We identify three macro and six portfolio themes for 2016.

Macro Theme 1: India outperformed its peer group in 2015. Notwithstanding high valuations and positioning, India’s low correlations in a world with low returns as forecast by our macro teams implies India could continue this outperformance in 2016. With other asset classes looking dreary, India’s domestic liquidity super cycle should gain pace in 2016.

Macro Theme 2: The key to performance could be a turn in earnings cycle, which is delayed due to a combination of sluggish global growth, tight fiscal policy in the early part of the year and PPI deflation. Our macro models point to double-digit growth, and the base effect is distinctly favourable, although we must quickly add that we held an optimistic view on earnings at the start of 2015 too.

Macro Theme 3: We expect policy makers in India to be fairly active in 2016, with the focus on building infrastructure, changing India’s age-old tax regime and lowering nominal interest rates further among other things.

Thus, fundamentally the case for India’s outperformance is supported by policy momentum, stronger relative earnings growth, falling interest rates relative to the US Fed and potential flow of robust domestic savings into equities.

Portfolio Themes: A strong US$, revival in rural consumption to add to the nascent recovery in urban consumption, infrastructure spending, GST plays and rate sensitives are the central themes embedded in our recommended lists.

In addition, we look for correlations across stocks, which have persisted at low levels contrary to our expectation that they would rise. A rise will signal a major macro trade away from the stock-picking approach that has worked very well for portfolio managers over the past two years. We also see continuing shift away from quality, as seen in the past three months into growth and cyclicals. Our portfolio approach, therefore, is to keep wide sector positions with a GARP-oriented stock-picking strategy. Our Dec-16 BSE Sensex base case is 28000 (vs. 28600 earlier for Nov-16) and our probability-weighted outcome is forecast at 30200 vs. 31000 earlier.

Risks to our views include: Policy inaction, SOE banks’ NPLs, Fed raising rates more rapidly than what is in the price, or the RBI slowing its pace of rate cuts despite declining inflation, global growth weakness, relative valuations and positioning.

Will the Micro Yield to the Macro?
India outperformed its peer group in 2015. A low-return world augurs well for India’s relative performance in 2016.

India’s correlations with EM have been falling since 2010, and this fall in correlations has accelerated since the end of 2013, when India made a big shift in its macro approach away from a dovish fiscal and monetary stance to hawkishness on both. The hawkish approach has helped India’s macro stability, resulting in a large balance of payment surplus and falling correlations for Indian stocks vs. EM. This means that India is tending to underperform EM rallies and outperform EM corrections.

As a corollary, a low-return EM world augurs well for India’s relative performance although its own absolute performance is also likely to be middling. Our global strategy team is forecasting low-single-digit returns for most equity markets and, if they turn out to be right, it seems likely that India will continue to outperform its peer group in 2016.

Fundamentally speaking, the four factors that are driving India’s outperformance are: (i) policy certainty; (ii) relative interest rates; (iii) relative earnings growth; and (iv) flow of domestic savings into equities. When India’s policy rates are falling versus the US, India tends to outperform emerging markets. It must be noted that the RBI’s recent action to cut the policy rate in front of a Fed rate hike underscores the RBI’s growing confidence in India’s macro stability.
Once again, India outperforms when its policy uncertainty is low. The EPU Index is off its all-time low thanks to recent political setbacks (including the Bihar election loss for the NDA) representing higher uncertainty on the policy front and also expressed in India’s recent underperformance.

Relative performance to the EM index is not surprisingly helped by higher relative earnings performance. The low starting point of equity savings in India is an additional point to support our view that India is in the midst of a liquidity supercycle for equities. We have seen strong flows from households into equities through 2015, and, consistent with our research (India’s Domestic Liquidity Supercycle), we think this will likely continue in 2016 with US$ 1 bn net inflows per month appearing as our base-case number now.

The biggest impediments to India’s outperformance continue to be rich relative valuations and high positioning, even though it appears that the quantum of India’s overweight position across EM funds has declined over the past few months. On relative valuations, these are an outcome of India’s large outperformance rather than absolute gains in share prices. Thus, while the relative price/book multiple is at the 95th percentile, the absolute book multiple is at the 50th percentile.

We initiate coverage on Eicher Motors with an UW rating as we believe that the valuation multiples from the current 33x/28x on FY16E/17e will moderate as growth rates ease and competition increases. After witnessing years of robust sales increases at Royal Enfield (54% CAGR over CY10-15E), growth is expected to ease from hereon off an elevated base—this is reflected in a sharp reduction in waiting periods. Further, competition is launching new products in the lifestyle biking segment. In the CV (commercial vehicles) business, VECV (VE Commercial Vehicles Ltd is a joint venture between the Volvo Group and Eicher Motors Ltd) has made limited headway in a competitive M/HCV segment as competition has gained market share over the year, driven by aggressive discounting. Thus, while the stock has corrected by over 20% from peak levels (post the sharp stock price run-up earlier in the year), we believe that these factors will drive it lower.

Growth rates to moderate at RE: Royal Enfield has witnessed a healthy 54% CAGR over CY10-CY15E as sales have been driven by latent demand for lifestyle bikes, an improved product portfolio at Royal Enfield and a more than doubling of the dealer network. However, the waiting periods for the RE bikes have been coming off lately, from ~6 months a year ago. We believe that growth rates will moderate from elevated levels earlier as: (i) latent demand is now normalising, (ii) a demanding base effect.

Competition is now emerging in the lifestyle biking segment as Bajaj Auto has recently expanded the Avenger series of bikes, albeit at a lower range i.e., 150-220cc category, which are priced ~30% below the RE products. Thus, Bajaj is attempting to downsize this segment. The initial response to these bikes has been encouraging as the OEM has ramped up production from under 4,000 units p.m. in 2Q to 20,000 units expected in December due to the encouraging response from the market.

VECV: Limited headway in a competitive market: Despite the roll-out of the next-generation Pro Series range of commercial vehicles for the Indian market by VECV, the OEM has made limited headway, particularly in the 16-40T M/HCV range. The market share has come off from 4.4% to 3.5% in this segment and the overall share in the CV segment has come off by 190bp to 12% due to aggressive discounting by incumbents.

Price Target (PT): We set a March-16 sum-of-parts (SOTP) based PT of R13,000—we value the VECV commercial vehicle business at 8.75x EV/Ebitda and we value the Royal Enfield business at 26x forward P/E.

Key risks: Sharper-than expected demand for RE products driven by new product launches, market share gains in the CV business.

Investment Summary
We initiate coverage on Eicher with an UW rating as we believe that the valuation multiples from the current 33x/28x on FY16E/17e will moderate as growth rates ease and competition increases. After witnessing years of robust sales increase at Royal Enfield (54% CAGR over CY10-15E), growth is expected to ease from hereon off an elevated base.
Further, competition is launching new products in the lifestyle biking segment. In the CV business, VECV has made limited headway in a competitive M/HCV segment as competition has gained market share over the year, driven by aggressive discounting.

Royal Enfield—Pent-up demand is normalising and competition is stepping in
The OEM has witnessed healthy growth over CY10-CY15 YTD as growth has been driven by latent demand for lifestyle bikes, an improved product portfolio at Royal Enfield and an expanding dealer network (which has more than doubled to 450 units currently). Thus, RE volumes have risen from 5,000 units p.m. in CY10 to over 40,000 units currently—sales have grown at a CAGR of 54% over CY10-15e. However, the waiting period for the RE bikes have been reducing lately— from ~6 months a year ago to less than a month for several variants (particularly in the 500cc category) and between 1-3 months for the 350cc category. We believe that growth rates will moderate from elevated levels earlier as: (i) pent-up demand is now easing, a demanding base effect.

(ii) Further, competition is gradually emerging in the lifestyle biking segment. Currently, RE derives the bulk of its sales from the entry 350cc segment (~90% of sales) range, while the 500cc products remain niche offerings. Bajaj Auto has recently expanded the Avenger series of lifestyle bikes, albeit at a lower range i.e., 150-220cc category, which are priced ~30% lower than the RE products. Thus, Bajaj is attempting to downsize this segment, in an attempt to attract value-conscious customers in our view.

Exports – a medium-term opportunity: Management is aggressively focusing on expanding its presence in the overseas markets to drive its next leg of growth—particularly in USA, Europe. They have set up showrooms in nodal cities such as London, Paris, Dubai etc. Further, they have appointed senior personnel to drive their international business including Rod Copes—President Royal Enfield North America—(ex Harley Davidson), Simon Warburton in UK—Head Product planning and strategy (ex Triumph), Pierre Terblanche, head of the industrial design team (ex Ducati), amongst others.

We believe that after witnessing
aggressive revenue growth over the past few years, growth rates are likely to moderate from hereon. After growing sales at a CAGR of 54% over CY10-15e, Royal Enfield is expanding capacity from 520,000 units to 900,000 units
over CY15-18, implying a capacity increase of 20% CAGR over this period. (Royal Enfield will increase production to 620,000 units with its Oragadam plant in CY16E. Further, the third greenfield plant proposed in Vallam Vadagal in Tamil Nadu is expected to be onstream in CY18—it will raise capacity to 900,000 units).

VECV commercial vehicle business—Limited headway in a competitive market: Post Eicher and Volvo’s collaboration in 2008, VECV launched its next-generation Pro Series range of commercial vehicles for the Indian market from 2013 onwards.

However, despite the rollout of the new products—which are developed with inputs from Volvo, the OEM has been unable to expand its market share in the heavy duty segment i.e., 16-40T range. Management highlights that their market share has been impacted due to ggressive discounting by local OEMs (Ashok Leyland, Tata Motors). Further, the incumbents have a wider distribution network across the country as compared to VECV, which is in the midst of its network expansion. The market share has come off from 4.4% to 3.5% in the M/HCV segment (16T and above) and the overall share in the CV segment has come off by 190bp to 12%.

The Ebitda margins at the VECV business have been range bound at between 7-8% over the past few years.

The VE Powertrain facility supplies medium duty engines to Volvo’s global requirements including Euro V and VI engines. However, the scale-up in this segment has been gradual, with the JV supplying ~1,000 Euro VI engines p.m., primarily to Europe.