking up but I don’t think it will be able to make up for the lack from the rural side. So, overall given the fact that consumption stocks are not necessarily cheap and the backdrop that we do not expect very strong consumption trends because of the things that we just discussed we are more lukewarm on consumption side.

Q: You are also lukewarm on pharmaceuticals, aren’t you because you have gone from an underweight to a neutral but you are still only a neutral on pharma?

A: That is more of a valuation call. The companies were existent, the pharma space are quality names so we do not have a problem with the management or the quality of the companies. However, at this point in time, the bigger band for the buck could be on the cyclical side versus the pharma side.

If you look at the valuation differentials, if you look at the trailing performance of these sectors and that is why I guess at a relative level we are pointing out that maybe we can make better money and better returns in some of the other sectors and therefore neutral on pharma.

Q: There is a huge valuation gap between consumers, pharma and the cyclicals that you talk about but in the last one year, the gap has narrowed quite substantially. If you look at some quality consumption companies like say Asian Paints, just 39 percent over the year when you compare it with 200 percent that cyclicals have gone up when do you see this valuation gap narrowing and when will you start getting interested in these companies?

A: We need to look at where we are in the cycle currently. I agree with you that cyclicals have moved up but that is also because they were beaten down so mercilessly in the previous two years. The way things would move for cyclicals is that once the cyclical recovery starts to play out and it is barely starting to show signs of that. So, I am positive over the next two years as the GDP moves and therefore the cyclical recovery plays out.

We would see that there could be exponential growth in earnings in some of these companies. So, till that time the stock prices may seem like they have moved ahead of time but that is the way it always plays out. So, the earnings will play catch up and there would be a massive earnings surprise and that is how the valuations in cyclicals will start falling inline.

So, although the valuation gap is narrowed we showed wait and be bullish on cyclicals till the time we start seeing earnings starting to play out and the analysts starting to do a catch up with the earnings. I think it is early days to switch that stance for now.

Q: In the context of what central banks are doing worldwide - especially the ECB and the Bank of Japan, the India story continues to be compelling one. Do you expect FII flows to gain momentum from here onwards or do you think that some point in the middle of next year or in the early part of next year we will run into some rough weather on account of let us potential raises in interest rates in the US, what are your clients telling you?

A: I think the way it looks is there are two points to note here. One is within the emerging market space the Indian story just looks extremely compelling. So, you compare it to any of the markets which use same kind of funds our investors would be looking at, I think India just comes on top. So, to that extent FIIs continue to be extremely bullish and just looks like the one default market that everybody just has to be in.

The only caveat over here is what you mentioned in terms of the US raising rates. Even we believe that sometime around June of next year we will start seeing the US raising rates. It remains to be seen how the global markets react to that. We do not particularly think that it would cause either the US, Europe or the emerging markets to start panicking on the back of that because it is a well flagged off event and therefore unless there is a massive slowdown in Europe or US which starts causing a global panic we should be fine. Even if there is a global slowdown, which plays out given the fact that Indian fundamentals just look so much more robust as some of the other countries, India may still continue to outperform.

Q: Where do you seeing the FII money come in any new sources?

A: It is pretty much the same sources in terms of geography but I guess there are new funds which are coming in terms of funds which were lukewarm or not looking at India aggressively over the last two years. So, lot of hedge funds who had gone quite on India has started looking at India. Quite a few of macro funds who thought India was any liquid market have started looking at India. ETF-s exposure I think you already know ETF money continues to flow in. Some of the global funds have raised their exposure to India so I guess there are new funds rather than new geographies.

Q: But the money keeps coming in at the same pace or a harder pace and I asked you this in a context of may be a potential correction that several people have been calling in the Indian Markets which we haven’t seen quite the signs of this yet. Do you feel in the recent past few weeks if you seen a degree of slowing interest in anticipation of such a correction. Can you talk us through the mood on that?

A: On a particular day, you could see the flows increasing or decreasing but overall the trend and the interest of FIIs in India just continues to be extremely strong. If we step back and have a slightly longer-term time frame we will be able to get this market more right than having a more short-term timeframe. So, if we are playing this people recovery or the next two years I think you should stay Put in the market and that is what lot of the global fund emerging market fund, Asia funds are looking at India.

So on a particular day we could see up and down in terms of flows but their commitment to India seems to be more long-term say it is about 18 months or 24 months. The intention seems to be to play through the economic cycle.

Q: The Participatory Notes (P-note) data that we saw come in yesterday is interesting because it seems that in amount terms we have now clocked in a P-note investments of close to what were seeing in 2007 though in percentage terms because the size of the market is grown it does come in far lower. Yet all of this is volatile money, hot money and money that is just waiting to flea if things turn or eye globally. How much of a concern is that to you at all?

A: That is a misconception that all p-note money is a hot money because there are many hedge funds that look at India at a very fundamental level not necessarily trading the markets in and out. As I mentioned, the new money that we have seen flowing in is actually looks to me at least has a commitment to play the economic cycle over the next 18 to 24 months. So, to that extent if there is a global issue then may be we face some outflow but by and large just clubbing p-note money as hot money is a misconception.

Q: How are investors looking at the recession? Do they see further expansionist monetary policy in Japan?

A: People have taken Japan with a stride, people are waiting and seeing what will happen on the elections front over there. Most of the conversation that we are having just comes across again and again saying that India as a market because of various reason is so much better as compared to some of the other emerging markets, other Asian markets. However, the one take away that I would take from this conference is that the mood among the investors for India is extremely bullish, excitement is extremely high and the intention is and the hope is to see this economic recovery play out over the next two years. Therefore the markets hopefully would be much higher if the commitment level of the funds continues to remain as it is.

Q: So we have seen the Modi trade play out, we have seen the interest rate trade playing out right now and at UBS you guys seem to be suggesting a GST trade in which you have picked a basket of stocks which will benefit the most as and when GST comes in. Talk us through some of the stocks that looks most promising as part of the GST trade?

A: I agree GST is one of the things the other thing I would just go back to what you were saying the interest rate trade that is another big call that we have. So, we are talking about much lower interest rate and therefore wholesale funded institution, high leveraged stocks which have quality managements that is one of the themes that we have.

On the GST side the theme that we have is that the company or sector in which there is a massive unorganised sectors that space would start moving to the organised space. So, to that extent some of these electrical or consumer names or packaging names or logistic names all of these would see massive benefit out of the GST coming through as the industry moves from the unorganised side to the organised side.