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Be there before the rally begins

After moving up 40 per cent from the post- September 11 lows, the Indian markets hit multiple roadblocks, starting with the Ayodhya controversy to the latest Indo-Pak border tension.

The markets surrendered more than half the gains as FII inflows dried up and domestic investors continued their two years wait on the fences.

Without considering the precedents on how the market performed after crisis times in the past, we recommend buying into potent ideas as we believe that just about everything is right with the Indian markets at this point. Consider the following:

** Valuations are back to near multi-year lows. A structural fall in interest rates is one of the biggest positives for India.

Equity valuations are now even more attractive compared to debt yields. Even corporate profits are getting a boost due to lower interest costs.

The Sensex now trades at a forward PE multiple of 11.x (10.4x at the recent low) against a forward multiple of 10.4x in September 2001.

This is at a 40 per cent discount to the three-year average forward multiple for the Sensex.

** Privatisation has gathered unprecedented momentum. The next twelve months will not only witness big-ticket privatisations, but also open the floodgates for a more broad-based divestment schedule.

Besides improving the efficiency of PSUs, we argue that privatisation will also be a major source of liquidity to the markets.

We believe NALCO will be the first to go off the block followed by HPCL and BPCL. We also expect PSU stocks to continue outperforming the market.

** Strong signs of economic recovery: there's a turnaround around in business confidence in 2002, GDP growth in Q3FY02 has been the highest in 10 quarters, credit offtake has improved, healthy growth in sales of consumer durables and cement, improved export growth, etc.

Even sick industries like textiles and steel, which have been a millstone on the neck of the banking sector, seem to be turning around.

** Corporates profits are expected to grow at 18 per cent in FY03 against 16 per cent in FY02 and 14 per cent during the past five years. Return on equity for the corporate sector has consistently improved during the past three years.

There will be upsides to our forecasts if there are stronger signs of a domestic recovery (driven by higher farm incomes, lower interest rates and infrastructure investments) or a US recovery (leading to upgrades in earnings of IT companies as well as global commodity companies).

** Reforms have moved at a healthy pace with good progress in oil, telecoms, power and on the privatisation front. Administered pricing mechanism has been dismantled and competition has been allowed in retailing auto fuels.

Telecom is another sector that has witnessed stunning changes in the past two years. India is set to become one of the most competitive wireless markets in the world in a year's time as the fourth operator rolls out and limited mobility service providers launch their services.

** No risk to the stability of the BJP government envisaged after the BSP alignment. The BJP has been fairly aggressive in pushing reforms in several key areas like oil, power, etc. even without the full support of its allies; the huge majority will only reinforce its commitment to push even less-popular reforms.

** Domestic investors are completely risk-averse and have consistently withdrawn money from equities for two years in a row.

But low bond yields coupled with attractive equity valuations, will force the domestic investor back to equities. Interest rates on G-secs have dropped sharply.

Administered interest rates on small savings will now be benchmarked to the average annual yields on G-secs and this will, in turn, drive down the yields on small savings. While this process has received a temporary setback due to the recent Indo-Pak tensions, we expect the domestic investor to be drawn in to the market gradually as these tensions ease.

** New sources of liquidity - LIC and open-offers - have emerged during FY02 and these are expected to grow significantly in FY03. This will serve as a floor to falling valuations as long as retail investors remains risk-averse.

LIC's high growth in premium income has increased its investible surplus. Therefore, its investment in equities is expected to treble from Rs 19.2 billion in FY01 to over Rs 60 billion in FY03.

And total value of equities bought through the open-offer route trebled in FY01 to Rs 26 billion is up over 80 per cent in FY02 to Rs 48 billion. We expect the momentum to continue in FY03 as open offers by bidders for PSUs alone will exceed Rs 100 billion.

** Finally, an Indo-Pak conflict seems remote as pressure from global majors has clearly put Pakistan on the back foot, forcing it to set its house in order.

Themes driving our investment strategy: The key themes in the year ahead are privatisation and economic recovery, besides the evergreen "bottom-up" ideas.

We recommend playing the privatisation theme by participating in large-cap ideas like HPCL, BPCL and Nalco, where the formal process has already been kicked off and inherent fundamentals will reinforce the re-rating of these companies.

Despite a heady outperformance, we continue to recommend the auto sector as it remains the best proxy to economic recovery and one of the biggest beneficiaries of falling interest rates.

The banking sector is also one of the biggest beneficiaries of the economic recovery (lower non-performing assets and higher credit off-take) and softer interest rates (cushion provided by investment portfolio appreciation).

Among bottom-up ideas, we expect continuing outperformance by domestic pharmaceuticals stocks and recommend Ranbaxy and Cipla.

Both of these companies have the best news flows and earnings growth trajectory going forward. We also recommend Zee Telefilms as we expect strong earnings growth, driven by higher pay revenues and upsides in advertising revenues due to domestic uplinking.

This is an extract from the Motilal Oswal India Strategy Report

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