Analysis: Nifty may be expensive but there's still value left if you dig deeper

For Nifty, the past year has been a tale of two halves. From July to December, the index lost more than 2 percent as demonetisation jitters rattled the bulls. However, the loss was more than compensated in the past six months with the index growing by over 17 percent.

Markets in the past one month appear to have entered the zone of consolidation and several experts opine that “markets have run up too fast” and there is very little comfort on valuation. Going by the headline number that’s not totally untrue, at 20x FY18 Nifty earnings, valuation does look a tad expensive.

But the Nifty itself has been a study in dichotomy. A section of the index (especially consumer-facing businesses) has rallied to dizzying heights while the laggards have cost investors money.

A close scrutiny, therefore, throws up pockets of value and visibility that long-term investors can still find within the Nifty constituents.

One of the biggest underperformers has been pharmaceuticals. US FDA action and pricing pressure in the US generics business has taken the sheen off this sector. While we do not blindly jump into the sector for the price underperformance, we believe that selective investing should pay off in the long term.

Generic companies broadly recognise that double-digit price erosion is here to stay in the US. Also, FDA (Food and Drug Administration) approval rate is still slow for complex products. On the CGMP (current good manufacturing practices) compliance, level of US FDA scrutiny has gone up, implying higher entry barriers for new players. In this context, we see reasonable margin of safety in Sun Pharma, Dr Reddy’s and Aurobindo Pharma.

For Sun and Dr Reddy's, FY18 might continue as another difficult year, but FY19 might spring positive surprises.

Dr Reddy’s has seen an improvement over the last month from a regulatory perspective with two key plants (Srikakulam and Miryalaguda) getting clean chits from the US FDA. However, remediation is still on for the other two. We like the gradual build-up of its IPR-intensive portfolio, biosimilars pipeline and another five products in early-stage global development.

Sun Pharmaceuticals, albeit the challenges in the US base business has stepped up its R&D expense and expects nearly 18 percent of revenue in FY20 to come from the speciality business like dermatology and ophthalmology, around 6 percent from the branded drug business, and about 45 percent from the complex generics business that involves long-acting injectables and controlled substances. The US FDA resolution of Halol could ease near-term pain.

Aurobindo Pharma’s diversified portfolio, large product pipeline and better quality ANDA filings as reflected in its quicker approval pace lend support to the topline, while its cost leadership makes it best suited to mitigate US pricing pressures. Broadening of portfolio with focus on injectables, OTC, and higher complexity products, along with operational efficiencies will help Aurobindo to grow faster than its peers.

In the financials space, we prefer to go with financials exposed to the NPA trouble as resolution gathers pace. Our preference is for large relatively better-managed corporate lenders like State Bank of India, ICICI Bank and Axis Bank. With decent provision coverage, the near-term hit on account of resolution of troubled NPAs will be relatively less. From FY19, the earnings will see a boost from significant reduction in provisions. These entities, being well-capitalised, are likely to grab incremental market share from the beleaguered PSU banks.

ONGC didn’t reap the benefit of subsidy reduction on account of falling crude prices and stagnant productivity. ONGC’s Rs 80,000 crore projects will come to fruition over the next 3‐4 years, which will enhance gas production by approximately 10 percent per annum. Sharpening focus on improving cost efficiencies will render these projects fairly viable despite challenging energy paradigms.  The company will fund its capex through internal accruals. The undemanding valuation captures the bear-case risk of oil.

Reliance Industries’ (RIL) grandiose USD 20 billion core capex is seeing fruition. The company is investing in world-scale projects like petcoke gasification, off-gas crackers and telecoms, which are expected to drive future growth. RIL's plans with BP to invest USD 6 billion for developing 3 tcf of discovered gas resources in KG D-6 block and exploring options to partner in downstream fuel retailing and other new opportunities in the energy value chain, should utilise its expected free cash flows post completion of ongoing capex cycle.

Tata Motors: JLR listing could be icing on the cake

For Tata Motors, multiple tailwinds could drive earnings performance as JLR’s (Jaguar Land Rover) model cycle will remain exciting over the next 18 months as it rolls out six new SUV models, driving mix improvement in both revenues and margins. JLR remains one of the fastest-growing global luxury company and it should continue to improve its market share. Profitability improvement at the China JV on higher utilisation should boost profits. Forex moves (GBP depreciation) should help earnings as the hedge book progressively rolls off and India business profitability too should start looking up from FY19.

L&T: New opportunities

For Larsen & Toubro, the operational performance should get a boost from inflows from metro, water and power T&D, the hydrocarbon business and the significant opportunity in the defence sector thereby growing the addressable market base. Execution should pick up with a positive rub off on margin and potential sale of developmental assets should reduce debt further.

Market gyrations in the upcoming earnings season and myriad global headwinds should provide ample opportunity to gradually invest in the zone of value within Nifty.