Tuesday, May 29, 2012

>STRATEGY: The flipside of policy inertia – rising FCF yields

  Sensex PER valuations belie the bottom-up pain. Though Sensex PER (12.5-13.0x) seemingly has more downside given (1) FY12-14E earnings CAGR of only 12%, (2) the still negative spread of earnings yield vs. risk free rate and (3) avg. Sensex PER of 11.5x during the GFC, we expect the rising FCF yields (focus of this report) to begin supporting valuations. The top-down market PER, however, has been supported by the increased weights in FMCG, IT and Pharma and the sustained premiums thereof, thus understating the severe de-rating in other sectors. It is also interesting to note that the India weight in benchmarked funds relative to MSCI EM has remained stable at an Overweight of ~1% during the past two years. Even the absolute India weight has declined only 190bps from the peak of 9.5% two years ago, suggesting significant sector rotation even as relative Over/Underweight has been stable.

  FCF yield at 2SD to provide downside support, identify stocks. Meanwhile, the flip-side of the collapse in the capex cycle is the rising FCF yields; the Sensex fwd FCF yield is now at 4.5%, higher than 2008-09 levels and almost at 2SD. We believe this could provide material downside support to market valuations notwithstanding the regulatory/policy overhangs. Continuing with our thesis, we map stocks based on the (1) FCF yield (FY13/14E avg.) and (2) the delta in FY13/14E yield vis-à-vis FY12. Stocks that stand out on both parameters are Apollo, Cairn, HZL, Crompton, M&M and TAMO. Stocks with high FCF yields but low deltas are HCLT, Ambuja, ACC, Infy, Bajaj Auto and BHEL. In the model portfolio, we reduce Staples to UW from EW and increase weight on Industrials (OW vs. EW), Financials (EW vs. UW, mainly through PSU banks) and Energy (Reliance). We also reduce weights in Pharma/Healthcare and Materials.

  FY12-14E earnings CAGR of 12% below nominal GDP growth now: Meanwhile, earnings have continued to slide – Sensex FY13/14E EPS stands at Rs1,216/1,338 (Rs1,247/1,372 in end-Feb). We don’t see too much further downside as margin expectations are low and gains from a weak rupee will start flowing through FY13 earnings. The Earnings Revision Index (ERI) for India has also declined from -0.5 in Sep-11 to -0.1 and has been stable in the past 3 months.

  Top picks: ACC, HCL Tech, DLF, ICICI Bank, Dr. Reddy’s. We replace Cipla with Dr. Reddy’s and drop HUVR, Tata Motors and Bharti from the top picks. Top Midcap Picks: Apollo, PLNG, Adani Ports, Sobha, YES Bank.

To read report in detail: INDIA STRATEGY