>Earnings and Sensex Target Raised (MORGAN STANLEY)

■ Earnings drivers looking in good shape: We are raising our top-down earnings estimates. Revenue growth seems to have bottomed out given our view that industrial growth is likely to recover sharply in the coming months. The strength of the recovery could bear upside depending on execution of policy reforms. The corporate sector seems to have cut costs and thus margins have
improved sharply. The macro environment (i.e., higher consumer price inflation vs. wholesale price inflation after adjusting for food prices) favors a robust rebound in margins in the coming four quarters. We think these three factors have set us up for strong earnings growth over the next 12 months.

■ Higher earnings forecast for BSE Sensex: We are revising our base-case BSE Sensex top-down earnings growth forecast from +10% and +20% in F2010 and F2011, respectively, to 15% and 23%. The consensus is expecting 5% and 20% growth for the BSE Sensex for F2010 and F2011, respectively. It is quite likely that broad market earnings growth will accelerate faster than the narrow market, as we saw in the previous cycle. We expect broad market earnings growth to average 20% and 25% in F2010 and F2011, respectively.

■ Sensex target raised: Following our earnings upgrade, we are also raising our BSE Sensex target. We have moved the target from Jun-10 to Dec-10 and increased the risk-free rate to 7.3% (reflecting the current long bond yield). The cumulative effect of these changes implies that our new BSE Sensex target is 19,400 for December 2010. Our bull-case scenario takes the Sensex well past its previous high whereas the bear case could lead it to test the post-election result close of May 18.

■ Market outlook: We reckon that Indian equities could to be in a sweet spot with low institutional ownership (coming off five-year lows), strong liquidity (policy makers are still reticent to take away stimulus), prospects of growth and earnings upgrade (indeed, we are at the start of earnings growth cycle), strong corporate balance sheets, and stable politics. Our Dec-2010 target for the Sensex suggests an upside of 13%, reflecting slower pace of gains after a stellar performance over the past six months. Our prognosis is that Indian equities could be volatile in the near term, since a lot of the next six months’ projected growth is already in the price. We believe that investors should use such volatility to buy Indian shares, since the growth outlook for the next 12-18 months remains firm and is still not priced into equities. Key factors that could determine market behavior include government policies, global markets, crude oil prices, long bond yields (reflecting fiscal position), the RBI’s exit policy (and hence liquidity), sentiment indicators (watch market breadth and momentum), equity supply, and valuations (relative valuations are moving above average levels).

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