Dead Presidents! - India Equity Research

Monday, October 15, 2007

Be watchful this week

Volatility is likely to be the highlight of the market in the week ahead. Cautious investors may utilise upsides to trim exposure to a market that has risen briskly and without any major pause till Friday. With foreign funds expected to continue pouring money into Indian equities unless there are indications that there would be no further rate cuts by the US Fed on October 30, the bias is broadly positive.

But, as of now, valuations of most shares are stretched and corporate earnings are showing signs of a slowdown. Optimists can take heart from robust industrial production figures and the latest comments by top Congress leaders that mid-term polls are highly unlikely. But experts argue that current market factors in most positives and leaves little room for disappointments.

There is a perception that catalysts for a sharp correction could be external such as a sudden selloff in the US markets. The absence of a rate cut by the US Fed, as expected by the market, could trigger a sharp correction in most emerging markets including India.

The Sensex has risen 20% since the US Fed rate cut on September 18, sparking sharp foreign inflows into many frontline shares, with several investors pulling out money from the US to invest in higher-yielding assets of emerging markets.

CLSA Asia-Pacific Markets’ analysts, in a recent note, says, “The extent of the rally and the lack of breadth suggest that in the event of any reversal in global risk appetite, deterioration in global credit markets or an escalation in political tensions domestically, the correction could be fairly sharp.”

As per CLSA’s findings, 68% of the Sensex’s gains so far this year is attributable to just five shares, constituting only about 36% of the index’s free-float market capitalisation. These five shares include Reliance Industries, Bhel, L&T, Bharti and HDFC.

Concerns about further tightening of domestic liquidity by the RBI is a cause of concern for investors. With the industrial production growth back on track this August after a sharp decline in July, analysts are almost certain that RBI would mop up excess money supply in the system through a hike in cash reserve ratio.

Investors in interest-rate sensitive sectors such as banks, real-estate and auto, fear that banks may not cut lending rates further in case of more absorption of money supply from the system.

“An increase in CRR or expectation of an increase in CRR is likely to cause some weakness in financial stocks. We would use this weakness to buy into our preferred stocks–HDFC, IDFC and the State-owned banks,” Morgan Stanley analysts said in a recent note to clients.

Stocks you can buy this week

IDFC
Research: Morgan Stanley
Rating: Overweight
CMP: Rs 177

Morgan Stanley has maintained its ‘overweight’ rating on Infrastructure Development and Finance Corporation (IDFC) with an increased price target of Rs 200. IDFC is entering a phase where loan growth is strong, spreads are improving and fees are very strong. During financial year 2005 and 2007 , IDFC delivered the best core earnings progression among Indian private banks and financial institutions at a 55% componded annual growth rate (CAGR). This trend will continue, resulting in out-performance. Morgan Stanley has raised it FY08 earnings estimates by 5%. IDFC has launched the first tranche of its proposed $2 billion project equity fund along with Citi.

This will result in a doubling of assets under management in 1-2 months. Moreover, its investment in the National Stock Exchange (NSE) is performing strongly, as NSE’s turnover is now averaging close to $18 billion. Given IDFC’s 8% stake in NSE, this can be very valuable. SSKI (IDFC owns two-thirds of SSKI) is also performing well. The stock is trading at 24.8x F2009E earnings, in line with private banks.

However, private equity (PE) and proprietary investments are not contributing significantly to earnings but provide almost 30% of value. Hence, core valuations are lower at 19x (cheaper than private banks, with better earnings profile) and could rise, given strong earnings growth expectations.

Bharati Shipyard
Research: Citigroup
Rating: Buy
CMP: Rs 614

Citigroup has reiterated its ‘Buy’ rating on Bharati Shipyard with a medium risk and a price target of Rs 790. Bharati Shipyard last week announced a $89-million order for constructing four AHTS vessels from Shipping Corporation of India for delivery in 2011. With this, the company has now announced order wins of ~Rs 1,600 crore over the past six months, primarily for offshore supply vessels, reiterating Bharati Shipyard’s strong global presence in this space, which now accounts for over 60% of the company’s current order book. With the new order win, Bharati

Shipyard’s total order book now stands at Rs 4,400 crore, with the unexecuted portion providing a cover of 5.3x FY08E sales. More significantly, the cumulative ship-building revenue forecast of Rs 3,400 crore over FY08-10E is now completely covered by the company’s unexecuted order book, providing comfort to earnings estimates. Its Mangalore expansion remains largely on track with the project likely to be commissioned this quarter. Following the acquisition of Swan Hunter’s equipment in April, the company is further exploring options to increase the Mangalore facility capacity to build larger vessels (up to 100,000 DWT).

Tata Steel
Research: UBS
Rating: Buy
CMP: Rs. 848

UBS has maintained its ‘Buy’ rating on Tata Steel with a price target of Rs 875. Tata Steel’s 1:5 rights issue is unchanged at a price of Rs 300. But, it has changed the terms of its cumulative convertible preference shares. It will issue cumulative convertible preference shares (with a face value of Rs 100) amounting to Rs 5,480 crore ($1,380 million) in the ratio of 9:10, 6 of which will be converted into equity shares at Rs 600 on September 1, ’09.

The new financing terms would cut the number of fully diluted equity shares issued from 851.2 million to 822.1 million (-3.5%). Tata Steel may also not make an ADR issue, which was earlier part of the dilution assumptions for FY09.

A lower issue of shares and the timing difference in the dilution assumptions has led UBS to raise FY08E EPS target from Rs 107.2 to Rs 112.05 and FY09E EPS from Rs 112.1 to Rs 119.79 Wire reports indicate that Tata Steel may sell off the Corus’ aluminium business. This could result in a small inflow of less than $100 million, which will not have any material impact on the financing requirements or earnings of the combined entity Changing product prices and increasing raw material costs can have a material impact on Corus’ earnings in ’08.

Infosys
Research: Credit Suisse
Rating: Outperform
CMP: Rs. 1930

Credit Suisse has maintained its ‘outperformer’ rating on Infosys as it finds the valuation of Infosys reasonable on a 12-month basis. Infosys reported strong September ’07 results. Revenues were 1% above estimates, EBIT margins 180 bps above the numbers and operating profit 8% above estimates. Lower financial income and higher tax led to EPS coming 2% below expectations. The company raised FY3/08 EPS guidance to $1.99 (from $1.92-1.94) or Rs 79.49-79.88 (from Rs 78.2-79).

Revenue guidance was increased by 3% in dollar terms and 1.3% in rupee terms. Operating numbers also remain strong, with a 2.5-3.0% increase in pricing and 7.7% QoQ growth in volumes. While quarterly gross hiring was lower than guidance (actual 8,500, guidance 11,000), this could be due to timing mismatch. For the full year, company increased its gross hiring target to 28,500 (excluding acquisitions) from 26,000. However, visibility remains limited both on further rupee appreciation and US macro environment. This could impact the near-term performance of the share .

Bharat Electronics
Research: CLSA
Rating: Buy
CMP: Rs 1,895

After four year of stagnation in order backlog, BEL ended FY07 with record new order inflows at Rs 6,450 crore and order backlog of Rs 9,130 crore, up 38% YoY. It launched 25 new products and the share of revenues from indigenized products increased from 73% in FY06 to 81% in FY07.

During FY07 share of revenues from civilian products increased from 14% in FY06 to 26%, with the MTNL project of convergent billing being a major part of it. The balance sheet remains strong with negligible debt. BEL will be a likely beneficiary of the estimated $10 billion opportunity arising from offset agreements. To capitalise on the opportunities BEL has entered into MoUs with leading aerospace companies like Lockheed Martin, Northrop, Boeing and EADS. BEL will also provide its international partners with ‘Build to Print’ and ‘Build to Spec’ services. Over a period of time, BEL will also be able to indigenise these designs.

BEL is also open to acquiring high-end niche technology companies, Indian as well as those overseas which it can fund through its Rs 2,300 crore in cash reserves. The elevation to the ‘Navratna’ status gives BEL operational freedom for capex and investments. Adjusting for Rs 260/share of cash, the stock is trading at an attractive 13.0x FY09CL. The risks to stock performance are from lumpy quarterly performance and possible decline in margins in quarters were incidence of imports is high.

Investment Strategy

Biocon

Events to drive the markets rather than earnings?

At various points in this four-year bull run investors have wondered where and when a bubble situation would arise. Last week showed the first clear signs of irrational exuberance. While the Sensex level of 17,000 was itself a bit stretched, the rise thereafter has been crazy. Fundamentals would hardly explain the kind of frenzied rise.

At these levels, the Sensex is trading at a trailing PE ratio of around 25x. Once again, this is not sustainable, since earnings of Indian corporates cannot rise at 25x over a sustained period. Over the past five-year period, beginning FY03, earnings have risen by around 35% annually. This performance is getting increasingly difficult to continue. The first quarter of FY08 saw a net profit growth of only 8%, if you stripped out other income.

Investors, and even broking firms, seem to have missed this altogether. The second-quarter results, many of which will come this week onwards, will finally set the tone for FY08, but drastic improvements are unlikely.

The reasons for a likelihood of earnings growth slowdown in FY08 aren’t hard to see. Interest rates are now 20-40% higher than three years ago when corporates weren’t borrowing anyway. Earlier, an average corporate could borrow at 7-8%, now they need to pay over 10%. While this looks like only 200-300 basis points, investors should look at it in proper context. A 3 divided by 7 is 43%.

So if interest rates go up from 7% to 10% for a corporate (or a home loan), cost of borrowing is up 43% and not 3%. Higher interest costs are affecting profitability and causing demand slowdown. It is visible in two-wheelers, and will now become visible in housing and cars if interest costs remain high.

With this background, lets pose two key issues:

Why did the market run up so fast, and from here, how do we spot outperformance? In both the cases, deals or rumours play a key role. The market’s run, post-Sensex level of 17,000, appears partly speculative, and partly deal news driven. Most of the scrips that have led the rally seem driven more by deal news, rather than the changing perception of earnings growth. Both Bharti Airtel and Reliance Communications seem to have benefited from tower business hive off.

There is something brewing in R Comm’s subsidiary Flag Telecom as well. Reliance Energy (REL) has gone from around Rs 600 to Rs 1,700 levels in maybe a month. This surge seems driven by the listing plans of Reliance Power, where REL holds 50%.

While there’s been no specific news in Reliance Industries, rumours abounded last week. One such was a possible large float from the retail business. The same pattern may persist if the market stays around these levels. With little hope of earnings driving outperformance, new triggers can best come from news flow.

Saturday’s newspapers, for example, had an announcement of a massive $9-billion investment plan from Reliance Industries. Reliance Industries chairman and managing director Mukesh Ambani said the company will invest $8-9 billion in the next three to four years at its Jamnagar ‘super site’.

It was not clear whether this is a new announcement or a reiteration of an earlier plan. Mr Ambani also talked about plans for ‘acquisition mode of growth’ and ‘forging new partnerships’. In other words, organic growth alone would not suffice for Reliance going forward.

Investors may take a cue from this line of thinking as well. Organic growth will rarely lead to earnings growth beyond 25%. In sectors that are growing faster than this, like telecom, growth is anyway priced in. Bharti Airtel is quoting at 43x trailing P/E, for example. Corporate action, either an acquisition/divestiture, or entering a new area, may be necessary to generate market excitement from hereon.

The reverse of this logic also appears visible. Scrips that lagged last month or so are perhaps the ones that haven’t made any great announcement to catch shareholders’ attention. ICICI Bank, another index biggie, for example, has lagged in this recent surge.

A lot of corporate activity happened in this stock around the time of its follow-on issue in June. Since then, things have been quiet on this counter. The bottomline for investors: absolute returns maybe hard to get for sometime, unless they are event driven.

Friday's correction could continue

Support levels for Nifty are 5350 and 5250. Extent of correction depends on FII fund flow.

Three very bullish sessions were sandwiched in-between two corrections. The Nifty hit highs of 5549 before easing off to 5428 points for a week-on-week gain of 4.67 per cent.

The Defty was up 4.89 per cent as the rupee closed at 39.33 versus USD. The Sensex blinked only after it had hit a high of 18845 and closed up 3.63 per cent at 18419 points. The Junior was up 2.6 per cent at just above 10020.

While volumes were excellent, breadth was less bullish. The BSE 500 was up only 3.03 per cent and smaller stocks less fancied. The Advances to Declines ratio was marginally positive for the week and very negative on Friday. The reason was clear.

The FIIs have poured money into the top 200-odd stocks. Indian funds have been net sellers for 15 sessions. Operator interest is concentrated on big stocks and retail investors have stayed out or booked profits.

Outlook: The correction could continue. Key support levels are Nifty 5350 (Sensex 18250) and 5250 (Sensex 17950). The market looked distinctly nervous by Friday evening. The depth of correction will, to a great extent, depend on FII attitude.

Rationale: In the past 7 weeks since August 24, the Nifty has climbed from 4100 levels without significant correction. That intermediate trend could last another 4-5 weeks in theory but every momentum indicator is overbought and breadth was negative on Friday. Also, volumes rose while prices fell, indicating that supply increased as traders fought to book profits.

Counter-view: The rally has come on the back of FII purchases driven by rupee strength coupled to an US Fed rate cut. Through October, Indian funds have been net sellers. If the FIIs stay positive, they have deep enough pockets to force the markets up. If they change attitude, there could be a significant correction.

Bulls & Bears: Breadth was exceedingly negative through Friday’s trading. The worst affected were finance and banking stocks with bellwethers SBI and Infosys taking a hammering and the other stocks in the two sectors following in their wake.

Among financial stocks, only Bank of India held out while Rolta was among the few gainers in the IT sector. Another erstwhile favourite, telecom major RComm also faced heavy selling.

There were isolated winners everywhere but the advance:decline ratio was 1:4 or worse across most market segments. Gail and ONGC were among the best performers. Powergrid continued to register gains through its second week of listing. Hind Unilever, Hindalco, IPCL, Mahindra and Mahindra and Reliance Energy were among the few big stocks that showed strength.

MICRO TECHNICALS

INFOSYS
Current Price: 1929
Target Price: 2000

Since it declared Q2 results, Infy has been sold down from a high of 2140 to a low of 1903 in three sessions. It has excellent support at current levels and may be due for a technical recovery till the 2000 level. Keep a stop at 1900 and go long.

MAHINDRA & MAHINDRA
Current Price: 828
Target Price: 900

M&M appears to have managed a high volume, upwards breakout despite the poor overall market trend. The projected target with this formation would be about 900. Keep a stop at 815 and go long.

ONGC
Current Price: 1094
Target Price: 1150

The stock seems to have performed a classic uptrending breakout on high volumes. Depending on your chart interpretation, it has a target of between 1150 and 1225. Keep a stop at 1070 and go long. Book partial profits above 1130.

R COMM
Current Price: 718
Target Price: 700

The stock saw a burst of selling on Friday after testing highs of around 750. It has good support between 700-710 but it is likely to test those supports again before it makes another upmove. Keep a stop at 730 and go short. If the stock closes below 700, repeat the short position with a stop at 710.

SBI
Current Price: 1862
Target Price: 1800

The stock has seen selling that pushed it back to support at 1850 before a small recovery. If that support is broken, the next reliable support is at about 1800. There is clear resistance at 1880. Keep a stop at 1880 and go short. Increase the short position if the stock drops below 1850.

Sunday, October 14, 2007

Mindtree Consulting

Currency Forecast

India IIP Numbers

Correction likely

The S&P CNX Nifty made a new top of 5,550 and closed at 5,528, while the Sensex closed at 18,419 after making new top at 18,844. Technical analysts have mixed views on the markets after a sharp correction on Friday. According to technical analyst Manas Jaiswal of Emkay Shares, the Nifty has made a bearish pattern on the daily charts and the RSI has given a sell signal with negative diversions.

Nifty may correct the recent rally from 5000 to 5549 and come down to 5339 and then 5275. The 5275 level is 50 per cent retracement level for the Nifty rally from 5,000 to 5,549. Any bounce back would be an opportunity to exit from long positions. For Monday, Nifty has resistance at 5493 and above that, 5549. There is support at 5402 and then 5339.

Technical analyst Kamalesh Langote of vfmdirect.com said that the divergence of relative strength index (RSI) indicates problems ahead. The divergence means higher tops and higher lows for benchmark indices and lower tops and higher highs for RSI due to the intra-day volatility. The RSI divergence leads to corrections in most cases, but this is unlikely to happen on Monday. The Nifty may scale to new highs before reacting to market forces.

Upside targets difficult to predict

The markets continued to rally for the eight straight week. The Sensex zoomed past the milestone of 18,000, and in fact came quite close to the 19,000-mark in intra-day trades.

The Sensex began the week on a negative note, losing 282 points on Monday, but the bulls came back strongly to take the index way past the 18,000-mark. It also recorded its biggest single day gain of 789 points on the following day. With the bulls being in no mood to relent, the index saw a massive intra-week movement of 1,557 points, i.e. from a low of 17,287 the index soared to a lifetime high of 18,845. The Sensex finally ended the week with a gain of 3.6 per cent (646 points) at 18,419. The index has now gained a whopping 30.2 per cent (4,228 points) in the last eight weeks.

The short-term target of 19,000 for the Sensex, mentioned last week, remains intact. Given the pace of the rally, the index may easily zoom past this milestone.

With the index at new highs, it is difficult to set an upside target. But one has to keep an eye on key support levels to watch out for any trend reversal. The key support levels for the Sensex are 18,070-17,740-17,300.

The Sensex is likely to find support around 17,825-17,640-17,450 this week, while it may face resistance around 19,015-19,200-19,385.

Similarly, the Nifty ended the week with a smart gain of 4.7 per cent (242 points) at 5428. It has surged 24.3 per cent (1,320 points) in the last eight weeks. The key support level for Nifty is around 5400-5330-5250.

The Nifty is likely to face resistance around 5640-5700-5770 next week, while support on the downside could be around 5220-5155-5090.

The 14-day RSI (Relative Strength Index) for the Sensex and the Nifty continues to remain in overbought zone at around 77.

An RSI above 70 is said to be overbought, while an RSI below 30 is oversold.

Weekly Wrap - Oct 15 2007

Weekly Stock Ideas

Buy Tata Power

Buy Bharti Airtel

Buy Welspun Gujrat

Buy Alok Industries

Buy Birla Jute

Asset Bubbles- The Unilateral Bet

Any deviation from fundamentals cannot sustain forever. Although liquidity may distort asset prices in the short run, the winner is inevitably the fundamentals in the long term.

I happened to have a chat with a stock broker friend of mine. He was euphoric about stock markets crossing 18,000 levels. I asked him wether he was worried; he replied, "The lesser you understand Indian markets, the more money you will make." He added that" you got to be a good jockey. If you jump off the horse in midst of the derby race, a few of your bones will be broken, but the horse will always move on (to 25,000)". This is the story of SENSEX or is it ‘X’ SENSE, where X stands for may be ‘NO’. As I was leaving, I heard him saying on the phone that the next 1,000 points would be a matter of next 5 trading days. Only one-way bets on stock markets!!!

I also called up the local jeweler and asked him, where he saw the Gold price going. In his opinion, it was Rs 20,000 per 10 gms, if dollar continued to depreciate. The real estate agent also jumps on and says, "Sell all your stocks and buy land on outskirts of Nagpur. Boeing will buy it from you at double the price after a year". I opined that prices have already doubled. He counters "So what??? Do Real estate prices ever come down? No supply & huge demand."

I quickly opened my old faithful Webster’s dictionary to look out for the correct interpretations of words like "Utopia" and "Asset Bubbles". I asked myself how all prices are going up together. When all asset classes move in the same direction, diversification is rendered redundant. And what about on the way down?

The Indian stock market index broke all time high records almost everyday over the last few weeks on route to crossing the 18,000 mark and coming perilously close to the 19,000 levels. Other asset classes such as crude oil, the U.S. stock markets, Indian Rupee, other emerging markets stocks (MSCI EM Index), commodities are also at record or multiple year highs.

Right from onions to pulses to real estate to stocks to commodities, everything is on a synchronized rising trend. And wages have also been sky rocketing.

Are Asset bubbles being created in India and the world?

What exactly has happened in India?
The roots are not in India, but thousands of miles away in the USA. Losing sleep over the housing and credit crisis, the Federal Reserve (the RBI of the USA) cut interest rates in mid September. Generally, lower interest rates are regarded as positive for the stock markets, since it lowers the cost of funds and enhances corporate investments & profitability. So when US house prices fall, go and buy Indian stocks. Read on to know why.

Lower interest rates and cheap money also encourages global investors to borrow & invest to generate higher returns. With lower cost of money, investors can afford to leverage, take more risk and invest into risky asset classes globally like stock markets in India. It is like a large bucket which, when filled with water beyond its capacity, will spill over the excess water into the neighboring smaller buckets, irrespective of the risk of drying up (losses) during the peak summer.

As Indian fundamentals continues to be attractive to global investors and as its markets integrate globally, more money comes in from the U.S. & other countries into Indian stocks and real estate, expecting higher returns. As the external liquidity rises, demand exceeds supply and asset prices move up rapidly. Real estate prices in India have risen significantly in the last 15 years.

Ever since the US Fed cut the rates (18th September), USD 6 Bn. (Around Rs 24,000 Crs.) have come into Indian stock markets, pushing the Sensex up by more than 3,100 pts (around 20%). From January this year, the Indian stock markets have got flows of more than USD 16 Bn. (around Rs 64,000crs). All this foreign money chases the index stocks, which move up rapidly. As can be noted from the table below, only the top 5 stocks have contributed to more than 56% of the Sensex rise, making it a little skewed and top heavy.

Is the prevailing liquidity and foreign cheap money undermining fundamentals & risks and in turn creating Asset Bubbles?
An Asset Price Bubble usually is a sharp rise in the prices of an asset or a range of assets; with the initial rise generating expectations of further rises and attracting new buyers, who generally are speculators interested in short term profits from trading in the asset, rather than its use or earning capacity (fundamental value).

In a typical asset bubble, the prices of the assets deviate from their underlying "fundamental or intrinsic values". An asset bubble is usually self fulfilling. Buying sends the prices up which causes other people to buy more. In a typical asset bubble scenario, experts often try to find a rationale for the overpriced markets (say structural changes or new economy) so as to not be against the crowd and everyone invests with the intent of finding a ‘greater fool’.

The world & India has a long history of asset bubbles bursting and an adverse impact on the financial markets & the economic system. India also has a precedence of scams & market dislocations erupting at the peak of the stock markets.