The comeback trail

Written by Akash Joshi | Updated: Sep 1 2009, 05:12am hrs
As the equity markets closed for the week on Friday, there was an underlying sense of accomplishment that was around the environs. A sense of peace and a possible chance of a strong rally abound. There were a few enthusiastic, who even suggested that this could be the beginning of a new bull-phase that could take the indices back to the 20k-mark.

The indicators were in place to start contemplating the return of the bull-charge. For one, the benchmark indices surged on the back of the revival of monsoon. The S&P CNX Nifty scaled its highest level in nearly 15 months. And, the market rose in all the five trading sessions in the week ended Friday, August 28, 2009, not even a single day saw the markets dip. Overseas investors have now pumped in $784 million in August and their investments have now reached $8 billion for the current year. And then global markets have also rallied to 10-month high on the hopes that the global economic recovery is gathering pace.

The current major threat in the market place, the monsoon impact, has also been absorbed by the market and the calculations based on a poor monsoon are in. We have now worked out estimates based on lower monsoon estimates and hence you saw the announcement that the kharif season would be 15% lower did not create much of a ruffle in the market place, says a senior fund manager with an overseas fund.

Coming out with its latest update on the monsoons and its impact, analysts at Morgan Stanley reckon, Although the rainfall trend has improved over the last two weeks, cumulative rainfall during the season so far has been much worse than expected. Depending on how rest of the monsoon season pans out, we believe our agriculture growth will be likely between -2% and -4% and GDP growth will be between 5.8% and 5.2%. Our current forecast is 1.5% for agriculture growth and 6.4% for GDP growth. We believe the droughts impact on non-agriculture GDP will be limited. Our current non-agriculture GDP growth estimate is 7.4%.

In line with these were comments from the finance minister. He mentioned that the government expected GDP growth to accelerate over 8% in 2010-11 as the economy would steadily recover. He also mentioned during the week that the economy would expand more than 6% despite scanty monsoon.

Fundamental support

So there are reasons for the mood to be upbeat. However, analysts were also pleasantly surprised by the earnings turnout in the June quarter. Sensex companies surprised positively in June 2009, says HSBC Global Research. Quarterly earnings grew 7% on a year on year basis, flat on the 8.2% annual growth achieved as at March 2009.

Earnings growth has bounced back largely as a result of improved cost control. Raw material expenses fell 10.5%, expanding margins by 4.1% from the low in the December 2008 quarter to 25.5% as on June 2009. Sales growth is yet to rebound, registering a 2.4% decline in the June 2009 quarter, say analysts at HSBC Global Research. And, they expect it to pick up in line with the economy in the second half of the fiscal year.

Hearteningly, the operating profit of EBITDA margins for Sensex companies rose to 25.5% in the June 2009 quarter, from a low of 21.4% in the quarter ending December 2008.

The performance of the wider market (BSE 200) was even better, though during the downturn the wider market was hit harder than the Sensex. Net income rose 18.1% on a year-on-year basis and 11.8% (without considering financial companies), despite an 8.2% decline in sales.

Cost control was the key to this performance as raw material expenses declined by 17.5% over the previous year, even after considering the oil marketing companies. Analysts reckon that decline in commodity prices explains only 3.2% of the 6.2% increase in EBITDA margin; approximately 3% is due to control of other costs.

Going ahead, analysts at UBS Investment Research reckon that their bottom-up earnings estimates for the Sensex indicates 4% growth in FY10, 22% growth in FY11 and 21% growth in FY12. We estimate strong earnings growth for pharmaceutical, cement and petrochem companies in FY10 while real estate and metals companies are likely to post strong earnings growth in FY11, says their latest strategy report released in the previous week.

And, despite the rally in Indian markets, they believe that fundamentals and liquidity are likely to support higher valuations. We believe Indian stocks are likely to re-rate further over the medium term as positive data points relating to IIP, GDP and quarterly earnings show positive momentum. Given FY2011 will fully capture the economic recovery and corporate earnings, we now set a March 2011 target of 20,000 based on a price to earnings (P/E) multiple of 14.9 times FY12 earnings. Sensex is trading at a forward PE of 15.9 times and forward price to book value or P/BV of 2.6 times, the report adds.

Analysts at HSBC Global Research reckon that the energy, IT and industrial sectors are most likely to see earnings forecasts revised upwards. The governments focus on infrastructure should bring attention to industrial stocks, in particular, they add.

Key factors

The bet is now clearly on the pace of economic recovery. And when numbers are released on Monday, trade experts will be sifting through them to check for signs of revival and then factor in earnings surprises if any.

Meanwhile, HSBC Global Research analysts prognosticate that the June quarter is likely to be the trough of the economic cycle, and as the economy picks up in the second half of the current fiscal year. They reckon that sales growth is likely to pick up.

What remains a risk, however, is the recent rise in commodity prices. Since the impact on EBITDA is with a lag of two quarters, this is likely to have an impact on margins from the December quarter. If sales growth rebounds, companies may be able to pass on some of the increase in raw material costs. Should the rebound in sales growth not occur, the risk to our outlook for an earnings growth rebound in the second half of the fiscal year would be very high, these are some of the caveats that they add in.

Looking for picks

At the moment, with the markets trending positively and valuations getting tighter, therefore, picking stocks would not be an easy task, reckon fund managers. However, there are significant opportunities that would present themselves. The key areas to look forward would be sectors and companies that could surprise analysts with their earnings and therefore move with momentum or sectors that are, historically subject to significant earnings forecast revisions, say analysts.

Analysts at Morgan Stanley reckon, Our sector model portfolio remains biased for a recovery in economic activity. Thus, we are backing the financials, infrastructure, and consumer discretionary sectors while remaining underweight in materials.

Another area to look for gains is the mid and small-cap segment. These stocks have in fact risen faster than the Sensex from the beginning of the year. While the Sensex has gained 60%, the mid-cap and small-cap indices have gained by 76% and 82%, respectively.

However, sifting through the mid- and small-cap universe can be a tough call, fraught with huge downside risks. For this analysts at ICICI Securities recommend a strategy of segregating valuable performers. The key criterion includes isolating companies with significant capacity expansion plans, relative to the size of the company, that have taken place in the past three years. The company should also have a comfortable debt to equity position so that it would be able to fund further expansions and also be snug in case rates rise. Absence of significant equity dilution in the past two years is also a positive.

Our rationale is that companies that have invested in expanding their businesses over the past few years without aggressively resorting to significant external funding will be well placed to capitalise on the improving economic situation in the next few years, says the ICICI Securities report.

The threats

And as the mood gets better, there surely are threats looming large over the horizon. There have been mentions of a cautionary mood emerging at the Reserve Bank of India and speculations are rife that a tighter monetary policy might come in as prices rise, especially in drought like situations. And this might act as a dampener.

However, analysts at Morgan Stanley reckon that the liquidity is still favorable and it remains accommodative of the Indian equities. The 91-day yield is a good indicator of liquidity in the system and in our view its current low level augurs well for the markets near-term outlook. Perversely enough, the prospects of a drought favor liquidity as both the government and the central bank may hesitate to initiate tightening steps in the face of an impending drought, adds a Morgan Stanley analysis report.

Over the past 13 years, there have been two tightening cycles. The first one followed the tech bubble starting in July 2000 and ended into January 2001. The second one began during the bull market of 2003-08 in October 2004, and culminated in July 2006, after which the RBI held rates steady until September 2008, when the global financial crisis hit Indias shores. The direct impact of policy rates on the market is always hard to isolate, as is the case with say the monsoons or any other market driver, say analysts.

So the markets will therefore look at key factors like economic recovery, earnings sustainability, the likely movement of interest rates and the global liquidity situation that could spur further buying by overseas investors. On the global risk aversion is not completely cured. Chinas resilient growth has been a key driver of flows into emerging markets equity funds in recent months. Investors were seen booking profits . EPFR Global mentions that outflows from Asia ex-Japan and Global Emerging Markets (GEM) Equity Funds hit 24 week and year-to-date highs respectively.

Hence, even while the mood remains positive, overall, chances of an outright bull-charge seem to be extremely optimistic.