Research Report

Market outlook and top picks for September 2018

Publish Date: 05th September, 2018

- By Rusmik Oza

Top picks for the month

Large-caps from a one-year perspective: Adani Port, ICICI Prudential Life Insurance, Maruti Suzuki, Petronet LNG and Vedanta.

We have picked them because earnings are expected to be good, valuations are reasonable and RoEs look good too.

Small- and mid-caps from a one-year perspective: Arvind Ltd, Amber Enterprises, CESC, Persistent Systems, Talbros Automotive Components.

Arvind and Amber are heading towards de-merger. Their earnings may unlock post that.

Performance of regional markets

India has done far better compared to Philippines and Brazil. But currency depreciation has taken the sheen off the performance.

Performance of sectoral indices

In the last one month, there has been a sharp recovery in the mid-cap space. Nifty has gone up too. On YTD basis though, both the mid-caps and small-caps remain in the red.

Healthcare, FMCG, IT sectors were the primary drivers in the last one month. Reliance and ICICI Bank are the major companies that revved the markets up.

GDP: Expect 7.3% growth in FY2019

The growth in GDP is led by agriculture (5.6%), manufacturing (13.5%) and construction industries (8.7%). However, the GDP growth will moderate and will hover around 7.3%. This year’s growth will be better from last year due to normalization of GST.

GST: Still below budgetary target

GST remains behind the eight ball as far as its annual target is concerned. If you look at the last four months, the average run rate has been around Rs 95,000 crore. But in order to achieve the annual target, the government will need to raise Rs 1.15 lakh crore in the remaining months.

A failure to do so will impact the country’s fiscal deficit. The government’s fiscal deficit target is around 3.3%, but we believe lower tax collection will expand the fiscal math to around 3.5%.

Yields will go up and so will government borrowings if the fiscal deficit target is not met. That is why it is important to keep an eye on the GST tax collection numbers going forward.

IIP: Healthy numbers on base effect

We are awaiting the July IIP data. But June’s IIP growth was 7% as against 3.9% in the previous month. If we go by the core sector by the numbers, they grew by 6.6%, which suggests the IIP number in July could be as healthy as it was in June.

Trade deficit and current account deficit

The monthly trade deficit has widened to $18 billion in July 2018. A Year back, when crude was around $40, the trade deficit was comfortable around $10 billion. This data will worsen further due to weakening of the rupee.

The current account deficit may expand to 2.6-2.8% of the GDP in FY2019E. High crude oil prices are one of the factors for the expansion in current account deficit. Another side effect could be that borrowing costs will increase for corporates and lead to further rupee depreciation. Hedging funds will go up too as a collateral damage.

Crude: Iran sanctions could lead to spike in global prices

The winter months will drive up crude prices.

The Iran sanctions, which are scheduled to come into effect on November 4, will impact the prices too. Iran exports almost 2.2 million barrels per day. The rising crude prices due to low production of oil — there are problems in Venezuela and Libya as well — is disconcerting for countries that are high importers of oil..

The sanctions on Iranian oil will be particularly harmful for India as it gets oil at a cheaper rate. That’s because India pays oil in Indian rupee, instead of US dollars.

Our estimate suggests that crude prices will be between $80-90 per barrel.

Monsoon update: Below normal but reservoir levels better

Until August 29, the cumulative rainfall has been 6.3% below normal. This is manageable as only anything above the 10%-mark is considered to be serious.

East India, in particular, has received scanty rainfall, though the north and west have especially seen decent rainfall.

Since the rainfall was not good in June, the sowing pattern has not been very good.

Indian rupee: Still looks weak, can depreciate further

For the last two years, the currency was quite stable. We were overvalued by almost 20% in CY2017. Therefore, the depreciation was imminent. The trade war and rising crude prices have expedited the depreciation.

Currency depreciated about 13% against the US dollar. We feel the Indian rupee can hover between Rs 70 and 75, especially because it has breached the Rs 69-mark.

Flows: Local flows dominate

FIIs have been a minor seller compared to other emerging markets. In the emerging markets, FII outflows have ranged from $3-9 billion. That’s not the case with India though.

Plus, there has been a healthy inflow in the mutual funds, thanks to the SIP route. The monthly run rate is above Rs 7,000 crore.

However, there has been a slowdown in the mutual fund segment since May. In May, the mutual fund inflow was around $2 billion but that has slowed down to $546 million in August.

Earnings

The Q1 earnings have been quite healthy. Excluding banks, the entire corporate sector clocked a 15% revenue growth and the net profit grew by 26%. The net profits grew on the back of last year’s low base due to implementation of GST.

The September quarter is expected to be healthy too due to last year’s low base.

However, the earnings numbers would come down in the second half of the fiscal year.

Nifty 50 earnings: KIE estimates

We should see around 18-20% earnings growth among Nifty companies this calendar year. It could go up to 25% in FY2020. The numbers may look on the higher side due t low base on the global side and recovery of the Indian economy. The numbers may be affected if the crude prices continue to go north. That’s because many industries as the input costs may shoot up. The margins, as a result, would be hit hard.

For FY19, we see a 10% cut in earnings estimates in the last six months. But we haven't seen any cut in FY2020 because analysts keep it on the higher side. On a realistic basis, it is better if you keep a CAGR growth of 15%.

On a 2-year CAGR basis, automobiles, banking, cement, pharma are expected to do well due to low base.

In the last 2 months, the rise in the index has been driven by a handful of stocks such as Reliance, TCS and Infosys. On YTD, there are 17 stocks that have outperformed.

The market rally, therefore, doesn’t have strong legs as they are shallow and based on a few stocks.

Most of the fund management companies are also underweight in almost all the outperforming stocks. For instance, there was only a 2.5% mutual fund holding in Reliance Industries and a 1.8% holding in TCS in June 2018. In that extent, there may be an underperformance in mutual fund investments.

Nifty valuation

The valuations are on the higher side as it is trading at 18.5x times. But is is not in a bubble zone yet as the Nifty usually needs to hit the 22x.

Further, there is no re-rating scope as there are macro headwinds and aggressive earnings estimates.

If you look at each sector, the cement sector valuations seem on the higher side. PSU valuations are below average and may be a dark horse in the long run. Private sector banks are not at peak valuations and may have a headroom for 5-10% move.

Consumer staples sector looks quite highly valued. Discretionary sector is also valued 50x. Both these sectors are vulnerable to de-rating.

Energy sector valuation seems reasonable because there is no visibility of earnings growth. The industrial valuation seems attractive and are just 10% above the 10-year average. This looks like a good bet especially as the elections approach. L&T especially looks good.

Metals and utilities look good from the valuation perspective due to 12-13% currency depreciation.

Pharma valuations seems stretched because earnings expectations are muted. The tech sector is coming to peak valuations.

The MSCI Emerging Markets are trading at 11x, while MSCI India is trading at 19x. Something has to give away here and strike a sweet spot. The premium is also close to its peak.

We are also unsure of the mid-cap space. We need to wait for further movement before we can analyze the mid-cap valuation further.

The percentage of delivery is at a four-year low, indicating there’s little confidence in the market.

Investment strategy

Valuations look stretched due to rally in high quality and high PE stocks.

Buy and hold may not work for some time. It is more of a tactical play market.

Long-term investors need to have a two-three year view and spread the buying in tranches.

It is better to focus on good management, superior earnings growth and reasonable valuations.

Q&A session

1) Outlook on IT and pharma companies in next three years: Currency depreciation will help both sectors. Almost 70-80% exports are to the US and Europe. We must point out that pharma looks more positive than IT as its valuation has already become high. Pharma companies can give anything between 60% and 100% returns in the next three years. The IT companies will provide lower returns than that.

2) Metals sector: Metal prices have corrected in the last 3-4 months but they still have the benefit of currency on their side.

3) MNC pharma: The entire space was undervalued but there was a hectic re-rating. Going forward, this space should moderate as they don’t have advantage on the currency. It would look good if there is 10-15% correction.

4) Airline stocks: The industry has robust volumes, passenger traffic growth but the rising fuel prices and raw material prices will impact the profitability. Maybe, one could look at the sector in month of December (peak winter).

5) Auto ancillary companies: We remain positive, be it passenger vehicles or two-wheelers. Bharat Forge is one of the companies that can do well. The currency benefit will come their support.

6) Tata Motors: We see a bottom formation happening and one needs a two-year view. The recovery may be painful. The capex recovery may take time too.

7) Punjab National Bank (PNB): PNB, State Bank of India and Bank of Baroda look good from a contra perspective. You may need to bear with volatility, unless you have a long-term perspective of two years.

8) Private sector banks: We like HDFC Bank post the correction. The company has a robust top management and that’s why the company may reflect the management potential. IndusInd Bank looks good too. But these banks may correct in the near-term.

9) Chemical sector: Chemical prices have shot up which is unusual because they shoot up in the winter months. This is good for the industry. Sudarshan Chemicals, Aarti Industries look good.

10) ICICI Bank: It might consolidate at current levels. There may be certain headwinds too in the near-term. The next two quarter numbers may be volatile. The upside could be Rs 400 and the downside could be Rs 300.

11) Eicher Motors: It is coming back into the limelight because they have sustained the earnings momentum. You can look for a 5-10% returns.

12) Paper industry: There has been a structural change now. Earlier, China had started importing scrap paper and started recycling it and then selling it in the global markets. But that has stopped now, which has driven up the paper prices. That’s why we remain positive about this sector. JK Paper looks good in this sector. Certain run-up has happened already, so it would be better to wait for a correction before buying stocks in this sector.

13) Bajaj Finance: The NBFC space saw a steep re-rating. We expect some bit of moderation a degree of realignment. We expect the valuations to correct. That’s why it is better to wait. Magma Fincorp is one such NBFC that may do well though. Housing finance companies may be a decent bet too.

14) JSW Steel: The stock was trying to stabilize but has gone up now. Our take is that it has moved up so much that we should wait for some time. However, we expect the steel sector to do very well.

Also read

• Our stock recommendations
• Sector research and updates
• Prolonged construction ban in three states can twist a knife in the real estate sector
• Godrej Consumer Products divests 100% stake in UK business: All you need to know
• Get our trinity account: Savings, demat, online trading account

Disclaimer: Our research should not be considered as an advertisement or advice, professional or otherwise. The investor is requested to take into consideration all the risk factors including their financial condition, suitability to risk return profile and the like and take professional advice before investing. Full disclaimer here