ambit - sensex exits

STRATEGY

Analysts:

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Saurabh Mukherjea, CFA

[email protected]

Tel: +91 22 3043 3174

May 2015

Sensex exits: The decadal story

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Gaurav Mehta, CFA

[email protected]

Tel: +91 22 3043 3255

Nitin Bhasin

[email protected]

Pankaj Agarwal, CFA

[email protected]

Tanuj Mukhija, CFA

[email protected]

Ashvin Shetty, CFA

[email protected]

Parita Ashar

[email protected]

Consultant: Anupam Gupta

[email protected]

Karan Khanna

[email protected]

Sagar Rastogi

[email protected]

Bhargav Buddhadev

[email protected]

Strategy

May 05, 2015 Ambit Capital Pvt. Ltd. Page 2

CONTENTS Sensex exits: The decadal story 3

Section 1: Modi hits the reset button 4

Section 2: How to play the upcoming change in the Sensex ..17

COMPANIES

Reliance Industries (NOT RATED) 27

ONGC (NOT RATED). 31

State Bank of India (SELL). 35

HDFC (SELL) 39

Bharti Airtel (NOT RATED) 43

L&T (SELL). 47

NTPC (SELL). 51

Mahindra & Mahindra (NOT RATED). 55

Vedanta Ltd (NOT RATED) 59

BHEL (SELL).. 65

Bajaj Auto (SELL).69

Hero MotoCorp (SELL).. 73

Tata Steel (SELL). 77

Hindalco (SELL)... 81

Tata Power (BUY) 85

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

THEMATIC May 05, 2015

Strategy

Sensex exit candidates (FY16-25)

Name Ticker Mcap (US$ mn)

6M ADV (US$ mn)

Reliance Inds. RIL IN 43,895 54.0

O N G C ONGC IN 40,910 26.1

St Bk of India SBIN IN 32,104 88.7

H D F C HDFC IN 28,980 56.2

Bharti Airtel BHARTI IN 23,962 31.7

L&T LT IN 23,864 52.8

NTPC NTPC IN 19,493 14.5

M & M MM IN 11,186 22.7

Vedanta* SSLT IN 9,786 16.8

B H E L BHEL IN 9,165 18.3

Bajaj Auto BJAUT IN 8,826 16.2

Hero Motocorp HMCL IN 7,315 35.3

Tata Steel TATA IN 5,505 32.9

Hindalco Inds. HNDL IN 4,177 19.3

Tata Power TPWR IN 3,225 5.2

Source: Bloomberg, Ambit Capital research. Note: *This is Sesa Sterlite.

THIS NOTE CANNOT BE USED BY THE MEDIA IN ANY SHAPE OR FORM WITHOUT PRIOR CONSENT FROM AMBIT CAPITAL.

Analyst Details

Saurabh Mukherjea, CFA

+91 22 3043 3174 [email protected]

Gaurav Mehta, CFA +91 22 3043 3255

[email protected]

Karan Khanna

+91 22 3043 3251

[email protected]

Consultant

Anupam Gupta

[email protected]

Sensex exits: The decadal story Modis resets are poised to transform the Indian economy over the next decade. Structural changes in savings patterns, disruption of the crony capitalism model and redefinition of Indias subsidy scheme are likely to drive down inflation and reduce the cost of factors of production whilst causing a short-term dip in GDP growth. The biggest investment implication of this is a sharp rise in Sensex churn. In this report we provide a framework to identity the 15 Sensex incumbents that are likely to exit the Sensex over the next decade, as the old order gives way to the new. We highlight that in the wake of irreversible external change, Sensex exit candidates underperform the index by 20% per annum until their exit from the index.

As Modi disrupts the way the Indian economy functions

We believe that Indias Prime Minister, Narendra Modi, is driving three structural resets that will meaningfully change the Indian economy over the long term: (1) shift Indias savings landscape away from gold & land and towards the formal financial system; (2) disrupt the Indian model of crony capitalism model; and (3) redefine Indias subsidy mechanism (click here for our 23rd March thematic on this subject). We highlight the Governments high profile campaign against black money and crony capitalism as a measure of its intent. Thus, the old contract between business and politics seems set for a major overhaul over the next decade.

the economy is set for a structural change

These structural changes will disrupt the way business is conducted in India in much the same way that the liberalisation measures of 1991 ended the License Raj. In particular, we expect the resets to have three significant impacts: (a) Inflation should fall structurally; (b) GDP growth will be adversely impacted in the short term; and (c) the cost of factors of production should decline thus making it easier for entrants to go head-to-head with entrenched incumbents.

Sensex churn is set to rise

Our analysis of Sensex churn across 10-year windows reveals that churn peaked at 67% (or 20 replacements in a 30-stock index) in the years following the 1991 reforms (1993-1995). From those levels, Sensex churn has fallen to a low of 27% (8 replacements) in the latest 10-year iteration (from 2004 to 2014). We expect a reversion to 50% churn, implying that 15 companies will exit the Sensex in the next decade.

Identifying the exit candidates

Using Ambits proprietary methods such as The Coffee Can Portfolio, The Greatness Framework and the Ambit P-75, we identify a list of 15 stocks that we believe are the most likely Sensex exit candidates over the next decade. These companies are Tata Power, NTPC, Hindalco, Tata Steel, Hero MotoCorp, SBI, Sesa Sterlite, Bharti Airtel, Reliance Ind, M&M, ONGC, L&T, BHEL, HDFC and Bajaj Auto.

For those who believe that giant market-leading firms are highly unlikely to be kicked out of the Sensex, we highlight that all of the following firms were in the Sensex in 1992 Century Textiles, GSFC, Bombay Dyeing, GE Shipping and Ballarpur Industries. The disruption created by the end of the License Raj was such that all of these firms were out of the Sensex by 2002. Similarly, in 2005, all of the following giants were in the Sensex Ranbaxy Labs, HPCL, Satyam Computers, Grasim Industries and Reliance Infra. No prizes for guessing what happened to these companies by 2015.

Strategy


Section 1: Modi hits the reset button Whatever we choose to do, from reaching the cutting edge of industry to meeting the most-critical social need, we require investment and technology, industry and enterprise. That is why for me, Make in India is not a brand. Nor is it simply a slogan on a smart lion!

It is a new national movement. And, it covers the whole spectrum of our government, society and business. To this informed audience, I hardly need to state the obvious: Our scale of transformation is vast; therefore, the opportunities we offer are huge.

- Prime Minister Narendra Modis remarks at the Inaugural Session of Hannover Messe on 12 April 2015. Source: http://pmindia.gov.in/en/news_updates/pms-remarks-at-the-inaugural-session-of-hannover-messe/)

Indias Prime Minister, Narendra Modi, continues with his agenda of transforming the way business is done in India. During his recent trip to Europe, PM Modi pushed the Make In India initiative by reaching out to France and Germany, Europes top-2 economies. In our March 2015 thematic strategy report, Modi hits the reset button, we posited that Mr. Modi, is likely to engineer three critical resets over the next four years.

The three critical resets over the next four years Reset 1: Shifting Indias savings landscape away from gold and land towards the formal financial system

India has a higher savings rate than its peers (see the exhibit below). For instance, data from the World Bank suggests that a typical emerging market has a savings rate of 24% when its per capita income is US$1,600. India, on the other hand, had a savings rate of 30% when its per capita income was at US$1,500 in CY13.

Exhibit 1: India has a higher savings rate than its peers

Source: World Bank, Ambit Capital research. Note: Data pertains to CY13

Exhibit 2: however, 68% of these savings are held in physical form

Source: CEIC, Ambit Capital research. Note: Data pertains to FY13

Despite this, India is characterised by a high cost of debt capital and poor accessibility to capital, as more than two-thirds of Indias household savings are held in physical form, which includes real estate and gold.

Physical savings instruments are preferred to financial savings instruments in India because of the following two reasons:

(1) Whilst the purchase of physical assets can be funded using black money, the purchase of financial assets cannot be funded using black money, and

(2) Physical assets are perceived to be a superior inflation hedge as against financial assets.

India

Philippines

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South Africa

Mexico

TurkeyBrazil

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Bangladesh

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Per capita income (in current USD)

Financial savings

32%

Physical savings

68%

The Modi resets are set to transform Indias economy

India is characterised by a high cost of debt capital and poor accessibility to capital, as more than two-thirds of Indias household savings are held in physical form

Strategy


The reset that Modi is likely to engineer

The FY16 Union Budget, which was unveiled on 28 February 2015, explicitly aimed to disincentivise the black economy and curb the demand for gold through a range of measures (see the exhibit below for details).

Since then, the Government has shown determination with a highly visible crackdown on black money. Our recent discussions with the promoters of small-midcap businesses in northern and eastern India reveal that black money is already exiting real estate at a rapid rate, as tax officials have become much more aggressive over the past year with regards to real estate transactions. As a result, demand conditions, according to several promoters who are active in the cement, paint, electricals and building materials sectors, are currently the worst since the quarter in which Lehman Brothers went bust.

Exhibit 3: The FY16 Union Budget explicitly aimed to disincentivise the black economy and curb the demand for gold

Aim of measure Quotes from the Budget Speech made by the Finance Minister

Disincentivising the black economy

Tracking down and bringing back the wealth which legitimately belongs to the country is our abiding commitment to the country. Recognising the limitations under the existing legislation, we have taken a considered decision to enact a comprehensive new law on black money to specifically deal with such money stashed away abroad. To this end, I propose to introduce a Bill in the current Session of the Parliament. With your permission, Madam Speaker, I would like to highlight some of the key features of the proposed new law on black money. (1) Concealment of income and assets and evasion of tax in relation to foreign assets will be prosecutable with punishment of rigorous imprisonment upto 10 years. Further, this offence will be made non-compoundable; the offenders will not be permitted to approach the Settlement Commission; and penalty for such concealment of income and assets at the rate of 300% of tax shall be levied. (2)Non filing of return or filing of return with inadequate disclosure of foreign assets will be liable for prosecution with punishment of rigorous imprisonment up to 7 years. (3)Income in relation to any undisclosed foreign asset or undisclosed income from any foreign asset will be taxable at the maximum marginal rate. Exemptions or deductions which may otherwise be applicable in such cases shall not be allowed. (4)Beneficial owner or beneficiary of foreign assets will be mandatorily required to file return, even if there is no taxable income. (5)Abettors of the above offences, whether individuals, entities, banks or financial institutions will be liable for prosecution and penalty. (6)Date of Opening of foreign account would be mandatorily required to be specified by the assessee in the return of income. (7)The offence of concealment of income or evasion of tax in relation to a foreign asset will be made a predicate offence under the Prevention of Money-laundering Act, 2002 (PMLA). This provision would enable the enforcement agencies to attach and confiscate unaccounted assets held abroad and launch prosecution against persons indulging in laundering of black money. (8)The definition of proceeds of crime under PMLA is being amended to enable attachment and confiscation of equivalent asset in India where the asset located abroad cannot be forfeited. (9)The Foreign Exchange Management Act, 1999 (FEMA) is also being amended to the effect that if any foreign exchange, foreign security or any immovable property situated outside India is held in contravention of the provisions of this Act, then action may be taken for seizure and eventual confiscation of assets of equivalent value situated in India. These contraventions are also being made liable for levy of penalty and prosecution with punishment of imprisonment up to five years. As regards curbing domestic black money, a new and more comprehensive Benami Transactions (Prohibition) Bill will be introduced in the current session of the Parliament. This law will enable confiscation of benami property and provide for prosecution, thus blocking a major avenue for generation and holding of black money in the form of benami property, especially in real estate.* A few other measures are also proposed in the Budget for curbing black money within the country. The Finance Bill includes a proposal to amend the Income-tax Act to prohibit acceptance or payment of an advance of Rs.20,000 or more in cash for purchase of immovable property. Quoting of PAN is being made mandatory for any purchase or sale exceeding the value of Rs1 lakh. The third party reporting entities would be required to furnish information about foreign currency sales and cross border transactions. Provision is also being made to tackle splitting of reportable transactions. To improve enforcement, CBDT and CBEC will leverage technology and have access to information in each others database.

Curbing demand for gold

India is one of the largest consumers of gold in the world and imports as much as 800-1000 tonnes of gold each year. Though stocks of gold in India are estimated to be over 20,000 tonnes, mostly this gold is neither traded, nor monetized. I propose to: (i) Introduce a Gold Monetisation Scheme, which will replace both the present Gold Deposit and Gold metal Loan Schemes. The new scheme will allow the depositors of gold to earn interest in their metal accounts and the jewellers to obtain loans in their metal account. Banks/other dealers would also be able to monetize this gold. (ii) Also develop an alternate financial asset, a Sovereign Gold Bond, as an alternative to purchasing metal gold. The Bonds will carry a fixed rate of interest, and also be redeemable in cash in terms of the face value of the gold, at the time of redemption by the holder of the Bond. (iii) Commence work on developing an Indian Gold Coin, which will carry the Ashok Chakra on its face. Such an Indian Gold Coin would help reduce the demand for coins minted outside India and also help to recycle the gold available in the country. One way to curb the flow of black money is to discourage transactions in cash. Now that a majority of Indians has or can have, a RUPAY debit card. I, therefore, propose to introduce soon several measures that will incentivize credit or debit card transactions, and disincentivise cash transactions.

Source: Budget Speech for the FY16 Union Budget, Ambit Capital research. *Note: This bill has been ratified by the Cabinet and has been tabled in the Parliament.

The FY16 Budget explicitly aims to disincentivise the black economy and curb demand for gold

A highly visible crackdown against black money has begun

Strategy


Measures pertaining specifically to black money stashed away abroad (as stated by the Finance Minister and highlighted in the first row of Exhibit 3 above) have been incorporated in the Undisclosed Foreign Income and Assets (Imposition of Tax) Bill, 2015 which was introduced in the Lok Sabha on 20th March 2015. We expect this Bill to be passed by the Parliament in the ongoing budget session i.e. before 8 May 2015.

In addition, we highlight the Governments recent proposals to enhance disclosures on Income Tax Returns. On 18 April, the press reported (Source: http://timesofindia.indiatimes.com/business/india-business/New-tax-form-to-seek-details-of-foreign-travel-bank-A/Cs/articleshow/46964327.cms) that the Government has prepared new Income Tax Return forms for the forthcoming filing season in July-August 2015. Assesses filing their tax returns will have to make disclosures on:

Information about all the foreign trips made during the year and money spent on these trips;

Details of all bank accounts (in India and abroad) and balances kept in these accounts; and

Details of immovable property, financial interest in companies and details of trusts created outside the country.

Whilst the Finance Minister (FM) has subsequently said that he will revisit the format of these forms, our sources suggest that even the reworked forms will ask for much more detail than Indians have ever had to provide in their tax returns. We also highlight that the Finance Minister said on 18th April that the Black Money Law will be the Governments top priority when Parliament reconvenes next week.

Besides explicitly targeting the black economy, PM Modi also aims to expand the white economy. He plans to exponentially increase the number of households with access to banking services through the ambitious Prime Ministers Jan Dhan Yojana (PMJDY) which was launched in August 2014 (see the exhibits below). Our meetings with the Finance Ministry over the past nine months suggest that PMJDY has been executed in mission mode with enormous pressure being exerted by the Prime Ministers Office on the banks to play ball. As a result, 140 million bank accounts have already been opened under the auspices of this scheme and in over 90% of districts all Indian families now have at least one bank account.

Exhibit 4: PMJDY is the most-ambitious financial inclusion programme in Indias history Targets of the scheme Description

Bank accounts Two bank accounts for each of the estimated 75 million poor bank households are to be opened by August 14, 2015.

This implies opening 150 million bank accounts in less than 12 months. As on 28 February 2015, 136.8mn accounts have been opened under PMJDY, out of which 81.7mn are in rural areas and 55mn are in urban areas. Rupay Cards have been issued for 121.9mn accounts.

Payment services and credit Each bank account is to be provided with an overdraft facility of Rs5,000 and a Rupay debit card.

The Mor Committee Report envisages Ubiquitous Access to Payment Services by January 2016. As per the additional comments made by Shikha Sharma and SS Mundra, While January 2016 can be an aspirational goal, given the scale of the task, a target date of January 2018 may be more realistic and implementable. The overdraft facility will only be extended to Aadhar-enabled accounts after satisfactory operation of the account for six months. Assuming that this linkage is achieved, the banking system will have to extend credit of Rs750bn (i.e. 75mn households x 2 bank accounts per household x Rs5,000).

Insurance cover Each bank account will be provided with accident insurance cover of Rs100,000 and life insurance cover of Rs30,000.

For life insurance cover, the Government has decided to set aside a sum of Rs500mn from the Social Security Fund (SSF) which was set up by the Government of India in 1988-89 and is managed by the Life Corporation of India (LIC). The National Payments Corporation of India (NPCI), promoted by public sector banks, will provide premium on the Rs0.1mn accident insurance cover on behalf of the customers.

Bank-based transfer of subsidies Each bank account will be linked to the Aadhaar card.

The linking of the Rupay debit card and the Aadhar card is critical, as this will allow the Government to transfer subsidies through banks and thereby allow banks to earn a fee income. Prime Minister Narendra Modi has directed the Unique Identification Authority of India (UIDAI) to ensure universal coverage under Aadhaar by June 2015. From 1 January 2015, the entire LPG subsidy has been transferred on the DBT platform. More subsidies and transfers will follow soon.

Source: PMJDY, Ambit Capital research

The Government is intent on promulgating a new law to curb black money

Enhanced disclosures on IT return forms are part of these measures

PM Jan Dhan Yojana will help in expanding the white economy140 mn bank accounts opened in nine months

Strategy


Reset 2: Disrupting crony capitalism in India

PM Narendra Modi, in his first ever interview to Indian media after becoming PM, said laws can't be different for Reliance Industries' chairman Mukesh Ambani and for common man.

Our job is to run a policy-driven government. Red tape nahin hona chahiye. Ab red tape nahin hona chahiye matlab Mukesh Ambani ke liye red tape na ho aur ek common man ke liye red tape ho, waisa nahin chal sakta' (red tape should not be there does not mean it shouldn't be there for Mukesh Ambani, but be there for a common man; that won't do).

- Prime Minister Narendra Modi in an interview given to The Hindustan Times on 8 April (source: www.indiatoday.in)

The second reset is aimed at changing the long-standing contract between politics and business. Until the 1990s, the pre-dominant model of corruption in India was the cream-skimming kind of corruption whereby private companies were required to pay an extra 5-10% of their project outlay to the local powers that be. During the ten years of UPA rule, however, Indias core model of corruption shifted to a different level whereby various political-business cliques captures large sectors of the economy and then suppressed competition in the sector in a bid to maximise their gains (see the exhibit below for details).

Exhibit 5: How high degrees of corruption led to high levels of inflation in India over the last decade

Source: Ambit Capital research

The reset that Modi is likely to engineer

Our discussion with policy experts suggests that Modi is cognizant of the fact that corruption and the consequent high inflation can affect his electoral ambitions. Hence, Modi, whose most defining character trait is his searing political ambition, is keen to disrupt the crony capitalist model in sectors ranging from food and real estate to improve the standard of living for the electorate (refer to the exhibits below for details of the steps already taken by the Government to check corruption in the Government machinery).

Indias core model of corruption shifted to a different level under UPA rule whereby various political-business cliques captures large sectors of the economy and then suppressed competition in the sector in a bid to maximise their gains

Modi is keen to breakdown the crony capitalist model in sectors ranging from food and real estate to improve the standard of living for the electorate

Strategy


Exhibit 6: Steps taken by the Government to check corruption in the Government machinery Measure Details

Creation of e-governance platforms

The Government has created an online system for environmental and industrial clearances. A similar system has been created for labour inspections at factories.

Direct Benefits Transfer (DBT)

The direct transfer of benefits, started mostly in scholarship schemes, is set to be further expanded with a view to increasing the number of beneficiaries from the present 10mn (i.e. 0.8% of Indias population) to 103mn (i.e. 9% of Indias population). Similarly, Rs63bn (i.e. 0.1% of GDP) has so far been transferred directly as LPG subsidy to 115mn LPG consumers. The Government plans to ramp-up this platform so as to disburse kerosene (i.e. 0.1% of GDP) as well as food subsidies (i.e. 1% of GDP) through this platform by end-CY15.

Reforming the Food Corporation of India (FCI)

Within two months of assuming power, the Government constituted a commission under Parliamentarian Shanta Kumar to suggest ways to restructure the FCI. The Government is likely to implement the recommendations of the committee which will dramatically bring down the operational cost to maintain the FCI and reduce corruption within it. The panel has recommended measures such as limiting the operations of the FCI to only grain-deficient states, bringing down the coverage of the National Food Security from 67% of the population currently to 40% and introducing cash transfers for food subsidy.

Source: Various media reports, Ambit Capital research

Exhibit 7: The Government has cracked down on certain officials and politicians

Month Development

April 2015 In a charge-sheet, the CBI accused former Congress MP and longstanding promoter of by Jindal Steel and Power (JSPL), Naveen Jindal, the former Chief Minister of Jharkhand, Madhu Koda, the former Minister of State for Coal, Dasari Narayana Rao, and the former Coal Secretary, HC Gupta, of conspiring to help JSPL acquire a coal field in Jharkhand in 2008.

April 2015 For theft of sensitive documents from the Ministry of Petroleum, the Delhi Police crime branch has filed a charge-sheet against 13 people including five executives from prominent corporates (several of whom are a part of Ambits P-75 list of connected companies), six clerical-level Government officials and two middlemen.

March 2015 The Government cancelled three of the eight coal blocks, two of which were won by JSPL, citing stark differences between bids in the same category. JSPL has taken the Government to Court and the case is currently being heard in Court.

March 2015 Oil minister Dharmendra Pradhan said in a press statement that the Government is examining the latest CAG report on irregularities in ONGCs rig hiring from RIL and will take appropriate action.

March 2015 The CBI arrested a Mumbai-based chartered accountant and two Government officials for allegedly leaking and selling confidential documents related to foreign investments from the finance, commerce and industry ministries. February 2015 The CBI arrested top officers of a consultancy firm involved in corporate espionage related to the Oil Ministry.

November 2014 The CBI is likely to examine the role of the former Environment Minister Jayanthi Natarajan for her involvement in the alleged diversion of forest land for mining purposes in Jharkhand.

November 2014 The Settlement Commission alleged understatement of professional income of Abhishek Manu Singhvi, the former Congress spokesperson, of Rs919mn over a three-year period and imposed a penalty of Rs566mn. The order has since been stayed.

November 2014 The Comptroller and Auditor General (CAG) stated that Robert Vadra (son-in-law of Congresss party President Sonia Gandhi) had earned Rs440mn in windfall gains because an indulgent Congress Government allowed him to do so in breach of law and did not recover Rs415mn of the profit he made by selling the land to DLF Universal.

Source: Various media reports, Ambit Capital research.

Similar to the move against black money, the Governments efforts against crony capitalism are also very visible. We highlight three such examples that have been in the press recently:

Example 1: On gas pricing

In April 2015, the Government hardened its stance on the long-standing and contentious gas pricing issue against Reliance Industries (RIL). In an affidavit submitted to the Supreme Court, the Ministry of Petroleum and Natural Gas asked the Court to reject RILs petition to appoint a third arbitrator of independent nationality to decide on the pricing of natural gas. This is, reportedly, the first time that the Government has taken the stand that this dispute cannot be solved by arbitration. The Government also accused RIL of demanding implementation of the pricing of January 2014, under the threat of arbitration proceedings, which was "mala fide". We see this accusation as a strong stance taken by the Government, which is in-line with its earlier actions (see Exhibit 7 above) aimed at attacking crony capitalism. (Read the full news report here: http://economictimes.indiatimes.com/articleshow/46914336.cms)

Example 2: On coal block allocation

In March 2015, the Government cancelled three of the eight coal blocks auctioned, two of which were won by Jindal Steel and Power (JSPL), citing stark differences between the bids in the same category. Recently, in April 2015, the Delhi High Court decided to hear the Governments plea against industrialist Naveen Jindal and one of his former employees who was caught recording court proceedings during a coal

Three case studies that show the Governments efforts against crony capitalism are serious

The Government has taken a strong stand in the gas pricing issue against RIL

The Government has pushed back against mispricing of bids in auctions

Strategy


block allocation matter relating to his company. (Read the full news report here: http://economictimes.indiatimes.com/articleshow/46911991.cms)

Further, on 29th April, the CBI filed a charge-sheet against Mr. Naveen Jindal, charging him with corruption and misrepresenting facts to secure a coal mine in Jharkhand during the UPA era. The charge-sheet named Mr. Jindal along with nine others, including Dasari Narayan Rao who was the junior Coal Minister during the UPA regime, Madhu Koda who was former Jharkhand Chief Minister and former Coal Secretary HC Gupta. (Link: http://economictimes.indiatimes.com/articleshow/47097991.cms).

Example 3: On stealing government secrets

On 17 February 2015, the Delhi Police Crime Branch arrested five people for stealing key policy documents from the Ministry of Petroleum and Oil & Gass office at Shastri Bhavan, New Delhi. Since then, press reports (Source: http://timesofindia.indiatimes.com/india/5-corporate-executives-among-13-charged-in-leakgate/articleshow/46973548.cms) suggest that:

The Delhi Police crime branch has filed a charge-sheet against 13 people including five executives from prominent corporates (several of whom are a part of Ambits P-75 list of connected companies);

These charges pertain to leaking of documents from the Petroleum Ministry and there is a second charge-sheet on the way which pertains to the documents leaked from the coal and power ministries; and

As we have argued in an op-ed piece for the Business Standard (Source: http://www.business-standard.com/article/opinion/saurabh-mukherjea-modi-hits-the-reset-button-115041501296_1.html), the Prime Minister seems determined to disrupt the Indian model of crony capitalism by visibly tightening law enforcement in the seedy borderland, where commerce and politics intersect in India.

Reset 3: Re-defining Indias subsidy mechanisms

According to data collected by the World Bank, Government spending on subsidies and transfers in India as a share of total expenditure is amongst the highest in EMs (see the exhibit below).

Exhibit 8: The Indian Governments spending on subsidies and transfers is amongst the highest in EMs

Source: World Bank, Ambit Capital research. Note: Data pertains to CY13

For instance, Indias subsidy bill expanded at a CAGR 19% p.a. between FY04 and FY14 (see the exhibit below).

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The Prime Minister is determined to disrupt the Indian model of crony capitalism

Indias subsidy bill expanded at a CAGR 19% p.a. between FY04 and FY14

Strategy


Exhibit 9: Subsidies under the UPA regime (FY04-14) expanded at a CAGR of 19% p.a. and are now being shrunk by the NDA Government

Source: CEIC, Ambit Capital research

The reset that Modi is likely to engineer Modi seems likely to change the face of the subsidy regime that propped up Indias rural economy under the former United Progressive Alliance (UPA) Government. Given the fiscal imperatives that India faces, the Modi-led Government is set to compress the quantum of subsidies that the Central Government pays for, as is already evident from the last two budgets that this Government has prepared.

Furthermore, the Modi-led Government remains committed to better targeting of subsides in India by creating and then using the direct benefit transfer (DBT) platform, a point which has been made to us repeatedly by several senior civil servants over the past six months.

Exhibit 10: The Government seems committed to transferring all the subsidies onto the DBT platform Source Case for transferring all subsidies onto the DBT platform

Economic Survey FY15 The survey makes the point that price subsidies (such as the MSP mechanisms) are regressive and product subsidies (such as those in kerosene and food) are subject to leakages. Hence, the Government should work towards transferring all subsidies on to the DBT platform

Union Budget FY16 According to the Finance Minister, The JAM (Jan Dhan, Aadhaar and Mobile phones) trinity will allow us to transfer benefits in a leakage-proof, well-targeted and cashless manner.

Source: Economic Survey FY15, Union Budget FY16, Ambit Capital research

The current Governments explicit effort aimed at checking pilferage in the subsidy disbursement mechanism is also evident in the series of steps taken by the Government since May 2014 to contain this dynamic (see the exhibit below).

Exhibit 11: Steps taken by the current Government to check pilferage from the subsidy system Step Description Date

The Shanta Kumar committee report

This committee was formed within two months of the new Government coming to power. The report recommends transferring food subsidies onto the DBT platform to check leakages. January 2015

Forcing the Food Corporation of India (FCI) to make its operations more efficient

Out of the total food subsidy bill of Rs1.15trn in FY15, the operating cost of FCI alone is Rs940bn. Recently, the Government has forced the FCI to get rid of surplus stock and it also plans to withdraw FCI from grain-surplus states to bring down the huge operating costs of FCI.

FY15

Transferring the LPG on to the DBT

The Government has transferred the LPG onto the DBT platform and this marks the first in a list of subsidies to be transferred onto the DBT. January 2015

Rapid progress on Aadhaar and PMJDY

The Governments commitment to roll out all the subsidies onto the DBT platform is visible in the rapid progress made on PMJDY and roll out Aadhaar cards which is a prerequisite for the DBT. FY15

Source: Media reports, Ambit Capital research. Note: PMJDY stands for Pradhan Mantri Jan Dhan Yojna

Over and above arresting the rapid growth in subsidies and the ineffective mode of disbursing them, Modi has also halted other large-scale fiscal transfers towards rural India. The most important amongst these is the Food Corporation of Indias enormous programme for buying food grains at Minimum Support Prices (MSPs).

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The Modi-led Government is set to compress the quantum of subsidies that the Central Government pays for, as is already evident from the last two budgets that this Government has prepared

Over and above arresting the rapid growth in subsidies and the ineffective mode of disbursing them, Modi has also halted other large-scale fiscal transfers towards rural India

Strategy


Under the UPA, the FCI was forced to push through MSP hikes of 10-14% every year. This necessitated intervention by the FCI on a grand scale in terms of buying food grains at these ever-rising MSPS; in the year to March 2014, the FCI spent around US$20bn (almost 1% of Indias GDP) on buying grains. Thus, by June 2013, the FCIs stockpile of grains was a record 78mn tonnes.

Modi seems to have cut these large-scale transfers radically; MSP hikes in July 2014 were only 3-4% and the FCIs food grain stockpile has started coming down (it stands at 38mn tonnes as of 1 March 2015). As a result, the FCIs transfer of resources from the Centre to the states has halted in large parts of the country.

Structural impact of the resets on Indias economy Having discussed the three Modi resets, we now summarise their impact on the Indian economy over the medium to long term.

Impact 1: Inflation should be structurally lower

Under the UPA as the corruption, competition, inflation triangle was entrenched, Indias inflation rate broke away from other EMs and went into an altogether different plane (see the exhibit below). This in turn had a range of adverse consequences for India such as: (1) lower demand for financial savings; (2) rising demand for gold, leading to a widening of the current account deficit (CAD) (see the exhibit below); (3) structural downward pressure on the INR; and (4) a perpetually challenged manufacturing sector.

Exhibit 12: Inflation went into a different orbit during the UPA regime


Exhibit 13: and so did the fiscal and current deficit as a percentage of GDP


It is critical to note that Indias long-term inflation track record, until the UPA came in, was low and stable. The three resets which Modi will engineer should help bring down inflation on a structural basis. In fact, the normalisation of inflation is already evident to some extent, as the inflation gap between India and the other EMs has started narrowing (see the exhibit below). Lower inflation should then result in structurally lower interest rates, a stable CAD, a stable INR and a more competitive manufacturing sector.

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Modi seems to have cut these large-scale transfers radically MSP hikes in July 2014 were only 3-4% and the FCIs food grain stockpile has started coming down rapidly

Indias inflation rate under the UPA broke away from other EMs

The three resets which Modi will engineer should help bring inflation down on a structural basis

Strategy


Exhibit 14: The gap between Indias and developing Asias inflation has started to narrow in CY14


Impact 2: Adverse impact on GDP growth in the short term

Whilst over the longer term (two years and thereafter), the three resets should help boost GDP growth structurally, GDP growth in FY16 seems likely to be adversely impacted, as:

Rural and semi-urban consumption and construction activity is adversely impacted by the rejigging of the subsidy regime: After seven years of frenetic growth, the rural and semi-urban India story now faces a serious challenge, as the old construct of pilfered subsidy cash being used to buy land, gold, SUVs, cars, 2Ws, electricals and other aspirational items by the rural elite comes to an end. The NDA will gradually unveil new rules which will govern rural growth henceforth. However, even if one takes an optimistic view of the NDAs as-yet unproven execution skills, it will take at least 2-3 quarters for the NDA construct centered on capex and DBT to bite. Policymakers in Delhi tell us that wherever the DBT regime is being introduced in India, within weeks, auto and cement demand is falling and construction activity is coming to a halt as black money dries up in that part of the country.

Crony capitalists refuse to begin capex activity as they see reduced scope for supernormal profits under Modi: As the Government goes after corrupt officials and businessmen, it seems increasingly unlikely that the big crony capitalist conglomerates will kick-start the investment cycle; in the absence of supernormal profits (which they earned under the UPA regime thanks to the corruption, competition, inflation triangle), these conglomerates seem disinterested in pushing through capex in India.

For a detailed account of why GDP growth is likely to surprise negatively in FY16, click here for our 13th April 2015 note, GDP growth may surprise on the downside in FY16. The key table from that note - summarising our growth forecasts has been reproduced below.

Exhibit 15: We expect GDP growth in FY16 to be recorded at 7.5% YoY Growth (YoY change, in %) FY13 FY14 FY15 (E)

FY16 (old est.)

FY16 (new est.)

Change FY16 (old) vs FY16 (new)

Agriculture 1.7% 3.8% 1.5% 3.7% 3.7% 0bps

Industry 2.3% 4.4% 5.6% 6.2% 5.9% -30bps

Services 8.0% 9.1% 10.6% 10.3% 9.7% -60bps

GDP at FC 4.9% 6.6% 7.4% 7.9% 7.5% -40bps Memo Item: Investment -0.3% 3% 4.3% 6.7% 5.6% -110bps

GDP at MP 5.1% 6.9% 7.4% 7.9% 7.5% -40bps

Source: CEIC, Ambit Capital research; Note: GDP at FC refers to supply-side GDP i.e. GDP at Factor Cost. GDP at MP refers to demand-side GDP i.e. GDP at Market Prices. This exhibit has been taken from our 23rd March note.

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Advanced economies Developing Asia India

Even if one takes an optimistic view of the NDAs as yet unproven execution skills, it will take at least 2-3 quarters for the NDA construct centered on capex and DBT to bite

Strategy


Impact 3: Cost of factors of production set to decline

The three resets that Modi is likely to engineer over the next few years is likely to have a profound impact on the cost of three factors of production, namely land, labour and capital in India. In specific:

Reset 1 and Reset 3 are likely to lower the cost of capital,

Reset 1 and Reset 2 are likely to lower the cost of land, and

Reset 2 and Reset 3 are likely to lower the cost of labour.

Reset 1 and Reset 3 would lower the cost of capital The diversion of savings away from the physical form towards the financial form is likely to increase the quantum of bank deposits in India. Back-of-the-envelope calculations suggest that if the share of financial savings in total savings increases from the current levels of 32% to 40% over the next four years (assuming an increase of 2% per year), bank deposits in the system could increase from 4.1% of GDP in FY15 to 5.8% of GDP in FY19. This implies that bank deposits would increase at 16% CAGR in FY15-19, which is considerably better than the FY11-14 CAGR of 2%.

Exhibit 16: Bank deposits will surge as a result of a rise in household financial savings if financial savings become a larger part of household savings

Head FY14 FY15E FY16E FY17E FY18E FY19E Total household savings (in Rs trn) 25.4 29.3 33.6 38.7 44.5 51.2 Financial savings (as % of total household savings) 32% 32% 34% 36% 38% 40%

Financial savings (in Rs trn) 8.1 9.4 11.4 13.9 16.9 20.5 Bank deposits (Assuming bank deposits are 55% of financial savings) (in Rs trn)

4.5 5.2 6.3 7.7 9.3 11.3

Annual Bank deposits (as % of GDP) 3.9% 4.1% 4.5% 4.9% 5.3% 5.8%

Source: CEIC, Ambit Capital research. Note: Nominal GDP is assumed to grow at an average of 11.5% YoY until FY19

Within the broader emerging market (EM) pack, India stands out as a country with a high fiscal deficit (see the exhibit below). The low liquidity in the secondary Government bond market is partially responsible for the high yields in India (see the exhibit below), but the rising quantum of Government borrowing has played a key role in driving G-sec yields higher (see the exhibit below), where a larger Government borrowing programme has been invariably accompanied by higher yields.

Exhibit 17: India has one of the highest fiscal deficits relative to its EM peers

Source: IMF, Ambit Capital research. Note: Data pertains to CY13 and captures the General Government fiscal deficit as a percentage of GDP

Exhibit 18: There exists a positive relationship between the size of Government borrowing and the risk-free rate

Source: CEIC, Ambit Capital research. Note: Data pertains to FY04-15

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The diversion of savings away from the physical form towards the financial form is likely to increase the quantum of bank deposits in India

Within the broader emerging market (EM) pack, India stands out as a country with a high fiscal deficit

Strategy


Finally, as the Government restricts its fiscal deficit over the coming years by migrating subsidies and transfers to the DBT platform, this is likely to also contribute to lowering Indias elevated risk-free rate (see the exhibit below on the proven relationship between the size of a countrys fiscal deficit and the level of its interest rates).

As the economy moves towards lower consumer prices and sustainable fiscal deficit, the cost of capital would go down. As the RBI will now target CPI inflation at the midpoint of 4%(+/-2%) beyond FY16 and as the RBI Governor himself has said that the RBI will target a real interest rate of 1.5%, the repo rate could come down to somewhere around 6% (from the current 7.5%), depending upon how CPI inflation and the Governments fiscal deficit turn out.

Reset 1 and Reset 2 would lower the cost of land

Rental yields in property markets in India have remained extremely low as compared to its other Asian peers (see the exhibit below), thereby pointing to the over-valuation of this asset class mainly because it can absorb black money

Exhibit 19: Rental yields in India are extremely low relative to peers

Source: Global property guide, Ambit Capital research. Note: Data pertains to April 2014

The increased disincentives to operate with black money (owing to the passage of legislations by the Central Government to penalise the same) and the reduction in the size of the black economy (as the Modi-led administration breaks down the crony capitalist model in India) are likely to profoundly lower the preference for land as an asset class, thereby lowering the cost of land in India.

In a fairly-priced real estate market, the rental yield has to be somewhere close to the cost of borrowing. Instead, Mumbai has a rental yield close to 2% whilst the lending rate hovers around 10%. The difference between lending rates and rental yields are one of the highest in India (see the exhibit below). Even if one assumes that buyers are willing to live with only 5% rental yields (as they might have an extremely bullish view of capital gains arising from real estate in India), this would imply halving of real estate prices in Mumbai.

Exhibit 20: Difference between rental yields and lending rates is one of the highest in Asia

Source: World Bank, Global property guide, Ambit Capital research. Note: Data pertains to CY13

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)As the Government restricts its fiscal deficit over the coming years by migrating subsidies and transfers to the DBT platform, this is likely to also contribute to lowering Indias elevated risk-free rate

Rental yields in property markets in India have remained extremely low

In a fairly-priced real estate market, the rental yield has to be somewhere close to the cost of borrowing; instead Mumbai has a rental yield close to 2% whilst the lending rate hovers around 10%

Research suggests that more than 30% of Indias real estate sector is funded by black money

Strategy


Reset 2 and reset 3 would lower the cost of labour

The combination of reset 2 (i.e. reduction of corruption in the Government machinery especially at the FCI; see the exhibit below) and reset 3 (i.e. reduction in the size of the Central Governments subsidy bill) is likely to help reduce wage inflation in India, which once again had become immune to the economic slowdown over the last few years.

Exhibit 21: The Food Corporation of India (FCI) has begun maintaining lower buffer stocks than its long-term average since the Modi-led Government assumed control

Source: FCI, Ambit Capital research. Note: The stock is as of first day of every month as reported by the FCI

The pace of growth in average daily wages in rural India systematically rose from 6% YoY in CY06 to a staggering 21% YoY by CY11. However, this pace has been systematically decelerating since CY11 and has fallen to 4% YoY in CY14 YTD (see the exhibit below). The main source of job creation in India over the past five years has been construction. Therefore, with construction activity slowing down sharply over the past six months, this source of demand for labour has dried up and has helped moderate the rise in rural wages.

Exhibit 22: Rate of increase of rural wages have slowed down in the past year

Source: RBI, Ambit Capital research. Note: * Data for CY14 excludes December 2014

Another factor which led to higher rural wage inflation was frequent and large hikes in the MSPs for different crops (see the exhibit below). MSPs for rice and wheat were increased at an average rate of 14% YoY and 11% YoY respectively over FY08-13. This pace of increases decelerated meaningfully from FY14 onwards, as MSP growth rates slowed down to 4% YoY for wheat and rice. This will further help in curtailing rural wage growth and hence overall inflation.

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The combination of reset 2 (i.e. reduction of corruption especially at the FCI) and reset 3 (i.e. reduction in the size of the Governments subsidy bill) is likely to help reduce wage inflation

The pace of growth in average daily wages in rural India systematically rose from 6% YoY in CY06 to a staggering 21% YoY by CY11this pace has now fallen to 4% YoY

Another factor which led to higher rural wage inflation was frequent and large hikes in the MSPs for different crops

Strategy


Exhibit 23: Frequent rise in MSPs was one of the factors for high wage inflation in past years

Source: CEIC Ambit Capital research. Note: Data pertains to CY01-14

R = 0.2304

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Strategy


Section 2: How to play the upcoming change in the Sensex The fragile wants tranquility, the antifragile grows from disorder, and the robust doesn't care too much.

- Nassim Nicholas Taleb (Antifragile: Things That Gain from Disorder, 2012)

Having laid out our case in Section 1 for a structural change in the Indian economy over the coming decade, we now move to the investment implications. In this section we make the case for:

a) A rise in Sensex churn in the next decade

b) A framework for identifying the most likely churn candidates

Sensex churn set to rise In our note, Decadal changes in the Sensex dated June 28, 2012 (click here for details), we said that the constitution of the Sensex is extremely dynamic, and churn in the Sensex is in fact the only constant. Furthermore, churn ratios in India are higher than that of other developed as well as emerging markets (see the exhibit below).

Exhibit 24: The Indian market is characterised by a high churn ratio*

Source: Bloomberg, Ambit Capital research. Note: * Churn is defined as the number of companies which get ejected from the index over a given period of time / total number of companies in the index. This chart has been reproduced without any changes from our June 28, 2012 note: Decadal changes in the Sensex

Our analysis of Sensex churns over a 10-year window from 1986 to date (ie: 1986-1996, 1987-1997 and so on to 2004-2014) shows that the churn ratio of the Sensex tends to rise when the economy is undergoing irreversible structural changes. For instance, the 10-year period spanning 1992-2002, which saw the era of the License Raj coming to an end, saw the Sensexs churn ratio rise to 60% (vs the 53% churn ratio in the Sensex over 2002-12).

(Note: We have calculated the Sensexs churn ratio in the following manner - 18 of the 30 constituents of the Sensex in 1992 were no longer part of the index in 2002. Thus, Sensex saw a churn of 60% over the 1992-02 period. Similarly, 16 of the 30 constituents of the Sensex in 2002 exited the index by 2012. Consequently, churn over the 2002-12 period stood at 53%.)

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Sensex churn rises when the economy is undergoing irreversible structural changes

Strategy


Exhibit 25: Sensex churn ratio shows a tendency to rise when the economy undergoes structural changes

Source: Ambit Capital research, Bloomberg. Note: Sensex churn has been calculated as the percentage number of companies forming a part of the Sensex in year t that get exited from the index by year t+10. For example, 50% in the 1986-96 period suggests 15 of the 30 Sensex constituents in Dec86 were no longer part of the index 10 years later, i.e. Dec 96.

The churn in the Sensex peaked in the four years following the momentous reforms launched by PV Narsimha Rao (as PM) and Manmohan Singh (as Finance Minister). A whole host of businesses which had flourished behind the protectionist barriers created by the License Raj in industries were ejected from the Sensex. These industries include: (1) Textiles (Aditya Birla Nuvo, Bombay Dyeing, Century Textiles and Future Polyester), (2) Automobiles (Hindustan Motors and Premier), (3) Steel (Mukand Limited), (4) Paper (Ballarpur Industries), and (5) Heavy engineering (Bharat Forge, Cummins India, Siemens and Voltas (although this final group of companies subsequently adapted well in the post-License Raj).

Post-1995, Sensex churn has fallen remarkably relative to the volatile era of the early 1990s. Sensex incumbents grew rapidly in size and we attribute this to the following reasons:

a) Large business groups ramped up domestic capacities in a license-free era and followed them up by large acquisitions in the noughties (Reliance, Tata Steel and Hindalco).

b) Export-led companies like software (Infosys and TCS) and pharmaceuticals expanded.

c) The noughties also saw the rise of infrastructure companies (L&T) and banks/financial institutions which funded their expansion (ICICI Bank) and also benefited (HDFC and HDFC Bank) due to the rise in overall GDP growth (from 3.9% in FY03 to 8% in FY04, 7.1% in FY05, 9.5% in FY05 and 9.6% in FY01).

d) Finally, towards the end of the noughties, the rise in rural-led consumption (refer to Exhibit 22 on pg 15 to see how rapidly rural wages surged) benefited auto (Hero MotoCorp, Bajaj Auto, M&M and Maruti) and FMCG (HUL and ITC) stocks.

Further, the likelihood of churn from new company listings was also limited, at least in the first half of the noughties.

After remaining flat for a decade (3% CAGR from FY93 to FY03), the Sensexs recovery began meaningfully only after FY03 (55% CAGR from FY03 to FY06). This recovery drove a slew of large IPOs, including Government disinvestment-driven ones (see the exhibit below). These new IPOs resulted in new entrants into the Sensex such as ONGC and NTPC from PSUs and TCS and Reliance Petroleum from the private sector. However, in terms of numbers, the impact of these changes on Sensex churn was much lower than those driven by the end of the License Raj regime. Only 8 replacements were made in the Sensex from 2004 to 2014 vs 20 from 1995 to 2005.

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Sensex churn peaked in the four years following the structural reforms in 1991..

and from those levels, Sensex churn fell as incumbents entrenched themselves in the post-liberalisation era

New listings of a meaningful size happened mainly in the second half of the noughties

Strategy


Exhibit 26: Three of four IPOs of more than US$1bn happened only after 2004

Year Rsbn

1 Coal India Oct 2010 150

2 Reliance Power Jan 2008 117

3 ONGC March 2004 95

4 DLF June 2007 92

5 Cairn India Dec 2006 58

6 TCS Aug 2004 54

7 NTPC Oct 2004 54

Source: Media reports, Ambit Capital research

In light of the three resets that Modi is likely to engineer, the next ten years in India appear likely to be akin to the 1990s rather than the noughties, as the period spanning 1992-02 too was a decade defined by irrevocable structural changes being administered by the political leadership.

Owning a Sensex exit candidate is a losing proposition

Stocks that eventually exit the Sensex do so after a long period of underperformance. Indeed, this is among the reasons why they lose their relevance to their benchmark before eventually bowing out. We present the price performance of the stocks during the 1992-2002 era and note their sharp underperformance to the Sensex during that decade.

Exhibit 27: Exits from the Sensex over Dec91-Dec01

Company name Sector CAGR returns (Dec'91-Dec'01)

CAGR returns (Dec'91-Dec'01,

rel. to sensex)

Year of exit from Sensex

CAGR returns (Dec'91-date of

exit from Sensex)

Aditya Bir. Nuv. Textiles 0% -5% 1996 8%

Ballarpur Inds. Paper -16% -21% 1996 -20%

Bombay Dyeing Textiles -21% -26% 1996 -20%

CEAT Tyres -15% -20% 1996 -8%

Century Textiles Diversified -20% -25% 1996 -12%

Cummins India Capital Goods-Non Electrical Equipment 5% 0% 1996 21%

Futura Polyester Textiles -20% -25% 1996 -22%

GE Shipping Co Shipping -14% -19% 1998 -21%

G S F C Fertilisers -27% -32% 1996 -23%

Hind.Motors Automobile -12% -17% 1996 5%

Indian Hotels Hotels & Restaurants 10% 5% 2000 19%

Mukand Steel -28% -33% 1996 -12%

Philips El India Consumer Durables DNA DNA 1996 DNA

Premier Capital Goods-Non Electrical Equipment -22% -27% 1996 -2%

Siemens Capital Goods - Electrical Equipment -1% -6% 1996 25%

Tata Power Co. Power Generation & Distribution -7% -12% 2000 -15%

Voltas Diversified -10% -15% 1996 -23%

Zenith Birla Steel DNA DNA 1992 DNA

Source: Bloomberg, Ambit Capital research

The next ten years in India appear likely to be akin to the 1990s

A long period of underperformance usually precedes the stocks exit from the Sensex

Strategy


In Exhibit 28 below, we show the share price performance for all the exits from the Sensex in two ways: over the next decade and until the time of exit from the Sensex. Whilst on an average these stocks have underperformed the Sensex by ~7% on a CAGR basis over the next decade, what is more interesting is its performance and underperformance until the time of exit from the Sensex. On an average, these stocks have delivered -10% CAGR returns until the time of exit. Further, relative to the Sensex, the underperformance (until the time of exit from the Sensex) is as high as -20% (in CAGR terms).

Exhibit 28: Sensex exit stocks - Massive underperformance until the time of exit from the Sensex

Period Number of exits from the Sensex

Median performance of exiting stocks over the

decade

Median underperformance (rel. to

the Sensex) of exiting stocks over the decade

Median performance of exiting stocks until exit

from the Sensex

Median underperformance (rel. to

Sensex) of exiting stocks until exit from the Sensex

1991-01 18 -15% -20% -12% -23%

1992-02 19 -8% -11% -9% -17%

1993-03 20 -1% -6% -16% -14%

1994-04 20 -2% -7% -27% -18%

1995-05 20 5% -6% -24% -33%

1996-06 14 8% -7% -21% -25%

1997-07 13 10% -8% -22% -31%

1998-08 13 6% -6% -6% -18%

1999-09 14 9% -5% -9% -11%

2000-10 16 13% -5% -3% -16%

2001-11 16 13% -4% 7% -17%

2002-12 14 21% 2% 14% -19%

2003-13 9 6% -8% 0% -11%

2004-14 8 13% -2% -9% -25%

Average 15 6% -7% -10% -20%


Finally, in Exhibit 29 below, we show the performance of companies that were part of the Sensex in December 04 but had exited by December 14. On a median basis, these stocks have delivered CAGR returns of ~13% over the 2004-14 decade (and -2% CAGR returns relative to Sensex). However, what we also note from Exhibit xx below is that these stocks have massively underperformed the Sensex until the time of their exit (having delivered -9% CAGR returns in absolute terms and ~25% CAGR terms vs the Sensex see the penultimate row of the table shown above).

Exhibit 29: Exits from the Sensex over Dec04-Dec14

Company name Sector CAGR returns (Dec'04-Dec'14) CAGR returns (Dec'04-Dec'14, rel. to sensex)

Year of exit from Sensex

CAGR returns (Dec'04-date of exit from Sensex)

ACC Cement 15% 0% 2010 20%

Ambuja Cements Cement 16% 0% 2008 13%

Grasim Inds Textiles 13% -2% 2010 12%

H P C L Refineries 3% -12% 2005 -39%

Ranbaxy Labs. Pharmaceuticals 0% -15% 2009 -18%

Reliance Infra. Power Generation & Distribution 0% -16% 2011 -1%

Satyam Computer IT Software DNA DNA 2009 -36%

Zee Entertainment Entertainment 22% 6% 2005 -27%


Hence, given the stark underperformance for the exit stocks, it becomes critical for investors to identify potential exiting candidates in advance. We now provide a framework for identification.

Sensex exit stocks underperform the index by ~20% (in CAGR terms) until the time of exit

Strategy


A framework to identify Sensex exit candidates We provide a four-step filter for identifying stocks that are most likely to exit the Sensex in the coming decade. To maintain consistency for a 10-year window we use financial data for the past 10 years (from FY05 to FY14).

In the first two steps, we score companies using our Coffee Can Portfolio and Greatness frameworks. From these scores, we select the bottom 20 companies and shortlist them as most likely Sensex exit candidates.

In the third step, we check if the shortlisted companies feature on the Ambit P-75 list of politically connected companies. In the final step, we check if the shortlisted companies are in a sector that has been unnaturally insulated from foreign competition.

We describe our methodology in detail below:

Step 1: Coffee Can Portfolio filters in reverse

In November 2014, we unveiled our Indian Coffee Can Portfolio for identifying stocks that investors can hold for a decade, without churning the portfolio. Our back-testing showed that a portfolio constructed on two filters, mentioned below, beats the Sensex across five 10-year iterations. We now use the same filters but in reverse to identify Sensex stocks that are on an exit path.

a) Sales growth of less than 10%: Indias nominal GDP growth rate has averaged 15% over the past ten years. As very few listed companies (only 5 out of the ~1,100 firms run under our screen) managed to achieve this over the past ten years, we reduced this filter rate modestly to 10%. Therefore, for the purposes of the Sensex exits exercise, we identify companies that have failed to deliver 10% sales growth in any year for the past ten years. Hence, the more years a company delivers sales growth of less than 10%, the lower will be its score.

b) RoCE of less than 15%: We use 15% as a minimum because we believe that if a company can deliver 15% RoCE over ten consecutive years, it is a proxy for the annual returns investors can expect from that stock. We also believe this is well justified theoretically by adding the risk-free rate (8.5% in India) and an equity risk premium of 6.5%. This equity risk premium, in turn, is calculated as 4% (the long-term US equity risk premium) plus 250bps to account for Indias rating (BBB- rating as per S&P). Note further that over the past 20 years and 30 years, the Sensex has delivered returns of around 16% per annum, thus validating our point of view that 15% is a sensible figure to use as a minimum RoCE criteria. Therefore, we identify companies that have failed to deliver 15% RoCE in any year for the past ten years. Hence, the more years a company delivers RoCE of less than 15%, the lower will be its score.

For Banks and Financial Services (BFSI) stocks, we modify the filters on RoCE and sales growth as follows:

a) RoEs of 15% for NBFCs and RoAs of 1.2% for banks: Whilst we have used RoEs (net profit to average equity) for NBFCs, we have used RoA (net profit to average assets) for banks. Whilst the underlying profitability of operations reflects in both RoA and RoE, RoE is also impacted by the leverage or capital position of the bank. Historically, many banks (especially PSU banks) have delivered high RoEs due to high leverage despite weak underlying profitability. Therefore, for banks RoAs is a better metric to use.

For every year that a bank/NBFC fails to deliver 1.2% RoA/15% RoE, we allot a lower score. Hence, the more years a bank/NBFC delivers RoA of less than 1.2% (or RoE of less than 15% in case of banks), the lower will be its score.

b) Loan growth of 15%: We believe loan growth of 15% is an indication of a lenders ability to lend over business cycles. Strong lenders ride the down-cycle better, as their competitive advantages surrounding their origination, appraisal and collection process ensure that they continue their growth profitably either through market share improvements or upping the ante in sectors which are

Our four-step filter identifies exit candidates from the current Sensex constituents

We use our Coffee Can Portfolio filters in reverse

We identify companies that have failed to deliver 10% sales growth in any year for the past ten years

and those that have failed to deliver 15% RoCE in any year for the past ten years

For banks, we screen stocks that failed to deliver 1.2% RoA/15% RoE in any year for the past ten years. and those that have failed to deliver 15% loan growth in any year for the past ten years

Strategy


resilient during a downturn. Therefore, we identify banks/financial institutions that have failed to deliver 15% loan growth in any year for the past ten years. Hence, the more years a bank/financial institution delivers loan growth of less than 15%, the lower will be its score.

Once we have identified a list of such companies that fail to meet our filters for any year in the past decade (FY05-14), we allot scores based on the number of years that the company has failed to meet the filter. Our scoring is based on the parameters mentioned in the exhibit below.

Exhibit 30: Scoring parameters - Number of years (from FY05 to FY14) that a company fails to meet our filters

From (years) To (years) Score

0 2 20

3 4 15

5 6 10

7 8 5

9 10 0


The thumb rule for the above exhibit is the more years a companys financials have been below our filters, the lower the score. For example, a company that delivers less than 10% sales growth for any eight years (of the past ten years from FY05 to FY14), gets five points. Similarly, a company that delivers RoCE of less than 15% for all ten years (of the past ten years from FY05 to FY14) gets zero points. The scoring structure is aimed at raising the penalty on companies that fail to meet these filters more often in the past ten years (from FY05 to FY14).

Conversely, the more often a company delivers sales growth of more than 10% and/or RoCE of more than 15%, the higher will be its score. Therefore, a company that delivers RoCE for all ten years (FY05 to FY14) will get the highest score of 20.

Step 2: The Greatness Framework

We had unveiled our greatness framework on 19 January 2012 with the first iteration of the Tomorrows ten baggers note see exhibit below.

Exhibit 1: The greatness framework


This framework has served us remarkably well over the years and has consistently helped us generate outperformance with our annual tenbagger portfolios. Now, to identify exit candidates, we reverse the framework i.e. the worse the performance of a company in greatness framework, the lower its decile as per the framework, the lower its score.

In the next step, we score companies using our Greatness Framework

b. Conversion of investment to sales (asset turnover, sales)

c. Pricing discipline (PBIT margin)

d. Balance sheet discipline (D/E, cash ratio)

a. Investment (gross block)

e. Cash generation (CFO)

Strategy


Exhibit 31: Scores as per our Greatness Framework Greatness Decile Score

D1-D2 20

D3-D4 15

D5-D6 10

D7-D8 5

D9-D10 0


Whilst we do not have a greatness framework for NBFCs currently, in our 20 February 2013 note we had unveiled the greatness framework for the banking space. Both these frameworks study a firms structural strengths by focusing not on absolutes but rather on improvements over a period of time and the consistency of those improvements. Please refer to Appendix 1 (on pg 89) for a detailed description of the Greatness Framework and to Appendix 2 (on pg 91) for the Greatness Framework for banks. For our scoring purposes, we allot higher scores for companies/banks as per their decile. A higher decile implies a higher score. Step 3: Ambits P-75 companies

In the next step, we check this short list of Sensex exit candidates to identify stocks that are part of Ambits P-75 companies i.e. companies whose core competitive advantage is politically connectivity.

We believe these companies are on a weaker footing given the impact of the Modi Resets. In our May 2014 strategy thematic, Can India Turn Back the Clock?, published just before the results of the 2014 General Election, we said that over the past decade, powerful cliques of politicians and promoters have suppressed competition in a range of sectors and driven Indias CPI inflation rate up from 4% to 11%. In that report, we posited that this vicious spiral could be on the retreat with the changes taking place in New Delhi and in the RBI. We further said that these changes could results in a redistribution of profits away from the winning companies of the last decade towards the also-rans of the last decade.

Over and above the distortionary effects that politically connected companies have had on competition and inflation, these companies are likely to have received undue access to capital (from PSU banks), land (from state governments) and public sector contracts (like the building of airports or roads). After peaking in the noughties, the strength of this under-the-table cooperation model between promoters and politicians has been ebbing since November 2010 (the month in which the 2G spectrum auction scam came to public attention thanks to the CAGs hard hitting report). Given that the rise of check and balance institutions (such as the Aam Aadmi Party and civil society) seems to be permanent, we expect connected companies in sectors such as Telecom, Real Estate, Infrastructure, Construction, Power as well as Capital Goods to underperform the Sensex.

The demise of the connected company continues to be captured nicely by Ambits five-year-old P-75 Index of the 75 most connected companies in the BSE500. Post the 2G spectrum allocation report publication, the share prices of the connected companies have systematically underperformed the BSE500, with a brief pre-General Election rally also getting snuffed out once the market realised that Modi was not going to indulge the connected companies (see exhibit below).

Companies that are already part of Ambits P-75 companies are already on a weak footing

We expect connected companies in sectors such as Telecom, Real Estate, Infrastructure, Construction, Power as well as Capital Goods to underperform

Ambits five-year-old P-75 Index nicely tracks the demise of connected companies

Strategy


Exhibit 32: The connected companies index has consistently underperformed the BSE500 since the release of the CAG report in October 2010


Thus, any company in our short list that is part of Ambits P-75 companies would qualify automatically to be a Sensex exit candidate.

Step 4: Belongs to an unnaturally insulated sector

Finally, from our short list, we identify those companies that belong to a sector that has been unnaturally insulated from foreign competition. We cite two-wheelers and metals and mining as two indicative examples of sectors that have benefited from this unnatural insulation.

Historically, the margins of incumbent metal companies in India such as Tata Steel and Hindalco have been cushioned by access to low-cost captive raw materials (iron ore/coal). However, with the adoption of the MMDR Act, all mines are likely to be auctioned (access to raw material at market prices) and existing captive mines would remain with these players up to 2030 at best. With raw material costs (iron ore and coal) gradually moving towards market prices, this increase in coal costs would result in a negative impact on margins and RoCEs. This coupled with our muted outlook for global steel and aluminium prices makes us believe that the RoCEs of Indian companies would move closer to that of global peers (high single digits), which makes them ideal exit candidates from the Sensex.

In a high inflation environment, well-established and well-managed companies with strong brand names tend to be better placed than their newer, more run-of-the-mill rivals, as the pricing power of the champion company allows it to protect itself from inflation. As a result, over the past decade, and especially, over UPA-IIs reign, high and variable inflation has been a friend of strong companies and an enemy of weak companies. In effect, inflation takes profit from weak firms and gives it to stronger firms. Hence, if inflation cools down, the position of the middle-of-the-road players could improve. In fact, in a range of sectors in India, the stronger players have been able to protect their margins the most over the past decade.

One example of a segment leader that profited handsomely in the distorted economy is Hero MotoCorp (HMCL IN, mkt cap US$7.3bn, SELL). Between FY04 and FY10, when it split from its JV partner, Honda Motors, Heros operating margin was stable at 17%. Following the end of its JV with Honda, Heros operating margin started sliding (13.0% as at the end of 9 months ending FY15), as it started investing in R&D and as it started losing market share to Honda; Hero MotoCorp has lost market share of about 300bps in the domestic motorcycle space over FY12-15.

On the other hand, TVS Motors seems to be finding its feet after ten years of almost relentless market share loss (TVSs market share in the Indian 2W (ex-mopeds) market has fallen from 14.6% in 2003 to 7.3% in FY14). Over the past year, however, even as Hero has slipped, TVS has started gaining market share thanks to the launch of new models of scooters/ bikes. Exports, which accounted for only 10% of revenues three years ago, now account for 20% of revenues. With revenue growth accelerating, TVSs operating margins have stabilised after a decade of sliding.

60 100 140 180 220 260 300 340

Jan-

09

May

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Sep-

09

Jan-

10

May

-10

Sep-

10

Jan-

11

May

-11

Sep-

11

Jan-

12

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-12

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13

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-13

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Ambit Connected Cos Index BSE 500

Sectors that have been unnaturally insulated from foreign competition stand to lose in the Modi resets

Increase in coal costs will negatively impact margins and RoCEs of incumbent metal companies

If inflation cools down, the position of the middle-of-the-road players could improve

Following the end of its JV with Honda, Hero has lost market share in the domestic motorcycle space

Even as Hero has slipped, TVS has gained market share thanks to the launch of new models of scooters/ bikes.

Publication of CAG report in Oct' 10 was an inflection point

Strategy


Exhibit 33: EBITDA margins of major two-wheeler manufacturers in India

Source: Company, Ambit Capital research

Exhibit 34: RoCEs of the major two-wheeler manufacturers in India

Source: Company, Ambit Capital research

Thus, any company in our short list that benefits from being a part of a sector that has seen unnatural protection from competition would qualify automatically to be a Sensex exit candidate.

We summarise our four-step process of identifying a Sensex exit candidate in the checklist below.

Exhibit 35: Checklist for Sensex exit candidates Step Criteria Parameters

1 Coffee Can filters in reverse Non BFSI: Highest number of years within FY05-14 where sales growth was

Strategy


Exhibit 36: Exit candidates from Sensex over the next decade Name Ticker Mcap (US$ bn) 6M ADV (US$ mn) Exit hypothesis

Reliance Industries RIL IN 44 54 Uncertainty on profitability of large investments in retail and telecom; downstream margins likely to remain muted

O N G C ONGC IN 41 26 Falling subsidies unlikely to aid profitability; uncertainty on production growth makes earnings growth a challenge

State Bk of India SBIN IN 32 89 Relaxation of Govt protection, rising capital requirements and competition from stronger private sector peers and introduction of new players

H D F C HDFC IN 29 56 Slowdown in real estate prices could hit mortgage loan growth; increased competition from banks will compress NIMs

Bharti Airtel BHARTI IN 24 32 High spectrum costs, new competition from Jio will weigh on Indian business profitability; African business will remain a drag on consolidated profits

Larsen & Toubro LT IN 24 53 High competitive intensity in a fragmented industry, no discernible competitive advantages in most sectors; L&Ts large size will be a constraint

NTPC NTPC IN 19 15 Increase in competition from private sector, decline in power deficit and end of preferential treatment from Coal India for fuel linkages

M & M MM IN 11 23 Utility vehicle business under threat from foreign car companies superior offerings; tractor business bearing the brunt of slowdown in rural demand

Vedanta* SSLT IN 10 17 ROEs will trend lower towards global peers; mine acquisition costs will rise under MMDR Act as global iron ore and steel demand stays weak

B H E L BHEL IN 9 18 Boiler-turbine-generator industry in structural downturn; over-capacity issues (and thus greater competition) will plague BHEL and its peers

Bajaj Auto BJAUT IN 9 16 Rising competitive intensity in domestic and export markets; exports further hit from macro-economic challenges in key geographies

Hero Motocorp HMCL IN 7 35 Over-dependence on legacy models, uncertain indigenous technology, shift towards scooters and rising competition from Honda

Tata Steel TATA IN 6 33 Downturn in steel prices to hurt global business; loss of low-cost raw material advantage under MMDR Act to hurt domestic business

Hindalco Industries HNDL IN 4 19 Weak aluminium prices and premiums to hurt global business; lack of cheap captive coal will mute RoCEs of new domestic smelters

Tata Power Co. TPWR IN 3 5 RoEs will remain lower than cost of equity; rise in coal prices and structural changes in sale of power will impact long-term prospects

Source: Bloomberg, Ambit Capital research. Note: *This is Sesa Sterlite.

We have chosen 15 exit candidates from this list on the following basis:

The top nine companies with scores of less than 45 qualify automatically for exiting the Sensex, based on our framework detailed above. These nine companies are Tata Power, NTPC, Hindalco, Tata Steel, Hero Motocorp, State Bank of India, Sesa Sterlite (Vedanta), Bharti Airtel and Reliance Industries.

The remaining six candidates have been chosen from companies with a score of 45-50, based on our analysts conviction of the long-term prospects of these companies against the backdrop of the Modi reset. These six companies are M&M, HDFC, L&T, Bajaj Auto, BHEL and ONGC.

We now present company-specific sections where our analysts present a case for these stocks to exit the Sensex.

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

COMPANY UPDATE RIL IN EQUITY May 05, 2015

Reliance IndustriesNOT RATED

Oil & Gas

Recommendation NOT RATED Mcap (bn): `2,791/US$44 6M ADV (mn): `3,609/US$57

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