"Earnings outlook and liquidity flows will drive the markets"

Sanjay Sinha
CEO, L&T Mutual Fund

These are interesting times for stock investors. On the one hand, economists are predicting a strong upturn in the economy - a development that is bound to benefit investors. At the same time, inflation has emerged as a grave threat. To prevent the economy from overheating, the central government is likely to raise interest rates this year (it has already raised key rates once). And high rates, as we know, are not good for economic growth, corporate earnings or for stocks. Moreover, while the global economy appears to be on the mend, it is not completely out of the woods yet. These, however, are the broad trends. Their ultimate impact on the stock markets will depend on the magnitude and strength of each. To get a view on how investors should negotiate these cross-currents, we spoke to Sanjay Sinha, chief executive officer, L&T Mutual Fund. Excerpts from an inter-view with Sanjay Kr. Singh

The market is currently trading at around 21.24 times trailing earnings. What are your one-year forward EPS and PE estimates?
Corporate earnings picked up momentum in the third quarter of financial year 2010. The recently announced IIP number and the government's forecasts of GDP growth for FY10 and FY11 seem to suggest that we may see earnings growth of 18 to 22 percent in FY11 if this momentum is sustained. In that case, the Sensex EPS would be in the region of Rs 1,100. If this level is achieved, then we are at levels significantly below the historically high PE ratios at which the Indian markets have traded in the past. At the same time, corporate earnings may be more sustainable, which would give our markets a certain premium over the average of 15 times at which they have traded during the last decade.

Economists are projecting a strong upturn in GDP growth this year. In your opinion, which are the sectors or themes that stock investors should look at in order to profit from this upturn?
In a recently concluded infrastructure conference, the government indicated that the outlay for infrastructure, which was $500 billion in the 11th Five-Year Plan, will be raised to $1 trillion in the 12th Five-Year Plan. This is a fairly ambitious number. Therefore, we continue to treat this theme as one of the largest wealth creators in the medium term.

Secondly, GDP growth is targeted to be raised to an average of around 10 per cent in the next few years. This coupled with the fact that the services sector accounts for almost 58 per cent of GDP, can lead one to expect banking and financial services to be the second most attractive theme.

2008 and 2009 were years of global slowdown. 2010 and 2011 are expected to be the years of global recovery. Along with this, contrary to the popular point of view, the dollar seems to be strengthening. The combination of these two factors seems to suggest that a thematic exposure to a group of companies that derive a significant portion of their revenues from global operations should be a third theme to play.

Now that the Reserve Bank of India (RBI) has already hiked key rates, do you expect another rate hike on April 20?
RBI has adopted a calibrated approach in response to inflationary pressures that are building up in the Indian economy. Therefore, it is quite likely that it may raise rates by another 25 basis points during the next credit policy.

By how much do you expect rates to move up during the next 12 months?
As corporates have not expanded capacity during last year's downturn, the fast-paced recovery may continue to put pressure on the supply side. This will put pressure on borrowing as well as create inflationary expectations in the short term. Hence, a 25 to 50 basis points hardening of rates over the next 12 months cannot be ruled out.

How are these rate hikes - the one that has already happened and those that could happen in the next 12 months - expected to affect the stock markets?
The initial reaction to every such announcement is likely to be negative for both the bond and the equity market. However, the fact that these rate hikes will not be unexpected and hence will continuously get factored in the market level, will give a certain amount of support to the downside.

The 10-year bond yield, which is hovering at around 7.85 to 7.90 per cent, is expected to harden to 8.5 per cent during the year. There will be a consequential impact on other bonds of various maturities. We should also see short-term rates move up and the yield curve get flatter than it is now.

In the equity markets, some of the interest-rate sensitive sectors such as banking, auto, real estate and others may react adversely in the short term. But the broader market level will be influenced more by the outlook on earnings growth and the liquidity flowing into the market from both local and global sources.

What would your advice to investors be on picking up stocks in an environment of rising interest rates? Which sectors or themes are likely to weather this environment better?
The choice before the investor is to focus on the short term versus the long term. As already stated, while quite a few sectors may react negatively in the short term due to the increase in interest rates, structurally they are going to be beneficiaries of an extremely firm macro-economic picture. Hence, the uncertainty over interest-rate movements will provide an opportunity to accumulate stocks in these sectors at attractive long-term valuations. This contrarian approach should reap dividends for investors and compensate them for the lack of return in the short term.

How is the situation on the global front now, specifically with regards to the fear of sovereign defaults in Europe?
Global concerns have receded but have not gone away totally. In Europe, the size of the economy of Greece is roughly about 2.5 per cent of the entire European Union (EU) and hence a concerted effort to stave off the problem may be possible. But the problem is also likely to affect Portugal, which has recently seen its long-term foreign currency issuer rating get downgraded by Fitch. Spain and Italy are relatively larger economies in the EU and UK is going to the polls shortly. They could be future flash points.

And how good is state of the US economy?
The key to global recovery will be the strength of the US rebound and specifically the improvement in its employment number. This will have to be watched very closely.

Is there a fear of global economic problems flaring up again, or are we more likely to see a prolonged and gradual recovery?
These festering issues will keep the global outlook hazy despite statistical numbers from other parts of the world reporting a gradual recovery.

Several follow-on public offers (FPOs) of well-known PSUs have not done well in recent times and had to be bailed out by LIC and SBI. By contrast, several IPOs of lesser known private sector companies have been subscribed and have also shown listing gains. What are the reasons for this?
The approach to public issues by the institutional and the retail investor is quite often contrasting. Institutional investors look at long-term prospects and are happy to pick up large chunks of equities at low transaction cost. On the other hand, retail investors are more encouraged by the listing gains of their subscriptions.

Quite a few public issuances by the government have been priced such as to leave little or no scope for appreciation on listing. And this has led to disappointing retail participation. The key lies in pricing these issues more attractively for retail investors. This has two advantages: one, there is no denying the fact that the prosperity of the primary market ultimately passes through into the secondary market also. Hence, a gain made by a retail investor, either notional or transactional, will boost the capital market. Two, it will also be in the interest of the government to have more widespread shareholding. Therefore, there is a need to see what needs to be done to ensure wider investor participation. Why is more widespread shareholding in the interest of the government?
If shareholding is very concentrated then efficient price discovery in the market gets diluted. Concentrated shareholding can drive prices in either direction in extreme situations.

So what factors should investors keep in mind while evaluating IPOs and FPOs?
They should be guided more by the prospects of the company and its valuation rather than by their impression of what the grey market premium indicates to them about the attractiveness of an IPO or FPO.

In your view, should the government try to maximise its gains from the sale of PSU stakes or should it price these offers low in order to encourage widespread participation?
The proper approach lies somewhere in between. There is pressure on the government to raise resources through divestment. Therefore it cannot offer its stakes at throwaway prices. However, the government also intends to bring to the market companies such as Coal India and Air India Ltd which would expand the scope of exposure in the industries in which these companies operate. It may be meaningful to price these offerings attractively, not necessarily inexpensively, to prepare the ground for future raising of capital which these companies will anyway need.

The price of crude oil is already above $80 per barrel. Other commodities are also trading at high prices. Are high commodity prices a cause for worry and will they affect corporate performance negatively?
Commodity prices had run ahead of the actual evidence of economic recovery. They have not moved that significantly after confidence in growth has become more established. One cannot rule out that there is scope for commodity prices to harden further from the current level. But as long as it is within a limited range, corporate performance will not get too negatively impacted. One has seen that the rise in excise duty has been passed on by producers to consumers without any large impact on demand. Therefore, they should be able to pass on the impact of rising commodity prices also if demand growth is fairly strong. This will be possible only within a range and will not be inelastic.

Which are the two sectors that you are currently bullish on?
In the engineering and construction space we see companies moving into a different dimension of topline and bottomline numbers. Therefore, their margins should expand because of economies of scale. And because the denominator in terms of the topline will grow exponentially, the net profit should go up significantly. What I mean is that if earlier a company had a revenue of Rs 100 crore and its profit margin was 10 per cent, then its net profit was Rs 10 crore. Now if its profit margin goes up from 10 per cent to 12 per cent, but its revenue grows from Rs 100 crore to Rs 500 crore, then its net profit will grow from Rs 10 crore to Rs 60 crore.

Secondly, we would like to suggest a contrarian call on the IT sector. If these companies were able to weather the period of recession without any impact on their volumes, they should be able to expand them when the global recovery gets underway. Their outlook will get a further boost if the dollar continues to maintain its current trend. Contrary to popular impression, it has been strengthening.

Which are the two sectors that you think investors should avoid?
This will be a function of their risk appetite and investment horizon. Banking many suffer in the short term but gain in the long term.

Real estate stocks have very high beta but they also have a structural flaw in terms of developers' reluctance to reduce prices to meet demand, on account of which the sector is getting clogged with a lot of inventory.