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Last Updated : May 31, 2016 05:49 PM IST | Source: CNBC-TV18

Stock prices look justified for 1st time in 2 yrs: Ridham Desai

A clear recovery economic and earnings is finally visible and growth is at an inflexion point, says Ridham Desai, Head of Equity Research & India Equity Strategist at Morgan Stanley.

A clear economic and earnings recovery is finally visible and growth is at an inflexion point, says Ridham Desai, Head of Equity Research & India Equity Strategist at Morgan Stanley.

“We are, for first time in last two years, seeing justification of share price,” he told CNBC-TV18 in an exclusive interview from the sidelines of a Morgan Stanley conference.

"Earnings, in this quarter itself, have turned positive with the exception of corporate banks. Mid teens earnings growth is likely over next couple of years," he said. 

Key calls to watch here would be deflation in producer price index and nominal effective exchange rate, Desai says.

Headline index looks like it will get exhausted. Another 3-4 percent upside is expected post which it might take a pause.

Desai says that at present, broad markets look very attractive and are expected to do better than narrow markets.

In global market, is any sell-off happens, it will trickle down to India as well. India, however, will continue its outperformance amongst emerging markets as it has a better long term story, he says.

Global correction continues to be a big risk. Short-term players should be more varied to put fresh money, he says adding that this is “not a moment to get too aggressive”

The stalled Goods & Services Tax (GST) Bill has great probability of passing in Monsoon Session because Congress is losing seats. Also, hereon government’s
work will gain more recognition.

Morgan Stanley has three main buy calls - banks, consumption and select industrial which are seeing increased government capex. Corporate debt cycle is over, but banks might still report asset quality issues over next few quarters.

“Over next five years, a boom is expected in retail loan growth,” he says.
Consumption infrastructure, like multiplexes, automobile showrooms, has seen strong uptick, which is expected to continue.

Below is the verbatim transcript of Ridham Desai’s interview with Latha Venkatesh & Anuj Singhal on CNBC-TV18.

Latha: What does it feel, you must have already had your early calls with the people whom you are calling, what is the sense you are getting? Is it as enthusiastic as the earnings season numbers have turned out? Are you feeling good about India?

A: It has been a long time, we have been doing this conference and the news from the ground is that we have got once again record attendance. So, clearly, there is a lot of investor interest in India. There has been for the past few years, we have notched up higher numbers, successively for the past five years.

So, even through our bad economic times we really didn’t see investor interest wane so it is pretty par for the course that we get greater investor interest as time passes. We are hoping to achieve the milestones that our China conference achieved which is you know get 1500 investors. We are not there but we will get there in the future.

With regards to your comment, I think we have for the first time in the last two years justification for share prices at least in the minds of the sceptics. In the last two years whenever the stock market has rallied people have turned around and said that fundamentals don’t justify this.

Latha: Is that the fundamental difference between the 18th Morgan Stanley Conference and the 17th Morgan Stanley Conference?

A: Yes, I think so; I think we have seen some conversion of hope into reality. So, when the Nifty was at 9,000 last year a lot of people felt that may be the market has run ahead of its fundamentals and it was based on some hope of recovery. Well, the recovery has happened, a bit more slowly than what we may have anticipated in 2015 but it has happened.

So, the underlying fundamentals whether you measure it in terms of economic growth, whether you measure it in macro stability which was the first thing to turn for India or now in terms of earnings in large part, I think there is justification to share prices. That is where the difference lies between say today and 12 months ago when we were speaking here.

Latha: What sense you got about the earnings season per se? Have you all seen more upgrades than downgrades? Is it giving you a sense of troughing out?

A: I think the revision cycle has clearly troughed out. I think we are at a start of a new earning cycle. The first thought at derivative earnings growth should turn positive next quarter. Indeed if you look at it even this quarter and ex out the corporate banks it has turned positive.

So, it is only the corporate banks are dragging down earnings. I think maybe they have one or two more quarters of pain but on the aggregate I think the earnings have inflected and that is consistent with what the macro is doing. The key call here, there are two things that we need to watch one is the deflation in Producer Price index (PPI), so one of the things that has happened over the past couple of months is that after 17th months PPI deflation has ended.

If that persists, I think there is reason to be more positive on earnings because if you look at the earnings picture margins have been improving for two years now. However, it was revenue growth that was sluggish. Revenue growth turned positive this quarter, so I think we have situation that if PPI deflation does not come back to hit us and if PPI persist in positive territory then I think there is reason to be positive on earnings.

The second thing in the earnings mix was what was happening on the global front. There were two factors there, one was global trade which continues to be weak and is a drag on earnings and the second is the nominal effective exchange rate. Mind you since 2014 the rupee has been on a stellar rise both on real as well as nominal bases. Over the past few weeks or I should say three or four months the nominal exchange rate has taken bit of a knock. That has helped earnings this quarter.

A lot of companies that have reported earnings this quarter which have operations outside India have actually done quite well. They were dragging down earnings last year and they have done well not because the underlying economies in which they operate have done better, the translation effect has turned positive. To the extent that they were not hedge, they have reported that as earnings. So, you will see more of that in the next few quarters.

There are reasons to be positive but of course we will keep an eye on PPI deflation and how global trade develops. I would hope that the global economy doesn’t take a leg down further and if that doesn’t happen I think we should probably get mid teens earnings in the next 12 months.

Latha: I was just coming to the earnings and the EBITDA’s but before that, before I come to your sectoral preferences as well a word on the recent market run-up? At 8,200 or on the cusp of 8,200 is there still value?

A: I think I will break this up into three parts. I was listening into Anuj and I quite agree with what he his saying. He usually makes very good analytical comments on your channel. I have to applaud him; I have done that in the past as well.

He said a couple of things, so as the headline index looks a little bit like it will get exhausted soon, so may be another 3-4 percent to go before I think it takes a pause. There is a lot of momentum which is coming from outside India, so again it is a tough call to make because I don’t know exactly where the world stops running up.

However, there is a lot of liquidity in the system that is finding its way in to various assets classes and therefore you are seeing these rallies across the world. In fact for most part this year, all that India has done both down and up are both related to global factors. I would say 80 percent of this is explained by the world and only 20 percent is India related. That may get more idiosyncratic in the second half if the world takes a pause.

The second on his comment is on the broad market. That is where the action may probably be in the next few weeks which is I think the broad market looks quite attractive. A lot of midcap companies have reported strong earnings, way ahead of expectations and I think they have turned the corner.

As the economy turns up the broad market will do better than the narrow market. The broad market also looks more attractive on valuations. Third thing is what India does relative to the world. More pertinently relative to emerging markets and on that count I think India should continue to outperform.

Since the Budget day we have delivered 7 or 8 percent outperformance and I think we should see that continue. So, in part of course it relates to what emerging market (EM) is doing. India’s correlation with the EMs is declining but there are still there.

Therefore it will play a role in how India delivers in terms of absolute levels. However, India should outperform because it has a better macro mix, it has better growth dynamic and of course it has got a better long-term story.

Latha: There is one major event that is on the anvil - the monsoon session and we will probably get the goods and services tax (GST) bill reintroduced yet again. If you took the traditional non GST voters, the opposition camp; Congress + Left + probably All India Anna Dravida Munnetra Kazhagam (AIADMK), you still get only 82 out of 244 - that is my math - that is still less than 1/3rd or just about 1/3rd. Assuming that everybody will be present and vote, the vote passes. Will that be game changing, if it passes?

A: We made that call in February. We stuck our neck out and we did a simulation of the upper house going into the next six months and our conclusion was that the GST Bill will have a fairly good probability of clearing in the monsoon session because the scales in the Rajya Sabha are tilting in favour of the government; more because the opposition is losing seats; not because the Bharatiya Janata Party (BJP) is gaining seats but because the Congress is losing the seats. A lot of that is played out. The nominations are done, so the scales have tilted in favour of the BJP. So there is a better than even chance that the GST bill gets clear in the monsoon session.

However, with respect to the market, I think expectations have been low; a lot of investors dismissed our reports saying that this is not happening. That said its impact on the market may not be dramatic. It's not like the Nifty will give 500 point rally on the back of GST. I think GST is one of those many things that the government is doing.

However, I think what is going to happen, as we were talking on the sidelines is that the government's work will gain more recognition. I think there were two things that were holding back that recognition because you have to agree that the government has done a lot of good work on the fiscal front, on infrastructure specially the power structure, roads, railways.

These have been stellar turnarounds situation, the bankruptcy law and even on projects; 90 percent of the stalled projects that they inherited have been cleared, so you can continue to count the list of good things that the government has done.

Yet narrative out there was that the government has not done anything and the two things that were holding back the positive commentary on the government, I think one that they failed to get the GST bill passed partly because they themselves lifted expectations that they will do it earlier than the previous target and the second was because earnings growth was feeble.

So somehow the participants in the market as well as the corporate sector were linking the earnings to government performance. Now both of these will change in the next quarter, so you may find that the narrative on the government will also inflect, which is that people will have a lot of positive things to say about the government but the GST's impact on the market, I do not think will be that dramatic, it is an ongoing thing that is happening amongst the various other things that will happen which is economic growth will look a lot healthier in the next six months, earnings will look a lot better and of course you get GST bill.

So it is looking like a solid environment for Indian equities. Therefore, I am fairly confident and in fact we upgraded India in our emerging markets' portfolio recently that India should outperform EM. What it does on an absolute basis is rather linked to what to world does in the short run but if you are a three or four year investor, I do not think there is any major debate here that you should be buying equities.

Latha: What kind of an earnings growth are you expecting and based on GST and your sense that the government will get recognition for what it has done, is there a rerating also? Therefore, what kind of Nifty gains or your index or whatever is your universe, what kind of percentage gains from hereon?

A: When you say rerating, that is a very interesting subject. India is trading at twice price to earnings (P/E) multiple. India is not, in conventional terms, cheap. I hesitate to use the word cheap because I think we should be looking at future cash flows and discounting them and I think India is still attractively valued. However, if you look at this pure headline P/E, headline price to book and compare it with broken EM, no doubt, it is not inexpensive.

The last time India traded at this relative multiple was in 2007 December and we know what happened after that. So rerating is less likely. However, India should retain its premium valuations. Anybody challenging India\\'s premium valuation will have to think about that challenge because India will offer a better growth and better policy momentum than most of its peer group.

With respect to earnings, we think mid-teens for the next couple of years is par for the course with upside risk because when earnings turn, they tend to turn quite sharply. Therefore, I think there will be upside risk. We are a tad ahead consensus but I think all of us will have to be careful that we don’t underestimate earnings over the next two-three years.

Latha: What are your favourites, do you still stick with consumer discretionaries, urban consumption themes or are you tweaking even your consumption theme to more rural considering that we are all talking about a good monsoon?

A: I think we are making three big calls. The first one is the corporate debt cycle is over. So the worst is behind us. That doesn’t mean there aren’t specific problems, that doesn’t mean that the PSU banks in particular have sorted their balance sheets because they may not have recognized the past problems, so they may still report the issues as we saw in this quarter and probably the next couple of quarters. However, I think the worst of the corporate debt cycle is over.

The accretion to the debt has slowed down. Free cash flow has turned positive for only the second time in 20 years. Excess returns are so deep in negative territory that restructuring is inevitable. So I think you will see a lot of mergers and acquisitions (M&A) activity over the next 12-24 months and I think the macro looks a lot better.

So all this combined, means that the corporate debt cycle is over. You will have memories from the 2001-2002 cycle and the only impediment for a V-shape recovery here is that interest rates cannot fall as much as they fell then.

When interest rates fell about 700 bps? That is highly unlikely right now because the interest rate is around 7-7.5 percent. It cannot fall that much. So that is the difference. Otherwise, I think the debt cycle is peaked.

So you want to buy banks, in that if you want to discriminate because as I said the PSU banks are yet to report all the pain that is there. The private sector retail banks should do very well. Retail loan growth is already at a 5-6 year high. In the next five years, they are probably going to get a boom in retail loan growth. So akin to what we got in corporate loan growth.


Latha: Even if retail loan givers are expensive you would persist with them?

A: I don’t think the stocks are rich. I think they are actually quite inexpensive and again don’t get carried away by the headline multiples because there is a lot of growth and that is how come founders are created. They get created from growth, so the starting point of valuation is not important right now because there is lot of growth that is in the pipeline, so that is the first call.

The second is I think consumption is turning, so we do a lot of work both public data as well as proprietary we have a City Vibrancy Index that we track. We have been doing it for five years. We track actual data from 200 cities across the country.

There are two things that I want to share one is that we have seen a perceptible shift in job growth in the last six months. So, jobs are back. They are coming back, I think mostly in services because we don’t do that best sector but that is my guess that is the services sectors that is driving it. It is question a lot of people ask me where are the jobs? Well the jobs are in services.

Second thing is that consumption infrastructure has had a big leg up. Now I will explain that, it means multiplexes, retails stores, automobile showrooms and things that are required for consumers to go and buy that stuff has seen a big pick up. Double digit growth in the last six months year-on-year, so I think that is a pre-cursor to the coming consumption increase in urban as well as in rural India.

We made the rural call at the end of the last year because I thought that rural consumption plays had been severely hammered and they looked very inexpensive and the only risk I was taking was that the monsoon will not be good. The early indicators were that the El-Nino effect was weakening already in December. So, it was a good risk to take. I think you persist with that.

Q: So, you Mahindra & Mahindra (M&M) and all the tractors makers and probably two-wheelers?

A: So, a combination of autos, media, retail amongst discretionary consumptions I think you want to buy them whether they are urban or rural I am agnostic. I don’t think it is going to be a deluge; the rainfall will be like normal. It is a weak La-Nina, it is not a very strong one. There is a possibility and going back to the Anuj’s point if I look at the weather bureaus forecast and this is risky to do but they are suggesting that the monsoons will kick in late.

Given how the market’s mood is right now if there is a slight delay to that I think you may get that type of Nifty correction in the next three to four weeks. However, again I will say that with a great caution because those are short-term calls, I am really bad at making.

The third call that I think will make is in select industrials; because I think the government CAPEX cycle has truly turned and any scepticism that was there I think should have been put to rest in this season.

Latha: What will be those select industries?

A: You buy companies that are doing government construction work. You may also want to buy infrastructure owners because you will see a pickup in activities. So, infrastructure owners as well as infrastructure builders are the two categories of stocks that you want to buy. I would still be a little bit hesitant on capital goods.

Latha: You had a good numbers from Larsen & Toubro (L&T), not good enough?

A: A lot of these companies actually do a lot more infrastructure work today than they did in the past which explains why they are doing well. So, the conventional capital goods companies which just only supply to private sector CAPEX will take a little while to turn.

However, from the numbers that I have seen this quarter everybody who is engaged in government CAPEX has actually done well is reporting better order books and is guiding up for the next 12 months. The biggest upgrades will come there.

Latha: There are two dog sectors as you said corporate facing banks and real estate. When do you think you will start buying them, end of 2016, second half of 2016 or is it going to be 2017?

A: Real Estate right away, I think real estate has turned. We are seeing new sales pick up. I am seeing inventory decline. The pain in real estate is over. However, it is unlikely to be a boom in real estate because the investment demand is unlikely to come back. Given that real rates are positive I think households will continue to prefer financial assets. So, you will continue to see positive growth in real deposits as well as in equities in comparison to gold and household.

However, consumption demand is going to be quite strong. In a way real estate is partly linked to the consumption theme which is that as you start looking at higher real income growth which is what urban India is experiencing because of the fall in inflation, you will start looking to buy your house which you wanted to buy but you could not buy because you were hit by inflation.

So, I think real estate may have turned the corner. All corporate banks you can wait. Let the pain be out of the window and then I think in a couple of quarters we can revisit that.

Anuj: While this month we have done well and outperformed all our peers year to date the Indian market is actually in line with what the MSCI emerging markets has done or what Asian Markets have done. Do you think we are ignoring the global risk whether it is Breixt or whether it is any kind of slowdown in fund flows because of Fed rate hike? How big a risk is a big global correction for Indian market?

A: It is certainly a big risk in absolute terms but as I said India continues to outperform. For sure if you are a short-term player then you have to be a bit more vary to put fresh capital to work. The moment to put money to work was in February 29th that was the moment when sentiment was totally broken.

You can see the turn the sentiment today looks a lot more positive. So, this is not a moment to get too aggressive, but the market has got momentum so it may have a little bit more upside. Anuj you are absolutely right, the risk are clearly that given where we are in terms of sentiment that you get a bit of correction.

Latha: Let me add to what Anuj was saying, for me that is the big gorilla. As you said 80 percent of the market is swayed by what is happening globally. There could be a Fed rate hike, if not in June, in July; the Fed fund futures are factoring in 60 percent chance of a rate hike in July. Last time the December rate hike resulted in a huge China instability in January as the currency responded to the rate hikes. Are these seismic moves in global markets possible in July or do you think we will weather it since we weathered the first rate hike; this time around it may not be that bad?

A: I think there are separate issues here. As far as the Fed is concerned, the Fed is guiding the market and therefore the market is pricing it in. It happened in December as well which the market had already been warned, so it was very well prepared and this time around again the market has been probably warned whether the hike happens or not, we do not know but it has been warned that there is an impending hike.

So the market may not be as volatile to the Fed event. Also there is a big difference between the Fed cycles this time versus at any point in time in the history. In previous cycles when the Fed started hiking, it was like a hike every quarter; for seven-eight-ten quarters on the trout, there was a big change in interest rates which always had damaging impact on emerging markets.

We are not now in that type of a cycle. The Fed itself is struggling to lift the rate; as much as they want to because they want to protect themselves from any future recession and therefore have ammunition in the bank. The fact is that the US recovery has been not as strong as they would have wished for and therefore they do not have the conviction to raise rates every quarter.

So it is a different type of a cycle in that sense. So there is less worry from that source for the Indian market but if global equity selloff India will also selloff and those who hinge to absolute levels in India, will see compression in their portfolio values and that is the risk in the near term.

You should not take me as a guide for a near term views because my view is that that when that correction happens, like it happened in February in March, you want to backup the truck and buy stocks because on three or five years basis there is money to be made here.

Latha: It really be materially difficult for you to sell in India in the global environment if the central bank Governor is not continued?

A: I think this thing comes up with investors all the time and there will be volatility around the appointment of the central bank Governor, but India's institutional setup has got some robustness and while there may be some volatility. I think we will pass that quite quickly.

I think Reserve Bank of India (RBI) as an institution is fairly established one and leadership does matter. All those points acknowledged but if there is continuity in policy it may not matter to the market.

Latha: What does the world want? The world wants Rajan to continue or it will be unruffled?

A: Raghuram Rajan enjoys great credibility with investors. He is associated with the turnaround that happened in 2013. His leadership with the RBI is associated with that turnaround. In 2013 India was classified as one of the fragile five.

It no longer is in that category and a lot of investors credit him with that transformation. I agree with it. Surely he has played a big role, ably assisted by very strong administration in Delhi, the two of them have combined superbly to take India out of that and bring macro stability.

As I say I have not seen this type of macro stability for India since '91, when we were in the balance of payments (BPO) crisis. This is the best that India has had and therefore you have to give credit to the leadership at the RBI Governor. So if you take a poll today with investors, I am sure 90 percent of them will wish and hope that Raghuram Rajan continues as the Governor for another term.
First Published on May 31, 2016 08:57 am