Micro-investment case
The macro narrative in the current calendar year (CY2015) was one of softening inflation and weak growth. The credit cycle remained difficult. Earnings expectations had to be consistently cut. Into the next calendar year (CY2016), we expect a modest recovery driven early cycle by better margins–aided by lower input and interest costs–and subsequently a volume recovery. Government led investment spending and urban consumption are likely to lead with private sector investments and rural consumption lagging. The policy environment remains mixed. The government has done a fair bit to improve the investment environment. But it remains constrained on reforms requiring legislative action, as they lack numbers in the Upper House of Parliament. Progress herein will be a pre-requisite for valuations to expand further. The broad market currently trades at 17x one-year forward earnings–one standard deviation higher than the historic mean.
Will EPS downgrades end in 2016?
Current earnings growth expectations of 11% for FY16e (estimates) and 20% for FY17e appear frothy in relation to the macro backdrop. Earnings have been flat over the first half of 2016. We expect the earnings downgrade cycle to continue for another quarter or two. Consumer Discretionary, Industrials and Materials sectors appear particularly vulnerable. We expect 6% earnings growth for FY16e and 15% for FY17e.
Drivers, trends, and datapoints we are tracking
The most important indicators to track, in our view, are:
(i) Revival in capex cycle (ii) Inflation trajectory and deviation from the RBI’s glide path (iii) Government sticking to the fiscal consolidation target. Also, progress on important factor market reforms—Taxation (GST), Land and Labour—would have an important bearing on sentiment and valuations.
Rationale behind our stock picks
We prefer to participate in the potential economic recovery through high quality financials with a solid capital and liability franchise—HDFC Bank and Kotak. The government’s early cycle investment priorities should aid the Cement sector. Lower global energy prices should benefit both the Cement and downstream Energy sectors. Ultratech and BPCL should be key beneficiaries. Infosys is likely to benefit from the revival in the US growth momentum and a strengthening USD. The new management’s strategy and initial delivery have been encouraging.
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