RBI may not pay special dividend to govt from cash haul: UBS

A: There is a big debate out amongst investors and even at our conference we are trying to bring that element into our various thematic discussions because that is what investors are looking for. How it impacts markets -- we tried to analyse the impact short-term and long-term based on our investor discussions how stocks have moved. So, in our view, the short-term disruption to informal economy and therefore sectors exposed to that, we have seen stocks correct there but most of these stocks are not trading at discount to say last three years averages. So, it is still not pricing in material disruption. Our investor discussion suggests that they believe this disruption will be short-lived.

The risk to this is, which is not a base case, is if this disruption to the informal chain or supply chain becomes prolonged, because most participants are expecting this to be one week, two week or at most a month phenomena, so, that is a risk which is still not priced in. Difficult to predict that, whether it prolongs beyond a month or not. On the other hand, the long-term, what we have heard from the investors is that this is a big positive primarily from the angle of fiscal impact from demonetisation in the form of Reserve Bank of India (RBI) dividend which we are not sure of because a lot of this is coming from the hope or analysis of looking at RBI as a company. However, you should not look at RBIs balance sheet like that of a company, RBI is a policy making organisation and what it does with the surplus on its balance sheet depends on the broader policy call it takes.

You have to remember the dividend it pays out is typically from its income in the form of interest, etc. It does not pay out dividend from revaluation of assets. So, how it treats this lower liabilities is as yet unclear but based on whatever has been talked about by various policymakers, it should not be presumed that they will use the surplus if any to payout a special dividend to government.

Sonia: Specifically for the banks and non banking finance companies (NBFCs), what kind of an impact do you see because cash flows are getting stalled, eventually do you think that it will lead to a pickup in defaults and are we starring at higher non performing loans (NPLs) formations for the banks in the near term?

A: If you strip out banks and NBFCs separately, banks, generally speaking the private banks and the state-owned enterprise (SOE) banks, they should benefit from current account-saving account (CASA) going up and hopefully from credit cycle also picking up because if you look at various scenarios as to what happens to the demonetization, it should be supportive of credit cycle, lower inflation and lower rates.

For NBFCs the short-term impact is obviously a dip in disbursements; that is the feedback we are getting from most NBFCs we talk to. However, whether it leads to higher NPL formation, it is still early days. It goes back to the same point whether the disruption is short-lived for a couple of weeks, one month or it prolongs beyond that. So, we will get a good sense of this only when we start seeing the cash levels in the system going back to normal and then gauge the impact whether that cash is also reaching the informal sector through a more formalised channel. It is very early days to predict that.

Anuj: In that case, how to approach this market because it is a bit of a black hole kind of a situation, the uncharted territory; for a lot of us, we haven’t seen something like this play out. Do you build portfolios in this market, do you wait for the market to bottom out, see one or two quarters numbers, how do you approach it?

A: You always look at the risk reward framework; that is what we have always been doing. So, again, in that context if I look at the fair valuation approach for the market as a whole, for Nifty December 2016 fair value for us still remains 8,000. So, we are still not at or below fair value from an attractive risk reward perspective. So, from an absolute risk reward and buying level perspective, I would still advice caution and wait for better entry points ahead.

For longer term investors, India is a perennial hope story and it remains so and rightly so because the fundamentals are intact. In fact this initiative also from a longer term perspective is a positive at least in the form of formalising the economy which the government has been trying to do in the form of GST and Aadhaar also. So, this adds to that approach to formalise the economy. However, the near-term disruption is also going to be quite significant.

Latha: Therefore is it back to IT, pharmaceutical?

A: IT, we still remain underweight. We have been taking that stance since early last year because of our structural concerns in the sector as a tactical move possibly but we would prefer to do that through pharmaceutical than IT. Pharmaceutical we still think the valuations are reasonable and the pessimism is overdone and tactically also possibly makes sense to increase allocation there.

Sonia: Tell us a little bit about your conference now. I have read this piece that you wrote about your GST trip on the ground, the whole host of experts that you met, what has the key takeaway been from that?

A: For GST trip, it has been that the ecosystem is very well prepared. Awareness is high. Everyone believes from tax experts to companies, to channel, wholesalers, dealers, that this is happening and that they are preparing for April; that is a good sign. The key bottleneck or delta is obviously the GST Act needs to be passed which given the current politics could become a question mark; we don’t know yet but that is the key bottleneck.

If the GST Act and therefore the rates, etc are decided by November and December, then GST should be a reality by April in terms of preparedness. For example, IT systems, etc, the database from existing taxes is already being migrated in November as we speak and we will have a trial run sometime in early January. So, the back-end, the preparation, awareness is on high track but the key is solving the nitty-gritty’s of tax rate, etc.

Anuj: It is interesting, let me go back to my last question then, you spoke about the fair value of index, that is at risk if you have so many sectors -- we have seen Asian Paints for example fall 27 percent, we have seen cement stocks, we have clearly seen housing market come to a bit of a grinding halt and that will have an impact on various sectors. So, that fair value needs to be readjusted for now, don’t you think so?

A: If you do a rough sensitivity of what this impact is for gross domestic product (GDP) for example, we make some assumptions on various segments of economy, our rough sense is a very basic presumptuous analysis if the disruption from the demonetisation happens for only a week, the impact on GDP is 0.3 percent. The disruption continues for a month, the disruption is more than 1 percent. So, goes back to the same point, whether this is short-lived or this prolongs.

A short-lived impact will not mean that much for earnings or for GDP but if it continues for a month or more, then the impact will be a lot more and then in that case our fair value of 8,000 Nifty would arguably be lower. However, remember that our fair value of 8,000 Nifty, we are anyway building a much lower earnings growth because that has been our call versus the market. So, we are looking at only 10 percent earnings growth in FY17 and 14 percent in FY18 versus the street at 15-19 percent. So, we were building in lower earnings growth but if this disruption is prolonged, even our estimates could be at risk for FY17.

FY18 is actually very interesting because if this disruption continues, you should also presume the policymakers, government and RBI to come and intervene in terms of liquidity, in terms of rates, etc or even in terms of government spending and which is what makes FY18 very interesting because that would be far more dependent on the policy choices the government and RBI make because over last three to four years, we have been in a cycle of consolidation. Now, whether that changes to a reflationary stance maybe forced by this demonetisation or maybe forced by other considerations that could be an interesting one to watch out for.

Latha: What do you do with the big finance pack then?

A: Again strip it out and look at the investor’s timeframe and mandate, still positive structurally and now for the retail focused private banks, they should benefit even from this. The corporate lenders, a mixed bag but we do think the NPL cycle is bottoming out and this demonetisation thing should not be a big delta for them.

SOE banks, we are selectively positive and this should be positive for them. NBFCs we remain longer term positive but we would advice a more tactical approach in the near-term given the disruption we are seeing because if this is prolonged that is a segment which gets hit the most. However, again, there are pockets there which will be impacted less.

Sonia: Wanted to also ask you a little bit about your view on the Tata Group saga because now not only are we seeing these stocks get plagued by the Cyrus-Tata feud but now some of these companies like Tata Motors and Tata Steel are delivering weak earnings as well. What do you do with these names?

A: For investors we speak to, the sense we get is while the feud is in the headlines, what they will care for is ultimately whether that leads to any impact on uncertainty, impact in terms of change in policy or business strategy and finally earnings. So, that is what will still dictate the stock prices. So, weak earnings, obviously is a negative but it all depends company to company.