The Hindu Business Line : Bottom-fishing in the index heavyweights

Investors rattled by the recent market upheaval will probably be obsessed with the downside risks to investing. However, if you are a long-term, patient investor betting on the India growth story, now is the time to bottom-fish and diversify across select index heavyweights — Sensex or Nifty (and, to some extent, Nifty Junior).

As long as investors can temper their annual return expectations to 12-15 per cent and ignore the short-term market momentum, the valuations are compelling.

We believe that the underlying fundamentals of the India Inc. story are intact. Three key assumptions underpin this view:

Subject to the country getting its infrastructure act together, the GDP growth trajectory is likely to remain in the 7-8 per cent bracket for the next couple of years. If this happens, the average earnings growth for the index constituents, at double the GDP growth rate, will be in sustainable. Though the Sensex PEM (price earnings multiple) at 19 (down from 22.2 on May 10) remains somewhat stretched, the high return on equity (RoE) of over 20 per cent suggests that select heavyweights may sustain growth rates of over 15 per cent.

The infrastructure, manufacturing and consumption sectors still rest on solid ground. Investors may be better off playing the stocks with a domestic growth story.

Though real interest rates have been creeping up fuelled by a domestic investment boom and in tune with global tightening, the impact on equity values will not be significant as long as they are contained within 1-1.5 percentage points. Given India's high RoE, the domestic heavyweights are better insulated than their global peers.

Investors, however, will have to monitor three key elements to keep a tab on the market direction:

Foreign Institutional Investors have pulled out over Rs 7,000 crore in May. However, if the FII flows are still negative for the next week to ten days, the ability of mutual funds/domestic institutions to shore up the market will be put to test.

Watch the capex cycle closely to ensure that earnings growth is in sync with the rise in capital investments. If regulatory or policy intervention increases over the next few months, like the recent moves on reservation, it is likely to stall the significant progress that has taken place on the reforms front over the past few years

Playing the themes

In this backdrop, we have evaluated three broad investment themes (excluding global cyclicals) and chosen our favourite picks for investors with a medium term outlook:

Regulatory/policy related

Infrastructure

Key investment triggers

There has been a marked rise in tendering activity, especially in the road, power and water segments over the past 12 months. Order-books of most companies in the sector stand at 4-6 times their latest revenues. Improved financing from government and other world bodies is likely to ensure that funding is no longer a constraint. The ability of companies to ramp up the equity base has also lead to increased participation and the success of business models such as the BOT in road, irrigation, and the oil and gas space.

High interest rates could have an impact on the bottomline as the industry operates on high short-term borrowings.

Execution capability and ability to sustain margins in the face of a rebound in prices of key raw materials will set apart well-managed companies from the rest. For companies with major orders from the Government any delay in project execution due to policy issues may stall revenue growth.

Favourite picks: Larsen & Toubro and IVRCL Infrastructures

Capital goods

Key investment triggers

Oil exploration, pick-up in mining activity, airport modernisation and port development are likely to broadbase the infrastructure growth story, restricted so far to power and roads.

Large-scale capex plans are coming in from auto/auto-ancillary and metals. These expansion plans will be executed over the next two-three years, and are expected to lead to a good flow of orders for industrial equipment.

Even if metal prices remain stable, the ability of capital goods manufacturers to pass on the price hikes puts them on a strong footing.

Favourite picks: BHEL.

Oil and gas

Key investment triggers

The Government's procrastination over raising retail fuel prices continues to haunt the refining companies Indian Oil, Bharat Petroleum and Hindustan Petroleum. It is best to stay away from the stocks of the three refining and marketing companies for now but they bear close watching because a further drop in their valuations could bring them down to attractive price levels.

With refining margins also plateauing, the outlook for standalone refining companies, such as Kochi Refineries, Chennai Petroleum and MRPL, also appears cloudy.

Upstream major ONGC has yet to get the fire-damaged Bombay High North platform fully operational and it is also paying a stiff subsidy share to the refining companies. Assuming that the same subsidy-sharing pattern as last year is adopted for the current fiscal, ONGC may report only an average financial performance in the first quarter.

Interest-rate sensitive

Automobiles

Key investment triggers

The cut in excise duty for small cars in the latest Budget provided the right acceleration to the auto sector; however, the rise in financing costs has been a dampener on demand pick-up in passenger vehicles.

New product launches will hog a lot of attention and boost buying activity within the sector. Maruti Udyog will launch a replacement for the ageing Zen later this year and a new diesel engine by the first quarter of 2007. In the two-wheeler category, Bajaj Auto has a more well-defined product strategy for the year ahead and will continue to eat into the market share of market leader, Hero Honda.

In commercial vehicles, the buoyancy in freight movement will neutralise the impact of rate hikes to some extent. The monsoon will, again, hold the key to overall sales trends. Given the uncertainty on interest rates and the monsoon picture, we shall make our recommendations in the coming weeks.

Defensive

Software

Key investment triggers

The revenue momentum is unlikely to slacken, even if the US economy shows signs of a slowdown, as offshore has truly gone mainstream.

As most companies have managed to broaden their portfolio of offerings, they have great flexibility in capitalising on the sharp rise in discretionary spends.

Client pipeline of top-rung companies is strong and large deals can comfortably add to this cushion. Wage inflation and attrition will, however, remain cause for concern.

FMCG

Key investment triggers

FMCG companies will be among the least susceptible to interest rate hikes, given their rich cash resources and low debt levels.

The return of pricing power will allow companies to pass on input cost hikes to the customer to a greater degree.

Companies that have a wide portfolio of brands will be a better choice as pressures in one category would be offset by strong performance in another.

Favourite pick: Hindustan Lever

Global cyclicals

Metals

Key investment triggers

The last fortnight's turbulence in the non-ferrous metals space, led by copper at the global level, has taken a toll on stocks such as Hindalco, Sterlite Industries, National Aluminium and Hindustan Zinc. Though internationally metals such as copper and zinc have staged a recovery over the past week, the choppiness seems set to continue. The market players will continue to watch the commodity fund positions built up, especially in copper, where prices have nearly doubled from January 2006. Investors may be better off taking a call on Hindalco or Sterlite once the metals market stabilises.

The Hindustan Zinc stock, which too has been riding on high international zinc prices, has corrected sharply from the highs touched earlier this month. Investors may consider taking exposure in small lots.

Steel prices, which have staged a recovery in the past couple of months, are likely to remain firm, aided to some extent by the ongoing consolidation in the global steel industry. Considering the potentially high demand emerging from domestic infrastructure, ongoing expansion, captive access to raw materials and recent acquisitions, Tata Steel remains a good investment with a medium-term perspective.

Favourite pick: Tata Steel