Tuesday, April 20, 2010

>Asia: Cut duration in Korea; extend in India

• Asian central banks have started to hike policy interest rates and yield curves are bear-flattening. But that does not mean investors should stay away from medium-term local-currency bonds

• A return of policy interest rates to pre-crisis levels has been fully discounted in many markets and yields on longer-term bonds will not change much this year

• All curves are so steep that buy-and-hold positions in bonds with intermediate maturities (5Y) will outperform positions in short-term debt instruments that are rolled over

• Shorter-term tactical positions in intermediate maturities are attractive in India, the Philippines and Thailand, while short maturities are the better choice in Korea, Indonesia and Malaysia

Asian central banks have started to hike policy interest rates. Malaysia was first in the region to hike policy rates on March 4, followed by India on March 19. China, Korea and Thailand are likely to follow in 2Q. For local-currency bond markets, that means that yields will be under upward pressure and benchmark yield curves will bear-flatten.

While there is no doubt that a bear market in bonds has arrived in Asia and bond yields across the term structure will be under upward pressure, fixed income investors do not have to limit themselves to short-dated notes to limit exposure to temporary price declines over the holding period. A return of policy interest rates to precrisis levels has already been discounted and there is value in intermediate maturity local-currency government bonds despite rising short rates. Indeed, yield curves are so steep at the front end that buy-and-hold positions in government bonds with intermediate maturities will outperform positions in shorter-term debt instruments
that are rolled over.

For example, Table 1 compares investments in 5Y Asian local-currency government bonds with investments in 3Y bonds that are rolled into 2Y bonds. For the two year bond investment that starts at maturity of the 3Y bond, the table shows the yield-to-maturity necessary to achieve the same total return over five years as an investment in a 5Y bond. The comparison shows that 2Y yields in three years time would have to be 130-340bps higher than today to outperform a 5Y bond purchased today and held to maturity (column H). Such a rise in 2Y yields, which already discount rate hikes, is very unlikely. Therefore, for buy-and-hold positions, the 5Y sector on the government bond curves is more attractive than the 3Y sector.

To read the full report: INTEREST RATE STRATEGY

>ROE pick-up likely to drive re-rating (UBS)

Two themes: ROE analysis; public sector undertaking (PSU) divestment
The BSE Sensex has gained 118% since bottoming out on 9 March 2009. We examine two themes in this report: 1) Does the Sensex warrant a further re-rating based on higher ROE? 2) Will PSU divestment limit secondary market gains?

ROE analysis indicates scope for further re-rating
We expect Sensex stocks’ (ex oil & gas) ROE to expand to 17.0% (+120bp) in FY11 and to 17.7% (+66bp) in FY12. With improving ROE, we believe stocks will trade at an average 12-month forward PE of 16.3x compared with 15x currently. Coupled with our 24% and 20% earnings growth forecasts for FY11 and FY12, we raise our March 2011 Sensex target from 21,000 to 22,000.

PSU divestment unlikely to derail stock market gains
India plans to raise Rs400bn from the divestment of PSUs in FY11. We believe this target will not hamper stock market momentum because of three factors. 1) Rs311bn was raised in the last eight months of FY10. 2) We expect FII and domestic insurance company flows to continue, driven by positive momentum in data points such as quarterly GDP and earnings growth. 3) We expect insurance companies in India to invest Rs777bn in Indian equities in FY11.

UBS India model portfolio changes
We move from Underweight to Overweight infrastructure and conglomerates; from Overweight to Underweight cement; from Neutral to Underweight consumer staples; and from Overweight to Neutral petrochemicals. We increase our real estate exposure from 2% to 5%. We add Adani Enterprises, GVK Power and Infrastructure, and Housing Development & Infrastructure (HDIL), and remove Ambuja Cements, Hindustan Unilever, Hindalco Industries and Nagarjuna Construction.

To read the full report: MARKET STRATEGY


Much more in store
The Indian organized retail sector has seen both boom and bust this decade, but we think the structural growth story is back on track, with same-store growth for the sector now touching 8-9%, on our estimates. As consumer confidence has rebounded after the global recession, we are once again seeing the evolution of the vast Indian retail sector from its traditional formats to modern retail, and this process still has a long way to go, supported by rising incomes and favourable demographics. We estimate organised retail penetration is just nudging 10% this year and project 20% by 2020F, which is still significantly below current penetration levels in many other emerging Asian markets. There aren’t many large-cap listed names in organised retail at the moment, but we believe our top BUY, Pantaloon Retail (PRIL), offers quality exposure to this theme. We expect PRIL’s revenues to post a 24% CAGR over FY10E-FY12E, supporting a 48% CAGR in net income, as the benefits of scale, cost savings and improved balance sheet structure flow through. The company has also initiated a restructuring programme to focus on its core businesses, which we think should be a catalyst for the stock. We reiterate our BUY rating on Titan Industries with a raised target price, for its distinctive exposure to high-end discretionary spending.

Organised retail to witness robust growth
Industry in a transformation phase
We are Bullish on F&B category and consumer discretionary
Market leader Pantaloon Retail to be a long-term winner

To read the full report: RETAIL SECTOR

>POWER UTILITIES: Eleventh Plan Capacity addition (MOTILAL OSWAL)

■ Capacity addition of 63GW for Eleventh plan (FY08-12), plus 12GW of projects on "Best effort basis": Based on revised estimates by CEA (in February 2010), XI plan capacity addition target has been maintained at 75GW, comprising of 63GW of firm projects and 12GW of projects on "Best effort basis". This represents an achievement of 84% v/s initial targets, and is significantly higher than the 54%, 48% and 52% achievement in the Eight, Ninth and Tenth plan respectively. Also, revised capacity addition targets in XI plan are ~3x of actual capacity addition of 21GW in Tenth plan.

■ Private sector capacity addition at 36GW (v/s 11GW estimated initially), share in capacity addition at 36%: Contribution to capacity addition by private sector in XI Plan now stands at 26.7GW, v/s 10.8GW in August 2007; and share has increased from 13.7% of planned capacity addition to 35.7% currently. Central sector has lagged behind with targeted capacity addition of 25.8GW now, v/s 40GW in August 2007. Also the targeted share of the Central sector has declined from 50.7% in August 2007 to 34.4% currently.

■ NTPC leads in total capacity addition, Adani / Lanco leads amongst private sector players: As per the revised XI Plan capacity addition target, NTPC is expected to add 13.8GW of capacity including 1GW of projects on best effort basis. Adani Power is the leading private sector player with capacity addition of 6.6GW (including however 5.3GW on best effort basis). Other players with sizable capacity addition are: Lanco Infratech 3.3GW (including 133MW on best efforts basis), Sterlite Energy 2.4GW (including 1.8GW on best effort basis), NHPC (2GW), Reliance Power 1.9GW (including 1.3GW on best effort basis), Tata Power 2.9GW (including 1.6GW on best effort basis), JSW Energy 1.8GW etc.

■ Merchant capacity at 10GW+ by FY13E: Merchant capacity is expected to go up from
3.1GW in FY10E to 10GW+ by FY13E, based on the announced capacities by various players
(excluding NTPC's proposed sale of unallocated capacity on merchant basis). Players with
meaningful merchant capacities by end of FY13 inlcudes: NTPC 1.5-1.8GW, Jindal Power
1.5GW, Adani Power 1.3GW, Jaiprakash Power 1.2-1.5GW, JSW Energy 1-1.5GW, etc.

To read the full report: POWER UTILITIES


■ Good 1QCY10 results boosted by strong volumes. Castrol reported 1QCY10 net income at Rs1.17 bn (+54% yoy) in line with our estimate of Rs1.12 bn. The strong yoy jump in earnings reflects (1) higher sales at 54.6 mn litres (+20.8% yoy) and (2) higher gross realization at Rs120.1/litre versus Rs112.5/litre in 1QCY09. We maintain our REDUCE rating on Castrol noting the stock is trading 15% above our revised 12-month target price of Rs330 based on 17X CY2010E EPS.

■ Strong results led by buoyant demand
Castrol reported 1QCY10 net income at Rs1.17 bn (+45% qoq, +53.6% yoy) versus our expected
Rs1.12 bn. 1QCY10 revenues increased to Rs6.6 bn (+29% yoy) due to (1) sharply higher volumes at 54.6 mn litres versus 45.2 mn litres in 1QCY09 and (2) higher realizations at Rs120.1/litre versus Rs112.5/litre in 1QCY09. The strong yoy growth in volumes reflects (1) pick-up in demand and (2) low base. We highlight that qoq results comparison is not valid due to seasonality; 2Q and 4Q in a calendar year are the best quarters.

■ Retain REDUCE given rich valuations and strong outperformance
We reiterate our REDUCE rating on Castrol stock noting that (1) the stock is trading 15% above
our revised 12-month target price of Rs330 based on 17X CY2010E EPS and (2) recent strong
outperformance. Castrol stock has rallied 24.5% in the past three months versus the BSE-30
Index’s modest 0.3% rise over the same period. We believe that the stock provides unfavorable
risk-reward balance at current levels and would advise investors to book profits and wait for better opportunities at lower levels to get back in.

■ Fine-tuned earnings and target price to Rs330 (Rs320 previously)
We have fine-tuned our CY2010E and CY2011E EPS estimates to Rs19.6 and Rs20.6 from Rs19.9 and Rs20.3 to reflect (1) higher volume growth (+ve impact), (2) stronger rupee (+ve impact), (3) higher LOBS prices (-ve impact), (4) lower employee costs (+ve impact) and (5) CY2009 annual report. Key upside risks stem from (1) lower-than-expected LOBS prices, (2) better-than-expected recovery in demand and (3) stronger-than-expected rupee. We also note that the stock has historically traded in a P/E band of 14-18X (see Exhibit 2). Thus, we do not rule out the stock trading at a higher multiple given strong liquidity in the market.

To read the full report: CASTROL INDIA

>Low-risk, High-return Strategy (MORGAN STANLEY)

Key Debate: We believe that Indian equities are likely to return positively in 2010. However, the rate of return is likely to slow over the 2009 levels In that context, stock picking is likely to be the key to portfolio returns. Are there some obvious candidates for an India portfolio?

Stock picking is working: The influence of macro in determining the behavior of stocks best measured by the correlation of returns from individual stocks (market effect) with the market has been declining since its peak in May 2009. Conversely, the average relative volatility of the stocks in our coverage universe has risen from a decade low. This is growing evidence that stock picking is in vogue. The fall in market effect tells us that individual stocks are being influenced less by market performance-related factors and more by idiosyncratic or non-market performance-related issues. We expect this phenomena to continue for the rest of 2010.

Trading beta may not be a panacea for making money…: With an upward biased market, one of the seemingly obvious ways to add portfolio performance would be to buy high beta stocks. However, high beta stocks come with high risk. Indeed, the work that we have done on our
coverage universe shows that low beta portfolios outperform the market over longer time frames. Why does this happen? We went back to 1994 using MS coverage as our data set. We constructed portfolios using the top and bottom quintile of beta. The portfolios are reset every month and we captured the equal-weighted 12-month forward returns of these two portfolios. The low beta portfolio has, on a cumulative basis, outperformed the high beta portfolio. Fundamentally this is because high beta stocks are implicitly stocks with a high hurdle rate and hence need a bigger cash flow surprise to perform whereas low beta portfolios have the opposite situation. Technically speaking, for a given beta, correlation with market returns could still be high (and hence relative volatility is lower) and hence it is not necessary for a low beta stock to underperform in a rising market. At market inflexion points, these portfolios tend to have extreme performance, i.e., when the market is turning from bearish to bullish the high beta portfolio outperforms low beta significantly and vice versa. However, in trending markets, the low beta portfolio does better most of the time. Of course, the practical difficulty with beta persists, which is that computed beta is backward looking and a constantly changing number and remains a challenge to beta-based portfolio construction.

…but there is an interesting angle: We know that beta is a measure of systematic or market-related risks, i.e., risks that cannot be diversified away. Systematic risks are caused by socioeconomic and political events that affect the returns of all stocks, and beta is an estimate of how the returns from a stock will move relative to the return from the market. Mathematically speaking, beta is the product of the correlation of returns between a stock and the market and the relative volatility of the stock to the market. For a relative investor who is bullish, it could be argued that a low risk (and we take the liberty of equating volatility with risk here) is achieved in low volatility of the portfolio and, thus, low beta stocks with low relative volatility are the best options since they come with a higher return correlation. However, such stocks could fall/rise in line with or more than the market, and such a strategy could lead to outperformance even if it means lower volatility in portfolio performance. Hence, for bullish investors, within a low beta set, we think stocks with low relative volatility should be choices in the pursuit of better relative returns.

Market Implications: Using our coverage universe and trailing 12M beta and its components, we derive a short list of stocks we believe could be outperformers in a rising market using the above logic (i.e., low beta and low relative volatility stocks).

To read the full report: INDIA STRATEGY