Despite high valuations, some stocks to gain

Despite high valuations, some stocks to gain

The Indian markets are seeing euphoric times. In September, the Nifty crossed the landmark 6,000 and the Sensex breached 20,000 levels, last seen 32 months ago in January 2008.

The markets are valued at 16 times estimated FY12 earnings, at a premium to other emerging markets.

Since the start of the calendar year, the foreign institutional investment (FII) inflow stands at over $19 billion, the highest ever so far. The euphoria is also spreading to the primary markets. It is likely to end up as the year of highest domestic fund-raising in the primary markets. Technical indicators such as traded volumes and open interest are significantly higher compared with the last market peak of January 2008. What should be the investment strategy in these euphoric times? We address this critical question by a multipronged approach to assess markets: Top-down analysis: Growth is back and the major drivers are in place. While official pronouncements of FY11 gross domestic product growth are being revised upwards, we are optimistic of growth being close to the potential at 9%.

 

A good monsoon has raised expectations of a bumper crop in FY11 and the broader agricultural growth is likely to turn up to 3.8%. Industry is riding on a capital expenditure boom to clock 10.3% growth (estimates for FY11). The service sector is also likely to emerge from a slowdown to register a growth of 9.7%. Our optimism stems from the fact that the investment cycle is still at play and the government has continued to support the economy. We have also seen private consumption recovering in the first quarter of FY11. Besides, interest rates and policy environment would remain largely supportive; no major concern is likely to emanate from the inflationary situation and higher trade deficit.

 

Bottom-up analysis: Despite rich valuations overall, specific large-cap stocks in highgrowth sectors still hold the potential to deliver steady returns over the next two years.

In autos, we like Mahindra and Mahindra Ltd, Tata Motors Ltd and Maruti Suzuki India Ltd.

We prefer State Bank of India, Punjab National Bank, Bank of Baroda and Canara Bank among state-owned banks, and ICICI Bank Ltd among private sector banks. In the engineering space, we like Bharat Heavy Electricals Ltd, Larsen and Toubro Ltd and Siemens Ltd. Infosys Technologies Ltd and HCL Technologies Ltd are our key ideas in the information technology sector.

 

In metals, we like JSW Steel Ltd and Sterlite Industries India Ltd. Among utilities, we like NTPC Ltd and Power Grid Corp. of India Ltd.

 

In the real estate space, our top picks are DLF Ltd and Unitech Ltd. Read on, as we have listed the outlook on the various sectors and the growth drivers.

 

Earnings analysis: In the second half of FY11, we expect Sensex earnings growth of 22% against 25% in the first half.

 

Moderation in the second half is due to a higher base (since recovery in corporate earnings commenced in the third quarter of FY10). Sensex earnings growth would be 20% excluding the swing of Tata Motors and Tata Steel Ltd. In the first half of FY11, it was 5%.

For FY12, we estimate Sensex earnings growth at 18% and expect Sensex earnings per share (EPS) of `1,259 (`1,068 estimated in FY11).

 

Valuation analysis: Sensex valuations in terms of priceearnings are at a 10% premium to the historical 10-year longterm average at 15.8 times estimated FY12 EPS. In terms of price-to-book value, valuations are at a 15% premium at 2.9 times estimated FY12 book value, with return on equity at 17.8% (lower than the longterm average of 18.7%). While the valuations are not excessive, we believe that the data points matter--more so in the event of market extremes.

Some sectors such as stateowned banks, private sector banks, fast moving consumer goods, metals, telecom trade at meaningful premiums to the long-term average.

 

Sectors such as auto, cement, engineering, pharmaceuticals, utilities trade at similar levels to the long-term averages.

Our view At the levels of 20,000 Sensex and 6,000 Nifty, India is an interesting bottom-up market. Despite rich valuations overall, specific large-cap stocks in high-growth sectors still hold the potential to deliver steady returns for the next two-three years.

 

Excerpts from a report on Indian markets by Motilal Oswal.