Risk-reward unattractive, not good time to buy: Gautam Chhaochharia

India has been the best-performing market globally thus far in calendar year 2017. Gautam Chhaochharia, head of India research at UBS Securities, tells Puneet Wadhwa that the current all-time high Nifty valuations can be justified only if we presume double-digit earnings growth into perpetuity. His CY17-end base case scenario target for the Nifty50 index is 9,000. Edited excerpts:
 
The markets are at an all-time high when economic indicators are at a decadal low. What explains this dichotomy?
 
Hopes of growth recovery aided by reforms and strong local retail flows explain the dichotomy. The goods and services tax (GST) and other reforms are giving hopes that over the longer term, these should drive higher growth rates in India. In this backdrop, we have seen local inflows gather pace. Domestic flows follow the historical returns momentum. So, they may keep pumping money into mutual funds as long as the returns are positive, irrespective of underlying growth, which may drive markets even higher.

 

Why have you lowered your Nifty50 target for the year-end?
 
We have adopted a more robust intrinsic value-based approach rather than just headline price-to-equity (PE) multiples. Incorporating FY17 actuals and PE multiples from our model, based on different earnings scenarios, our calendar year end-2017 base case Nifty value is 9,000 (based on 17x PE). Our downside scenario is 7,500 (15x PE) and upside scenario is 10,000 (18x PE).
 
How comfortable are you with the valuations at this stage?
 
Our discussions with investors imply some worries about rich headline valuations. Notably, PE expansion rather than earnings growth explains nearly all of the performance this year for India, especially for cement, consumer staples, autos and non-bank financials. We believe risk-reward is unattractive and we are not comfortable buying at these levels. The current all-time high Nifty valuations can be justified only if we presume double-digit earnings growth in perpetuity.

 
In the past when the markets have been near such multiples, the earnings have been quite strong. This time around, however, the multiples are high in the absence of earnings growth. We maintain our view of a muted macro/earnings recovery in India, over the near-term.
 
Can you elaborate on your takeaways from the recent earnings season?
 
Nifty Q1FY18 earnings declined by 3 per cent year-on-year (y-o-y), with revenue growth of 8 per cent y-o-y (three per cent excluding global commodities) and an Ebitda decrease of 4 per cent y-o-y (Ebitda is earnings before interest, depreciation and amortisation). Forty per cent of Nifty companies missed consensus earnings expectations, while 22 per cent were ahead. Consensus Nifty earnings expectations for FY18 now imply 14 per cent growth y-o-y, having been cut 8 per cent in 2017 year-to-date and 2 per cent during the Q1FY18 earnings season. All sectors except metals and mining saw earnings downgrades.

 
Earnings estimates for FY18 and FY19?
 
FY19 estimates still imply 20 per cent growth. For the rest of the nine months in FY18, we expect further earnings cuts, as hopes of a H2FY18 macro growth recovery will likely be disappointing (again), despite the optics of a favourable base of note ban, which impacted the second half of CY16.
 
What are the key risks to the rally?
 
The global situation is always a risk, as we saw recently, given the geopolitical developments, despite strong local flows. Local flows may not be a risk yet — flows follow returns and not drive them. A local negative growth surprise in second half of FY18 is possibly the key local fundamental risk.

 
How are the FIIs viewing India now?
 
FIIs have trimmed their ‘overweight’ stance on India, but it still remains the key ‘overweight’ market for them. Local flows can sustain if the markets do not correct as one-year returns remain in positive territory. Local flows will be at risk after any market correction of more than 5 per cent and not at current levels.
 
What are your overweight sectors?
 
Clear overweights are consumer staples. Tactically, information technology (IT) services and retail-focused private banks, non-banking finance companies, and telecom and media.
 
Are metals, IT and pharma sectors good contrarian bets?

 
Tactically, IT can be a good contrarian bet selectively, as the structural headwinds may be priced into earnings estimates and multiples. We remain ‘neutral’ on the pharma and metal sectors from a strategy perspective.
 
How elusive will be the earnings recovery for the IT companies, especially Infosys, given the developments?
 
Individual companies will always have specific issues and drivers. We expect the IT sector as a whole to recover a bit cyclically. They will not go back to high growth rates given structural headwinds, but there is room to positively surprise over the next one year cyclically given low expectations.

Are the markets being over-optimistic on the banking sector?

The government and the (banking) regulator seem to be serious in getting this resolved and the optimism may be justified partially/selectively. We remain positive on private retail-focused banks, NBFCs specifically mortgage finance ones. We recommend a selective approach on corporate private bank lenders.