Equity Outlook: The common man awakening

The common man on the street wants change and change they did. The recently concluded Assembly elections in four major places were unprecedented in nature. For a party that did not exist a year ago, the AAP (Aam Aadmi Party)'s performance has been stellar. Coupled with a record of more than 70 per cent turnout across states, this reflects the current mood among voters, who have chosen governance over freebies and populist schemes. The markets reacted positively and the rally reflected hope - of governance, policy and growth - and also the triumph of a vibrant democracy, India. Whether this will result in a Bharatiya Janata Party (BJP)-led government in the 2014 general elections is yet uncertain, though the probability has definitely increased.

The rally is not built just on hope. There are several indications the Indian economy might have troughed, though the debate on possible pace of recovery continues. After seeing economists falling head over heels trying to downgrade GDP growth for FY14 between June and August, we are seeing some upgrades and we should finish the year with 4.8 per cent growth. We believe economic recovery will be gradual in FY15 to 5.4 per cent and pick up from FY16 onwards to more than six per cent. The near-term support to growth will be from external demand while consumption and investment are likely to stabilise at current levels. We also expect some pick-up in investment activity largely on the government initiatives to clear logjams to speed project implementation. However, we think private capex will take another 12-18 months to take off, as overall capacity utilisation of various sectors in India is around 70 per cent and the private sector will likely wait for the new government to firm up policies.

This improvement in the economy is also getting reflected in earnings forecasts of companies. After a year of downgrades, the momentum improved with better than expected second quarter results. The market now appears to be slowly pricing in a recovery over the next few quarters. The consensus estimate for FY15 index earnings growth is 16 per cent, driven by 10 per cent revenue growth and 100 basis points margin expansion, which we think is easily achievable.

At the current FY15 estimated price to equity ratio (PER) of 12.6 times for the Nifty, the market is 14 per cent below its 17-year average. On a price/book basis also, the multiple at 2.4 times is 20 per cent lower than its long-term average of 3.1 times. The historical relationship between GDP growth and valuation multiples suggests that current valuations are consistent with five per cent GDP growth and lower than our GDP forecast of 5.4 per cent. We think, given the gradual recovery in the economy, the market will trade at slightly above the long-term average valuations at 15 times PER, and that gives us December 2014 target of 7,200 for Nifty. The market can see multiples stretch even further if we get a strong government in the Centre.

That said, markets have corrected over the past week on the back of quantitative easing (QE) tapering fears and rate hike due to high inflation. The delay in QE tapering by the US Federal Reserve and quick measures taken by policymakers have helped in stabilising the rupee and provided some breathing space in the near term. However, US tapering is imminent and coupled with inflationary pressures, will continue to dominate RBI's concerns over the coming months and keep interest rates elevated for more time.

Given the nascent stage of domestic recovery and possibility of event risks of QE tapering and elections, we are cautiously optimistic. We recommend taking exposure in export-oriented themes (information technology, pharmaceuticals and metals), rural demand and positive earnings momentum. At the same time, we recommend adding beta through quality cyclical stocks. The top five stocks to buy for 2014 are L&T, Axis Bank, Jindal Steel & Power, TCS and Sun Pharma.

The author is head of research, Macquarie Securities