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Last Updated : Oct 20, 2015 02:22 PM IST | Source: CNBC-TV18

Market has lower risk-reward ratio; upside limited: Kotak

The 8 percent rally in the Indian stock market since its recent September 7 low has removed some of the "dislocations" that previously existed, says Sanjeev Prasad of Kotak Institutional Equities.


The 8 percent rally in the Indian stock market since its recent September 7 low has removed some of the "dislocations" that previously existed, says Sanjeev Prasad of Kotak Institutional Equities.

Accordingly, the risk-reward ratio is now turning lower and market's upside remains capped from hereon, he told CNBC-TV18 in an interview.

In light of the rally, Kotak has carried out certain changes to its model portfolio, within its overarching theme of playing on lower interest rates and higher financial savings.

It has added Indian Oil, increased weightage on Cipla and removed M&M, Dabur and Wipro.

Below is the transcript of Sanjeev Prasad’s interview with Sonia Shenoy and Latha Venkatesh on CNBC-TV18.

Sonia: The market has been in a good position of late. We are sitting at a 2-3 month high. Do you think the uptrend is intact or would you start to get a bit cautious at higher levels?

A: The risk reward balance is no longer that favourable as it was 45 days back when a lot of stocks had corrected quite significantly. When you look at market from a bottom-up basis, we do not see where the momentum will come from going forward.

If you look at the consumer, pharmaceuticals space, the stocks look very expensive over there. Most of the good quality private banks are trading at reasonably high valuations. So, effectively, you are left with some of the beaten down names where if things go right, maybe there is some money to be made. For example, there is Reliance, regulated power utilities, some of the private banks with large corporate exposure, if there is not much of incremental negative news on non-performing loans (NPL) side, maybe these stocks could get rerated from where we are.

But on a broader market basis, the upside is somewhat limited from where we are. If I look at the Nifty-50 index for example, that is already trading at almost 16 times on a March, 2017 basis now, so further scope for rerating on a broad basis would be somewhat limited.

Latha: Why this dampness of mood? Is it earnings related or is it that there is a binary event in the form of the Bihar elections?

A: I do not think the Bihar election matters when it comes on a medium-term basis. It is just that the stocks run up quite a lot and if you look at valuations whether it is consumers, pharmaceuticals, they are just trading at very expensive valuations now. So, how much more money you can make on an immediate basis, on these names.

If you look at the private banks, the same story. Most of these guys are now trading at three times price to book on a March, 2017 basis. So, that is the whole problem. There has been little upside left in most of the frontline names and the scope for rerating is there in some of the names, some of the commodity stocks for example, regulated power utilities, Reliance as I was talking about earlier. But beyond that, I do not see how this market can move up significantly from where we are.

So, it is just a question of valuations and what kind of reward risk balance we are looking at at current levels given the fact that we are not seeing too much of news flow on the reform side, earnings season, we have not seen any great surprises, thankfully there have not been any great disappointments also, but it is not as if we are seeing any great upgrades to earnings numbers for now.

Sonia: After a long time we have seen the fund flows return back into the emerging markets. Would that not enthuse you that at least the liquidity situation will remain benign and India will continue to get flows for a while?

A: If I look at it this way, the reason why we are seeing some flows coming back into the emerging markets is primarily because the expectations of a US Fed rate hike have been pushed back to maybe December or even March I would think. So, you have a global risk-on trade, which is going on and you are seeing some amount of money going back into emerging markets.

Whether anything has changed fundamentally, the answer is really no, as far as most of the emerging markets are concerned. Most of them still have to go through a lot of painful structural reform phase, it will take two-three years to correct some of the structural imbalances which have got built into these economies.

So, it is not as if things have changed dramatically overnight from where we were 45 days back when things were looking ugly. People were, at that point in time, looking at exiting emerging markets completely. Nothing has changed in the last 45 days barring the fact that the US Fed rate increase has got postponed by a few months, that is about it.

So, I do not think we should get overly excited or overly depressed just based on some news flow. Things will improve, but it is not as if things are going to change dramatically overnight.

Latha: We have a lot of questions for you stock-wise because your strategy note says that valuations of quality stocks in consumer and pharmaceuticals continue to remain expensive, which leaves us few ideas to choose from at current levels. Now, let me come to the sell that you have. You removed Dabur from your model portfolio. Is this because it is expensive or is it because of the Patanjali competition?

A: It is expensive to start with and on a medium term basis, we are quite negative on most of the consumer staple names. For a very simple reason, if I look at India going forward, one call which we are making is lower inflation going forward and if that is a structural bet, which I think everybody is making for India now. The topline and bottomline growth of the consumer staple companies will come off compared to what we have seen in the past -- compared to 15-20 percent topline growth and bottomline growth which has been the norm for most of these consumer staple companies.

We are looking at a period where you would probably see more like 10-15 percent growth which is not bad. But in the context of the fact most of these stocks are trading at anywhere north of 30 times on a March 2017 earnings basis, whether that makes any sense, I am not sure. If you look at it historically, the trading band has more in the range of Rs 20-25 with the stocks growing at 15-20 percent compounded annual growth rate (CAGR).

Now that the earnings numbers will probably grow at a much lower level, should you make a case for you at 30-35 price to earnings ratio (P/E) multiple? That is the whole issue over here.

Latha: But is there any other fast moving consumer goods (FMCG) that you will like for instance, Emami or Marico, just anything else competition for Dabur or Godrej?

A: Nothing at current levels. The stocks have to correct quite significantly from where we are for us to get excited.

Sonia: I just heard you mention a while back that amongst the stocks that could be value creators, Reliance is one of them. What did you make of the earnings this time and from this USD 10.6 a barrel gross refining margin (GRM), how much of an upside do you see in the quarters to come?

A: USD 10.6 is sufficient as far as this quarter is concerned. If I look at our numbers, we are building in significant lower numbers going forward. On a more recurring basis, we are looking at USD 9 a barrel for 2017 and 2018.

On top of that you add about USD 1.5-2 per barrel coming from the coke gasification project. So, that is the kind of refining margins we are looking at. Look at the stock this way. It will do about Rs 80-81 of earnings per share (EPS) in current year. It has done already Rs 40 in the first half. If you adjust for the treasury shares, add about 10 percent higher, so effectively, you have about Rs 190 EPS for the stock this year itself. So, give 10 multiples, it is already at Rs 900, not too bad.

On top of that, we have two big projects which are coming up which will contribute earnings significantly in the next two years and we are looking at somewhere about Rs 110 EPS and the normalised quarter when the two projects start contributing fully.

In that case, this stock can easily go to about Rs 1,100 without giving any value for the rest of the businesses which is shale oil or telecom, anyway we are giving zero value for both these businesses, no value for retailing, no value for exploration and production (E&P) etc. So, this is one of the few stocks which I see where you are seeing some amount of decent earnings growth going forward at reasonable valuations. In India most stocks will grow, so that is not the issue, the issue is what price you are willing to pay for that.

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Latha: Let me come to another of your themes which defines your model portfolio; low interest rates, higher financial savings. How do you look at the finance stocks itself? Private sector banks have been everyone's favorite, is there still value left in that space?

A: It depends on what kind of private banks you are looking at. So if you look at HDFC Bank or IndusInd Bank, they are getting more or less valued on a March 2017 basis. HDFC bank would be trading at about 3.3 times, IndusInd would be close to almost three now, so I do not think there is much upside left on a immediate March 2017 basis. But these are compounding stories so I would continue to have a reasonable portion of the portfolio in HDFC bank for sure.

As far as the likes of Axis Bank and ICICI Bank go, now it is a question of what kind of intermittent news you see on the NPL side. Both of them are trading at about roughly slightly below two times in March 2017 basis. If you see some good news on NPL side, some of the issues which are plaguing the infrastructure sector, power companies, metal and mining companies for whatever reasons if the intermittent news starts getting positive, you do not see too much of damage through them. But we just do not know how big the problem is, stocks will probably continue to languish where they are.

Sonia: The other stock in your model portfolio that you have increased weightage on is Cipla. This is one pharmaceutical stock that has just refused to participate in the upmove, even this year the Cipla stock is up just about 7 odd percent. What has been restricting the upside and what do you think could be the triggers from here on?

A: 7 percent is not bad in a market which has not gone anywhere, so I am okay with that. The big issue over here is what kind of news flow you will see on the portfolio, which they have. So there is still a lot of ifs and buts over there, people have different valuations for that segment, some of the regulatory issues will hopefully come through, starting with UK and USA going forward. The size of the opportunity is pretty big.

Unfortunately the earning number for this company has been somewhat disappointing barring the last quarter. It was the first quarter where we saw some positive earning numbers but historically last two-three years people have been very disappointed by big increase in expenses without too much of that resulting in any topline growth. For example there was a big increase in research and development (R&D) expenses of this company in the last three years. So we are looking at a company, which is now available at somewhere about low 20's on a March 2017 basis, without giving any real value for the entire portfolio which they have. So I think that is the story which we are looking at here. The risk reward balance still looks okay, there is still a lot of value that can be created in the portfolio which this company has.

Latha: You have also removed Mahindra and Mahindra (M&M) from your portfolio on the argument that it is already trading close to your 2017 fair valuation. M&M has not been performing very well in the last few weeks though it had a fairly decent performance if you look at the last three months. Can you compare it to any other auto stock that you might like?

A: Some of those names, which we have removed recently, they were all tactical additions to the portfolio when the market corrected big time in late August-early September, so we had added Bajaj and M&M at that time.

M&M has run its course, we are not seeing any real positive news on either of the two segments, the SUV segment or the tractor segment. Second half recovery story looks very unlikely even the new SUV launches, they do not seem to be creating much of an impact, that segment is becoming more and more competitive. So Rs 1,100 to Rs 1,300 is a good enough return  in a matter of 40-45 days and I am happy and booking profits over there.

As far as other stocks in the auto sector are concerned, we are still okay with Maruti. But having said that, the stock is now on an expensive side, it is about 18 times on a March 2017 basis Rs 250 EPS. The long-term story is still intact but it is not a cheap stock anymore.

Tata Motors is another one which we have in the model portfolio, it is trading at about three EV/EBITDA adjusted for the value of the India business, the Jaguar-LandRover (JLR) part is available at three EV/EBITDA, so it is a cheap stock, but obviously there are still a lot of issues with respect to what is happening in China.

If you look at China data, it is not as if the country is in a closing down or anything like that. You can see even the automobile numbers for the month of September -- the market grew at about three percent over there and if you look at the full year this year, it will probably be slight increase compared to last year when it was very strong numbers for the overall market somewhere about 20 million units of volume.

So second half of this fiscal for JLR should be a lot better given they have product launches over there both in this quarter as well as the next quarter, so it will start some volume recovery over here and that should maybe a trigger for the stock going forward.

Sonia: You said that the upside for the market is limited now but what about the downside? Where do you think that is restricted to and what could be the trigger that could take our markets to the lows once again?

A: I do not see any negative immediate trigger until and unless there is complete negative surprise in terms of the US federal rate increase in October, which is highly unlikely or even in December, I do not think the market is prepared for that.

Having said that I will not be too worried about one rate hike, what you will need to keep your eye on is what the subsequent actions by the US Fed are; thankfully India is a lot well prepared compared to two years back, when our current account deficit (CAD) used to be in the range of around almost 5 percent. So hopefully it will not have that bad an impact but the point still remains that emerging markets are not looking that great on a fundamental basis, there are a still a lot of macro economy challenges over there with respect to high twin deficits in some of the countries or very high current account deficits in most of the countries.

So, they are still very exposed to any bad news globally which essentially arises from US Fed rate increase and unfortunately India falls in that emerging market basket. It is quite a large overweight as far as any active fund is concerned probably at about 5 percent overweight in general. So any sell off for whatever reason in the emerging market, India will get impacted. So downside my best assumption would be, take somewhere about 5-10 percent lower from where we are, but having said that I do not see any immediate trigger for a big correction in the market.

Latha: I wanted to ask you about cement. Finance minister just spoke about how they are going to spend and they are continuing to spend. The idea at least in the road sector, a bit of expenditure has been sanctioned and is being made is there. You would not want to play any of the cement stocks?

A: Not at all. They all are terribly expensive. There is a big myth about this whole infrastructure spending and how great it is going to be for the cement sector. Ultimately, if you look at cement consumption that comes under real estate and unless and until the real estate market revives in India, I do not think you have much of a story as far as real estate or rather cement demand is concerned.

Even if you assume decent cement demand over the next 2-3 years, you will still end up with a sector where the overall capacity utilization will be less than 80 percent. Assume a very steep improvement in EBIDTA per tonne for the like of Ultratech going forward, if you look at the current quarter which was just reported Rs 860 per tonne EBITDA, we have assumed Rs 1,500 per tonne for fiscal 2018 and even in that case the company will do Rs 180 EPS. So from Rs 860 per tonne going up to Rs 1,500 per tonne, Rs 180 EPS at the peak of the cycle, I will probably give 10 P/E multiple, that is a very good multiple. We are looking at Rs 1,800 stock, in that case why should I be excited about this sector at all. I think people just make stories whatever is convenient, sometimes it becomes a consumer play, sometimes it becomes an infrastructure play depending on whatever is the theme of the day people make stories.



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First Published on Oct 20, 2015 09:42 am
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