ET NowET Now: The markets have scaled 7900 this week and consolidation seems to emerge as the new norm. Where do we go from here?
Sanjeev Prasad: We will have to see how the momentum of reforms pans out going forward. There has been a fair bit of progress on the fiscal reforms side where some discussions on GST have taken place. Hopefully, cash transfer schemes will get implemented as well and fuel subsidies will now be gradually reduced. Moreover, there is a fair bit of work being done on the investment side, although it is less visible compared to the other big bang announcements.
As of now, I assume the market will be range-bound for the time being, since valuations are at the upper end of the historical trading band. The BSE 30 index on a 12-month trading forward basis is already at about 15.5 times, which is not very different from the historical band of 12.5 to 16-16.5 times. Therefore, the markets are clearly at the upper end of the trading band.
Having said that, if more reforms are brought about going forward and if in the first quarter of the next year, we see a rate cut, then that could provide another impetus to the market. However, for the time being, the scope for re-rating looks a little difficult, since most of the stocks have gone up significantly without any meaningful change in fundamentals or any meaningful upgrades to earnings so far.
ET Now: What explains the underlying appetite of foreign and domestic investors, even when there are no triggers?
Sanjeev Prasad: Clearly, investors now look at India as a 5 to 10-year-long story and not so much as the next quarter investment play. Therefore, the focus has now shifted to the right combination of forces working for India. Obviously, the long-term story seems favourable with income levels rising and with a government that can catalyse India’s potential over a period of time.
So, even though nothing may change immediately in terms of investment, but two-three quarters down the line, when the government fixes some of the building blocks like more transparent or faster approval processes and allocation of resources or some changes in the labour policies, the GDP could accelerate from fiscal 2016. I would not be too surprised to see GDP around 6%, 6.5% for 2016 and maybe 7% from 2017.
Since the fiscal side reforms are intact, hence the fiscal deficit could shrink to a range of 3% to 3.5% by 2017, assuming GST gets implemented. Fuel subsidies are anyway under control now and hopefully, the cash transfer schemes would also be implemented, so as to cut leakages in the distribution of subsidies. Therefore, in the longer term, the India story holds a promising hope for a higher GDP growth, which could translate into higher earning numbers over a period of time.
Secondly, with fiscal deficit coming down, the RBI will have more flexibility to act on the monetary side, which could bring down the cost of capital in the medium term. This is also what investors are expecting as a move in the right direction, with respect to both earnings increase and the cost of capital coming down over a period of time.
ET Now: Is it time to profit-take or the best strategy would be to ride the wave, waiting for the recovery and the significant gains that the market may see eventually?
Sanjeev Prasad: In my opinion, there is no point trying to be too cute about things. You should just stay invested for the medium-term story and if at all there is any correction, then put equivalent money into the equities market. Maybe things could slow down a little bit, if the market remains stagnant for the next few months, unless and until there is a big acceleration of reforms going forward. There could be an announcement from the government regarding the right-pricing for gas or there could be one on the right policy framework for sharing of subsidies. These could be triggers for government-owned PSU companies. Though they have done well, but there can be some more leg to go there.
Therefore, if some of the reforms start coming through, then it will be a push for the markets to start doing well. There is still a lot of value in the PSU banks and stocks are still undervalued. If the government can fix underlying challenges in the power, roads, steel and telecom sectors over a period of time, then maybe there could be some re-rating of these stocks too. Obviously, there is a lot of talk about restructuring the PSU banks over a period of time. So it is contingent with reforms over the next six months.
If you do not see visible reforms, I assume the market will hover in the current range for some time. However, since investors have bought into the long-term story in India, any correction would more be an excuse to buy into India.
ET Now: As a house you have been bullish on autos and it appears that the auto stocks are in a sweet spot, given the dispatch numbers.
Sanjeev Prasad: Yes, we continue to be positive on the auto pack, since it should obviously benefit from an economic recovery, given the fact that the volumes have been recently flat over the last three-four years, at least for the passenger vehicles. Even the two wheelers have not grown as much and penetration levels in India were very low. Therefore, as and when the economic pace gathers momentum, there will be new job creation and clearly automobile consumption will increase in India.
Although I would say that the valuations are a bit on the higher side, but not in the context of the huge opportunity which lies in the auto space for the next 5-10 years. Even though most of the stocks are trading at, say, about 14 to 15 times on earnings basis, which is somewhat on the higher side of the historical trading band, we remain comfortable, given the fact that volumes, whenever they start recovering, can always surprise on the upside.
We are positive on Tata Motors which is not so much a domestic play. It has big volume momentum coming in 2016 when it launches new products, especially the small Jaguar and the various variants of the Range Rover model.
ET Now: What is your view on the entire PSU banking pack, amidst all the concerns about asset quality and some scam news as well? Does this sector find favour with you?
Sanjeev Prasad: I am in the wait and watch camp as far as the PSU banks are concerned, although the RBI and government are focusing on to fixing the problems in the PSU banks. There is a proposal from the PJ Nayak Committee which the government wants to implement and which will hopefully correct some of the issues that have been pulling down the performance of these banks - with respect to the terms of the management and its appointment, the whole governance issue and lending practices.
But having said that, in the more immediate term, of say, the next one or two years, I am very worried about the NPL problem which continues to plague the PSU banks. Some of the data points as of now indicate that 10% of the assets of the banking sector in general are impaired on the higher side.
What worries me even more is that the problems from sectors such as power, steel and telecom have not surfaced as yet. There are several companies in these sectors that will default in the next one or two years. It’s difficult to imagine how the PSU banks will continue to stay out of trouble. SBI claims to have only about 0.9% of loans in the power sector as NPLs as of now. We all know about the problems in the power sector and clearly 0.9% is a very low number compared to that. Given the problems on generation and distribution side, many of these newly-commissioned projects will get into trouble, unless and until the government can fix those problems in the next one to two years.
Even in the steel sector, most of the smaller companies are already under CDR and I would not be surprised to see some of the larger entities probably getting into trouble in the near future, unless and until suddenly there is a lot of activity on allocation of mines - be it steel or coal blocks - although I see no reason why the government should be so beneficial to these companies.
Similarly, in the telecom, there are at least two-three companies sitting on massive amounts of debts and virtually no EBITDA to speak of. Some of them can be bailed out by their parent companies, but at least one or two would get in trouble. Therefore, my worry is whatever the NPLs that have come out in the open from sectors such as agriculture, aviation, textiles and some smaller pharma companies or some smaller steel companies, there are still bigger elephants yet to get into trouble. Seeing the balance sheet many of these companies, it is amply clear that they will get into trouble unless and until there is a considerate effort by the government and the banking system to address the problems and the underlying challenges.
Sanjeev Prasad: Let us keep in mind that the market is already up about 25% on an year to date basis. Therefore, the bulk of the appreciation is probably already there. However, there is no reason to sell the market. It may look slightly on the higher side at this point in time, but investors should look at the long-term growth potential in India and stay invested to participate in that. Maybe in the second half of this year, there will not be much return, but that is fine since investors have already made about 25-26% from the beginning of the year. Do not expect that to repeat in the second half also.
Hence, my strategy would be to stay invested and see how the reforms process plays out. I am positive that over the next six months. There will be a lot of announcements as far as reforms are concerned, since a lot of activity is happening in the background which probably gets missed by investors.
ET Now: Now with the crude cool off, there are questions being raised if diesel deregulation is imminent. Moreover, the stock prices are mighty excited of late. What is your view on the oil and gas space?
Sanjeev Prasad: The stock prices, to a large extent, are discounting benefits from lower subsidies. So far, the government has still not announced a proper subsidy sharing mechanism, but the overall fact is that subsidies have declined significantly. For last year, the total under recovery was about Rs 1.43 trillion and the same for this year - the second half annualised number - would be somewhere in the low Rs 700 billion range. Therefore, effectively, between 2014 and 2016, Rs 700 billion have been saved as far as under recoveries are concerned. Now the key question is what it would mean for the companies - whether the government will change the subsidy sharing formula it has historically followed?
As for the upstream companies, the $56 per barrel discount that they have been paying makes no sense in the current context. Maybe that number has to be brought down and I assume in the next one or two months, we will see a proper formula being put in. Maybe the normalization for upstream companies goes up to somewhere about $60, which makes sense for the upstream companies, to do larger amounts of reinvestment in their core business.
The downstream companies, including GAIL, had an overall under recovery of about Rs 40 billion. When the government will save about Rs 700 billion in two years’ time, I see no reason why the downstream companies should continue bear the burden of these Rs 40 billion. If this gets sorted out, then the earning numbers of these companies would get a significant boost. The earnings numbers of a company like BPCL on a more normalised basis, that is taking out all the under recovery for the next year, then we are looking at about Rs 52-53 of EPS. Given a multiple of let’s say 9 or 10 times, you are looking at about Rs 450-500 as the core value of the marketing business at about Rs 300 as the value of the investments in E&P and some of the gas businesses. You are looking at a stock which is more like Rs 750-800 in terms of fair value. The same math would apply to HPCL and IOC also. GAIL should also theoretically benefit quite significantly from lower subsidies. Last year, the EPS in fact was about Rs 10 and hopefully, that will go down to zero.
ET Now: Do you think in the next one year HDFC Bank will make more money or SBI will make more money?
Sanjeev Prasad: It is a difficult one, but if the government can solve all the problems, then it is SBI. However, even HDFC Bank will give you about 12 to 15% return from where we are today.
ET Now: So you will not be surprised if the markets give a 15% return in the next one year - is that reasonable to expect?
Sanjeev Prasad: We expect about 13.5% earnings growth. So, if the multiple holds off, about 15% upside can be expected. The important thing is to see the dollar response going forward. For countries like Mexico or the Philippines, which are in similar bracket in a sense, investors are betting the right combination of political reforms as also the right government and demographics, leading to much stronger GDP growth over a period of time. These markets are trading at about 17-18 times on calendar 2015 basis. Whereas India, on a calendar 2015, would be somewhere about 14.8-14.9. So that is the rerating game which we can play if we get the reforms process right over the six-seven months.
Sanjeev Prasad: The investment cycle will probably take some time to take off. The cap goods and the asset owners will be the late cycle plays. The problem is that the valuations have become stretched now since the market had discounted a fair bit of recovery in the investment cycle going forward. It could be that maybe the recovery will happen two to four quarters down the line compared to may be what the markets has already factoring in.
The other problem is that there is no guarantee that all the companies will participate in the investment cycle. Now, investors must ask themselves questions like who gets the orders at what margins and whether a lot of overseas companies will be willing to compete aggressively. Since, a lot of orders going forward will be done by Japanese companies, so orders could go to Japanese construction companies. You could see Korean contractors getting more excited about India. Therefore, we will have to see how the dynamics in terms of demand-supply play out.
Thirdly, there are not as many quality companies in India when it comes to the infrastructure or cap goods space. I would stay clear of many of the asset owners. Although industrial companies are better, but many of them are still trading at pretty high valuations.
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