Sensex can touch 23,000 mark by December 2013: Saurabh Mukherjea

Interview with CEO - Institutional equities, Ambit Capital

Saurabh Mukherjea, CEO - Institutional equities at Ambit Capital, remains optimistic on the markets given the pick up in Indian economy and easing rate environment. In conversation with Sheetal Agarwal, he says that now is the time to add some cyclical stocks to one's portfolio. Edited Excerpts:

Where are the markets headed?

In the last three months, US bond yields have risen quite steadily, suggesting that bond prices are falling, which in turn suggests that the migration from bonds to equities has begun. First leg of the rotation trade is for western fund managers to buy their own cyclicals and second leg of the rotation trade is for them to buy a market like ours. We are in the second leg of that rotation trade. My read is that our long-standing Sensex 23,000 target for the year-end holds through thick and thin. I think the positive momentum in Indian market will sustain till the elections.

Has economic growth picked up in the past few months?

I think it is becoming relatively clear that Indian economy is recovering. Whether you look at consumption, investment, government expenditure, net exports - to varying degrees each aspect is recovering. For the March 2013 quarter, volume growth was strong for consumer staples, electricals. Companies like Bluestar and Voltas are reporting record surges in sales this summer compared to last summer.

In two-wheelers we have seen the de-growth stop while that in passenger cars and CVs will stop once economy recovers further. So I think the consumption picture has improved materially in the last 3-4 months.  Going by the government’s budget estimates for FY14, there will be a very sharp jump in government spending this year as it is a pre-election year.

On investment, the picture is mixed. There are three building blocks of investment if you use the CSO data. First is construction activity which has picked up in the last six months. Residential construction launches are somewhere between a 3-5 year high and that in turn is corroborated by the amount of lending the banks are doing vis-à-vis home loans. As rates have come off, banks have become very keen to lend and have pushed home loan mortgages to grow their businesses.

Light industrial investment activity by companies such as Maruti, Hero, Cummins India is continuing. Heavy industrial investments done by mining sector, power generators, transmission and distribution companies will be muted till election. However, I think we will see a pick-up in investment growth from 3-4% in FY13 to 6-6.5% in FY14.

The only source of concern is the net exports situation. The current account deficit (CAD) situation was bad at 6.8% in Q3 and is expected to worsen in Q4 at a negative 6% CAD. While FY13 GDP growth is estimated to be around 5%, I think that metric will inch up to atleast 6% in FY14. India’s gold import volumes remain high despite rising import duties. And the only way I think this can be allayed is through tangible announcements from the government on the FDI front. So if FDI in Insurance, Banking sectors is pushed through, that could lead to some degree of investor concern on this area being addressed.

What is your view on FII flows in emerging markets?

There is increasing skepticism about commodity-exporting emerging markets such as Brazil, Russia and Indonesia to some extent. Because the Chinese economy seems to be stagnant at around the 6-7% growth, the rampant demand for commodities that we had seen has disappeared. That in turn means commodity prices are structurally trending downwards. So if you look at the emerging market landscape, we are the only large emerging market where the domestic demand fundamentals are decent because we are a commodity importer rather than a commodity exporter. So there are two reallocations – one from bonds to equities generally and the second is away from commodity exporting emerging markets to commodity importing markets like India. Both of these will be very constructive for us.

How much rate cuts do you expect going forward?

Our view till a couple of months ago was that beyond the 75 basis points of rate cuts that have happened, RBI can cut about 75 basis point more at best. Even if commodity prices don’t trend downwards and hover at current levels, I think the scope for rate cutting goes up to something like 120 basis points. If commodity prices trend downwards, I think it goes up from 120 to 150 for 2013.

How do you play these markets?

In the last two years every quarter, we publish a good and clean portfolio of 50 stocks. And pretty much every quarter, we have outperformed the BSE 500 by around 2-2.5%. Now, the whole premise for good and clean was because these are difficult economic times, you want to invest in clean companies where the governance is clean, the accounts are clean, companies are not connected to politicians and so on. These are well managed companies having strong balance sheets. Our investment strategy between now and the elections is to say that lets focus on cyclicals more aggressively. So take our set of good and clean companies, and focus on a tighter group say 30 of them which are more cyclically oriented.

As investors get more confidence that this economy is recovering albeit at a slow pace, they will start throttling out of FMCG, pharma and IT and they will start looking for more cyclically oriented sectors. But in the cyclically oriented sectors we are saying that don’t go for weaker companies with broken balance sheets. Go for quality plays. So for example construction I think is a well-placed sector and I like stocks such as L&T or a Sadbhav Engineering in the midcap space.

I think Auto sector would rally very strongly. If you really want to play the auto recovery theme, its worth looking at a company like Bajaj Auto, Exide industries. The fourth sector I would say worth looking at very closely is oil and gas. There are a variety of political and election-linked reasons as to why oil and gas related reforms will continue. And the straight forward play on that remains ONGC because it benefits from higher APM gas prices as 50% of ONGC’s revenues is gas. Secondly, as they keep decontrolling the diesel prices, the under recovery reduces and the burden on ONGC therefore goes down. So that’s how we would play the recovery.

Your view on the banking sector?

I am underweight on Banking sector. There is a great deal of trouble coming for the BFSI sector. Part of it is the well-known issues around credit quality. But I think part of it is this whole investigation around KYC, third party financial products. Our reading is that this is a very serious investigation. Fee income has been a disproportionate driver for private sectors banks’ return on assets ratios and I think that aspect will come under fairly severe pressure in the coming few months.  Our country has too many insurers and I think over the next couple of years, some of these smaller insurers will exit the market. Many of the private sector banks distribute for these smaller insurers and they make very hefty sums of money distributing insurance products for the smaller insurers. For some of the private sector banks, as much as a fifth of their RoAs comes from these distribution linked rewards that they get. So leaving aside anything that the regulator might or might not do, I think these free market forces will result in the whole third party distribution rewards being throttled back. The bigger insurance players such as SBI, ICICI, HDFC, Max will sustain. Smaller players will exit and so will general insurers. Only Half a dozen substantial insurers will get FDI.

Which sector you think will be the next outperformer?

I think real estate is a sector really worth looking at. I think investors should remember that real estate accounts for 10% of our GDP and less than half a per cent of our market cap. And that disconnect is not sustainable. I am pretty confident that in the next few years a new generation of real estate companies will come through which will be well managed, generate cash, launch properties regularly, have good accounting standards and will be able to scale up their businesses. So companies such as Sobha Developers, Prestige Estates, Oberoi realty are worth looking at.

Are earnings downgrades over?

Our FY14 Sensex earnings growth is around 10-11%. But, I think consensus went through this bizzare bout of euphoria half way through FY13, where they expected FY14 earnings growth to be 14-15%. The consensus FY14 Sensex EPS figure still has something like 12-13% FY14 EPS growth built into it and I think that will come down to 10-11%. So, you could say that there is probably 100-150 bps of Sensex EPS downgrades left which are yet to come through.