india inc. a look ahead

Back to the future: A Glimpse of India Inc. 2019A conservatively optimistic saga of Indian markets

July 28, 2014

Vikas [email protected]

Kshitij [email protected]

Viraj Vajratkar [email protected]

NIFTY 50

SENSEX

26,000

86,000

3.5xINDIAN INVESTOR

INDIA FY19

The goal of the non-professional should not be to pick winners neither he nor his helpers can do that but should rather

be to own a cross-section of businesses that in aggregate are bound to do well

-Warren BuffettSource: 2013 Annual letter to Berkshire Hathaway shareholders

July 28, 2014 Back to the future: A Glimpse of India Inc. 2019

We estimate Nifty to reach 26,000 and Sensex 86,000 by FY19 in our best scenario which is based on a rather conservative forecast of improvement in fundamentals. Our best case projections for Nifty and Sensex imply compounded per annum returns of 28% and 27% respectively from current index levels. Scaling of the benchmark indices to new highs will be driven primarily by improvement in fundamentals and to a very limited extent by valuation re-rating. We forecast a 20% FY15-19 CAGR sales growth resulting in a 24% CAGR profits growth in our base case scenario and a more stellar 23% and 30% respectively for our best case. The two major pillars of improving fundamentals are recovering EBIT margins and Asset turnover which we believe should normalize to their historic levels. On the valuations front, we expect a re-rating of 9-26% of the various valuation metrics (10-12% in earnings based and nearly 20% in other multiples) in our best case (from 10-July levels).Temporal similarity between FY05 and FY15: We find a strong parallel in terms of qualitative socio-economic factors (change of government) Pent-up demand in the last couple of years prior to FY05 had been released post elections, resulting in strong real GDP growth of about 10% p.a. causing a boost in top-line growth. We expect a similar situation for the current times as well wherein the economy is likely to be bolstered by pent-up demand and resultant revenue expansion.Fundamentals improvement to be the main champion of returns: We project 20% sales CAGR and 24% earnings CAGR over FY15-19 in our base case.Our best case points toward a 23% sales CAGR and 30% earnings CAGR. We believe that this is quite conservative when compared to the sales and earning CAGR of 28% and 27% during FY05-09, respectively.EBIT margin and Asset turnover to be the major pillars of improving fundamentals: We expect the impetus from pro-business government policies to translate to improving sales growth, higher capacity utilization and therefore a higher asset turnover ratio. The current YTD asset turnover average of only 73% is significantly below the FY05-09 average of 84%. On the back of improving sales growth and impact of operating leverage, we expect EBIT margins to expand by 40bps p.a. over the next 5 years which is conservative vs the 60bps p.a. expansion during FY05-08 (excluding FY09 due to the US crisis). Our optimistic projection factors a 75bps p.a. improvement in EBIT margin to recover to FY05-09 average levels of 20%. Further, intrest rate burden should also reduce going forward in light of cooling inflation.

Valuation re-rating to additionally bolster returns: Though absolute market levels are breaching their previous highs every day, valuation metrics such as P/E, P/BV, EV/Asset are below their top-quartiles. Valuations can attain their previously established highs only if underlying fundamentals improve spectacularly. Given that our best case for fundamental improvement is conservative, a re-rating in multiples is possible. For our best case, we build in a conservative multiple expansion to top-quartile levels, which are themselves 28-45% below their all-time highs.NIFTY @ 26,000 & Sensex @ 86,000 by FY19: We expect market returns of 28% p.a. (as of 10-July) driven largely by improvement in fundamentals. For instance, we expect EV/EBITDA multiple to grow at 9% p.a. and EBITDA to grow by 20% p.a. for our best case.Key risks to our views: Our thesis rests on the foundation of improving fundamentals driven primarily by a recovery in the Asset turnover ratio and a healthy improvement in EBIT margins. A recovery in these may not materialize over the next 5 years if a) pent-up demand in the economy over the past couple of years does not kick in resulting in depressed capacity utilization, lower revenues (lower asset turnover) and lower EBIT margins and b) there occurs a slowdown in the global economy and global external shocks which may impact NIFTY 50 companies given their increasing global character and global dependence.

Source: Arthveda, Reuters

Figure 1: Strong, yet conservative fundamentals (CAGR FY 15-19)

Figure 2: NIFTY50 price projections

Figure 3: Sensex projections

Source: ArthvedaNote: All charts are for Fiscal Years

19% 30% 23%

17%24%

20%

15%19% 17%

35%27% 28%

0%8%

16%24%32%40%

Book Equity Earnings Sales

Best Base Worst CAGR FY05-09

26,03817,320

11,681

04,5009,000

13,50018,00022,50027,000

2003

2005

2007

2009

2011

2013

2015

2017

2019

BestBase

Worst

85,57156,921

38,3880

20,00040,00060,00080,000

1,00,000

2003

2005

2007

2009

2011

2013

2015

2017

2019

Worst

BaseBest

Table 1: Market Returns

Returns CAGR 15-19

Best Base Worst

NIFTY TRI (incl. divi.)

29.9% 20.0% 11.3%

NIFTY 50 28.0% 18.0% 9.0%

Sensex 27.1% 17.1% 8.3%


Table of Contents

Markets expensive as per headline index numbers but not valuations 1

A market proxy for the economy NIFTY 50 stocks 2

NIFTY 50 fundamentals drive expectations of an improving economy 2

Can history repeat itself? 4

Outlook on fundamentals for FY15-19 7

Valuations Outlook 9

The final confluence of fundamentals and valuations RETURNS! 10

How to ride the bull? 12

July 28, 2014

1

Back to the future: A Glimpse of India Inc. 2019

India a star among the emerging nations: Modi-led euphoria has caused the Indian markets to run up significantly in the recent past so much so that over the last few months India has been one of the best performing markets amongst key emerging markets. MSCI India has over the last 3, 6 and 12 months in local currency beaten almost all MSCI Emerging Markets indices.

Prices as of 10th July 2014 3 month 6 month 12 month

Brazil 4.9% 7.9% 15.2%

China 0.3% 2.3% 15.4%

India 10.5% 18.5% 26.9%

Indonesia 9.0% 23.6% 18.9%

Malaysia 1.1% 2.5% 4.8%

Mexico 7.7% 2.7% 9.2%

Philippines 3.9% 19.0% 11.8%

Russia 9.0% 0.7% 10.7%

Taiwan 9.6% 16.8% 21.4%

Thailand 8.0% 17.8% 6.3%

Turkey 7.4% 17.3% 12.9%

India Rank #1 #3 #1

Similarly, Nifty 50, the marquee index for domestic Indian investors has touched an intra-day high of 7,809 on 8-July following Modis victory (16-May). Post 16-May, the day of election results, Indian markets have rallied 8% and 10% in local currencies and USD respectively. Post April end, Indian markets have returned a spectacular 14% return. Nifty 50 TRI which includes the returns contributions of corporates actions such as dividends as well, has touched an even higher level of 10,208 on 7-July.

Though the markets may be at all-time highs in terms of their absolute levels, we assert that the absolute levels are hardly any measure of the true price of the markets. The true price should be gauged w.r.t the underlying fundamentals such as earnings, assets, book value or dividends by using valuations metrics such as P/E, P/BV or EV/EBIT.

At the first glance, the table shown below indicates that current valuations are certainly expensive w.r.t to markets own history. For example, earnings based multiples (P/E and EV/EBIT) are above their median values, though asset based multiples (P/BV and EV/Assets) are roughly at par with median values. However, we would like to point that the current valuations are not the peak of the valuations and that markets have traded at a premium of as high as 40-100% over and above the current levels. However, we do not suggest that the markets are cheap because they have not yet reached their all-time high valuations. On the contrary, we believe that markets can be cheap/expensive even at the peak/trough of valuations and that they can move beyond their last recorded peak/troughs if the changes in fundamentals warrant so. Therefore current valuations should be introspected in light of expected changes in fundamentals, albeit with a conservatism.

Table 2: Strong performance of MSCI India vs other emerging markets indices (local currencies)

Source: Arthveda, Reuters

Markets expensive as per headline index numbers but not valuations

July 28, 2014

2


Current (10-July) Top Quartile Bottom Quartile Median Min Max

P/BV 2.8x 3.5x 2.5x 3.0x 1.6x 6.0x

EV/Assets 1.6x 2.0x 1.4x 1.7x 1.0x 3.4x

P/E 18.0x 20.1x 12.2x 15.9x 7.5x 28.6x

EV/EBIT 13.7x 15.1x 9.2x 12.4x 6.1x 20.8x

We believe that markets chase expected changes in fundamentals in the short-to-medium term and eventually revert to

the true fundamentals of the underlying businesses in the long term.

The current seemingly high valuations, therefore, warrant a further investigation into what lies ahead for the underlying market fundamentals in the long run, and much more so in light of huge expectations of strong growth from the Modi-led government. However, we would raise a voice of caution in predicting the future in that the market fundamentals cannot improve drastically and abruptly because of a change in government. The health of the businesses will take their own inherent time (18-24 months) to normalize and revert to its true potential provided right actions are undertaken by the new government.

Analysts estimates of expected changes in fundamentals have been proven wrong time and again and the fact has been very well documented by various academic studies. As value investors, we, therefore, try to be conservative in predicting the future. We believe that the market history can serve as the best guide to understand the extent of improvement in market fundamentals from current levels. We would rather be happily proven wrong while being conservative than proven wrong while being optimistic. Not surprisingly, we restrict our discussions to trailing valuations and fundamentals because they represent the proven reality of the underlying businesses and not a castle of expectations built around interesting stories.

Before moving ahead to building conservative expectations about the future based on history, let us have a close look at NIFTY 50 stocks a basket of stocks that closely mirrors the changes in the broader economy. Collectively, NIFTY 50 stocks account for ~60% of the FY13 organized GDP (30% of total GDP), ~70% of total Indian market capitalization, span across 22 sectors and are generally either #1 or #2 companies in their domain. These figures are nothing but a connotation of the truly ultra large cap nature of these stocks. Because of such a large representation, any changes in the economy will be reflected in the fundamentals of these stocks to a very large extent. As a result, we would highly recommend owning such a diversified basket of securities to investors but not necessarily with stock weights as per free-float-market cap, as is the case with Nifty 50. In the words of Warren Buffett in his 2013 letter to Berkshire Hathaway shareholders: The goal of the non-professional should not be to pick winners neither he nor his helpers can do that but should rather be to own a cross-section of businesses that in aggregate are bound to do well.

Any changes in the fundamentals of the NIFTY 50 companies for the purpose of value creation for their shareholders results in improving returns on equity. Now, given the strong degree of fair representation of the NIFTY 50 stocks of the economy, it is reasonable to expect that any improvement in the economy going forward should be driven by improvement in the NIFTY 50 company fundamentals. Furthermore, we assert that these changes in the economy can be attributed to the changes in the ROE for these companies.

Return on equity can be decomposed to five (nearly) mutually exclusive and collectively exhaustive factors 1) asset turnover, 2) EBIT margin, 3) interest burden, 4) tax burden and 5) leverage. Changes in tax policies, interest rate environment, inflation, GDP growth and other macro-economic factors will be essentially captured by the 5 factors illustrated above. Our analysis, therefore, focuses on DuPont components to estimate changes in underlying market fundamentals while using history as a guide. Analysis of the components of fundamentals shown below reveals that

A market proxy for the economy NIFTY 50 stocks

NIFTY 50 fundamentals drive expectations of an improving economy

Table 3: Historical valuations: Current Asset based Valuations of Nifty 50 are below Top Quartile & Median

Source: ArthVeda Research

July 28, 2014

3


asset turnover, EBIT margins and interest rate factor (EBT/EBIT) are currently lower than FY05-09 levels. The 5 factors that we have examined are:

Asset turn over: has been analysed in terms of historical trends, both long term as well as in the reference FY05-09 period. A key observation unearthed has been that asset turnover averaged about 84% in FY05-09, while current (fiscal) year to date turnover stands at only 73%. This signals a pick-up as mean reversion is likely to kick in here primarily from a trigger in the release of pent-up consumer, industrial and government (public) demand and the resulting multiplier effects on sales and capacity utilization.

EBIT margin: The main factor influencing EBIT margin is operating leverage. With respect to our reference period, EBIT margins improved 60bps p.a. from FY05 to FY08 (excluding the weak FY09 impacted by US crisis), helped by a favourable macroeconomic environment then (with the exception of FY08/09, CPI remained fairly low and GDP growth remained robust). YTD EBIT margins stand at 16.4% while FY05-09 averaged 20%.

Interest burden (pre-tax earnings/EBIT): has been analysed on the basis of the cost of debt experienced by companies against the back drop of cooling inflation and possible interest rate cuts by RBI in FY15, FY16 and onwards.

Tax burden (net profit/pre-tax earnings): Has been analysed in terms of historical levels for FY15-19.

Leverage: in terms of equity multiplier and Debt/Equity in turn depending on the interest rate backdrop and historical trend levels. In this regard, leverage increased only modestly from FY05-09

FY ROE NP/EBT EBT/EBIT EBIT Margin

Sales/Assets

Leverage (A/E)

Net D/E CPI Cost of Debt

2003 21.7% 0.72 0.92 16.6% 100% 1.96x 0.19x 3.9% 16.0%

2004 25.2% 0.73 0.93 19.7% 91% 2.07x 0.20x 3.8% 12.4%

2005 25.7% 0.73 0.94 19.7% 97% 1.95x 0.10x 4.4% 21.0%

2006 21.1% 0.74 0.95 17.9% 88% 1.89x 0.11x 7.3% 12.8%

2007 22.2% 0.72 0.95 19.3% 85% 1.97x 0.16x 6.1% 9.7%

2008 20.8% 0.73 0.93 22.0% 69% 2.02x 0.30x 8.9% 8.2%

2009 15.2% 0.74 0.88 15.3% 72% 2.12x 0.41x 13.0% 7.3%

2010 16.0% 0.72 0.91 18.3% 66% 2.02x 0.35x 10.5% 7.2%

2011 17.2% 0.72 0.91 18.1% 69% 2.08x 0.37x 9.6% 6.8%

2012 16.6% 0.72 0.90 16.4% 75% 2.08x 0.30x 10.2% 10.3%

2013 15.3% 0.71 0.87 16.3% 73% 2.07x 0.34x 9.5% 10.6%

2014 15.8% 0.71 0.90 16.4% 73% 2.06x 0.28x 8.0% 10.1%

FY15 YTD 15.8% 0.71 0.90 16.4% 73% 2.06x 0.29x 7.5%* 10.0%

Long Term Peak 26.2% 0.82 0.96 22.4% 112% 2.23x 0.43x 13.0% 30.6%

Long Term Average 19.7% 0.73 0.91 17.9% 83% 2.01x 0.26x 7.9% 11.8%

Long Term Trough 15.0% 0.71 0.85 13.5% 65% 1.86x 0.06x 3.8% 6.8%

05-09 Peak 26.2% 0.74 0.96 22.4% 101% 2.12x 0.41x 8.9% 30.6%

05-09 Average 22.4% 0.73 0.94 19.9% 84% 1.96x 0.17x 6.7% 13.5%

05-09 Trough 15.2% 0.72 0.88 15.3% 65% 1.86x 0.06x 4.4% 7.3%

Table 4: Historical trend of Nifty 50s DuPont factors

Source: ArthVeda, Reuters, IMF.*As per RBI CPI inflation to reach sub- 8% levels by January 2015 and to 6% by January 2016

July 28, 2014

4


Temporal similarity between FY05 and FY15: We find a strong parallel between the current socio-economic environment and that of FY05. The parallel exists in terms of qualitative factors such as change of the government. Like FY15, FY05 also saw a change in the government from Vajpayee-led NDA government (ending its term in May 2004) to UPA government, though the in-coming and out-going parties have interchanged places this time. Additionally pent-up demand in the last couple of years prior to FY05 had been released post elections, resulting in strong real GDP growth of about 10% p.a. causing a fillip in top-line growth. We expect a similar situation for the current times as well wherein the economy is likely to be bolstered by pent-up demand and resultant revenue expansion.

Factors for FY05-09 growth: Growth in FY05-09 period was led by several factors such as MNREGA (spur for rural consumption), implementation of 6th Pay Commission (urban and semi-urban consumption increment), low inflationary environment and fiscal prudence (boost to consumption, industrial, government demand and capital investments). We believe that similar other factors are at play currently which can bring about a similar economic growth and therefore history can repeat itself.

(Potential) Factors for FY15-19 growth: Factors such as 1) clearing of infra & power projects and their multiplier effects, 2) possible next revision in Government salaries due in the next 1-2 years (7th Pay Commission), 3) easing of input cost inflation, 4) kick-starting of the manufacturing industry, 5) rationalization of MNREGA for asset creation, 6) boost to agro and food processing industries, 7) favourable policies for the real estate sector, insurance and defense and many other factors paint a fairly rosy picture for the economy going ahead. Further, with global markets reviving and Indian markets opening to foreign investments, India can see large amounts of FDI, this time from Japan as well (Indias Look East Policy and potential Modi-Abe synergies).

The following tables present our base, best and worst case scenario of our outlook on how the economic growth may reflect as changes in 5 factors of the DuPont decomposition.

Base (FY) 2015 2016 2017 2018 2019 Commentary

Asset Turnover 78% 81% 83% 86% 86%

As per FY05-09, mean reversion driven primarily by release of pent-up demand dictates an improvement from current YTD levels of 73% to FY05-09 average of about 85%.

EBIT Margin 16.4% 17.5% 18.0% 18.3% 18.5%

Forecasted sustained YTD figures in FY15. We expect sales growth to outpace input cost inflation post FY15. This should percolate down to margin improvement thanks to strong operating leverage.

EBT/EBIT 0.89 0.90 0.90 0.91 0.91 Modeled on the basis of cost of borrowing in turn dependent on the interest rates set by RBI which also has appeared to tame inflation.

NP/EBT 0.71 0.72 0.73 0.73 0.73 Expect the tax burden to alleviate slightly in FY17. Should remain fairly stable thereafter in-line with history.

Leverage (A/E) 2.01x 2.01x 2.02x 2.02x 2.01x

Has remained fairly stable in last 5 years and we expect minimal variations going forward, in-line with LT history as well. As interest rates can be expected to decine, companies could look to maintain leverage levels.

ROE 16.2% 18.3% 19.8% 21.1% 21.2%FY15 YTD ROE's have been depressed (near all-time lows in FY13), though have already started recovering. We have modeled a rebound in ROE to about FY05-09 average levels.

Table 5: Base Case Scenario

Source: ArthVeda

Can history repeat itself?

July 28, 2014

5


Base (FY) 2015 2016 2017 2018 2019 Commentary

Asset Turnover 80% 83% 86% 89% 89%

As per FY05-09, mean reversion as well as pent-up growth from infra projects, power segments and resulting multiplier effects dictates an improvement from current YTD levels of 73% to a bullish 5 percent points above FY05-09 average, yet conservative in the sense is below that periods highest turnover.

EBIT Margin 16.6% 17.8% 18.5% 19.6% 20.1%

Forecasted a modest 20 bps increment from YTD figures in FY15 on the back of buoyant 23% sales growth in FY15 (which should translate to EBIT margin improvement due to good operating leverage).

EBT/EBIT 0.90 0.90 0.91 0.92 0.92

Forecasted on the basis of cost of borrowing in turn dependent on the interest rates set byRBI (guidances for rate cuts ahead as inflation appears to simmer down on the back of favourable CPI readings).

NP/EBT 0.72 0.73 0.74 0.74 0.74 Expect the tax burden to improve in FY16 itself. Should remain fairly stable thereafter in-line with history.


Has remained fairly stable in last 5 years and we expect minimal variations going forward, though increasing debt on books due to possible rate cuts going forward in FY16/17 could see a spike here.

ROE 17.3% 19.8% 21.9% 24.1% 24.7%FY15 YTD ROE's have been near all-time lows in FY13 and have already started recovering since. We have modeled a rebound in ROE to near FY05-09 peak levels.

Table 6: Best Case Scenario

Source: ArthVeda

July 28, 2014

6


Worse (FY)

2015 2016 2017 2018 2019 Commentary

Asset Turnover 77% 78% 80% 82% 82%

As per FY05-09, mean reversion dictates an improvement from current YTD levels of 73% to a very conservative case of stabilizing at 2 percent points below FY05-09's average levels. We have modeled an almost flat real sales growth in FY15 (9% nominal growth) which paints a modest picture for turnover improvement.

EBIT Margin 16.3% 17.0% 17.5% 18.0% 18.1%

Forecast a -10 bps decrement from YTD figures in FY15 on the back of weaker sales growth (only 9% nominal sales growth in FY15), though operating leverage could boost margin in the longer term.

EBT/EBIT 0.88 0.89 0.89 0.90 0.90 Forecasted on the basis of cost of borrowing in turn dependent on the interest rates set byRBI and inflation remaining sticky.

NP/EBT 0.71 0.71 0.71 0.71 0.71 Expect the tax burden to remain status quo, with in fact a slight 1 bp decrease from current YTD values should the Govt. focus on further reducing fiscal deficit.


Has remained fairly stable in last 5 years and we expect minimal variations going forward, though increasing debt on books with possible rate cuts going forward in FY16/17 could see a spike here.

ROE 14.9% 16.5% 17.7% 18.9% 18.8%YTD ROE's have been near all-time lows in FY13 and have already started recovering since. We have conservatively modeled a rebound in ROE to sub FY05-09 levels.

Fundamental improvement further corroborated by unsustainable diminishing (ROE rf) spreads: We can yet again look back at history and observe that the excess return premium for equities (i.e. return on equity risk-free rates) has over the years been declining from a maximum of 19.5% in FY04 to 6.4% in FY14. We find this trend unsustainable in light of the above factors and hence a correction here can be expected going forward. The bulk of the correction has to come from an increase in returns on equity since the fluctuations in risk free rates are relatively lesser in magnitude and can account for not more than a 3% contribution (should they drop).

Source: ArthVeda

Table 7: Worst Case Scenario

Figure 4: Possible mean reversion for excess equity returns over risk-free rate

Source: ArthVeda, Reuters, NSE

0%

5%

10%

15%

20%

25%

30%

2003 2005 2007 2009 2011 2013 2015 2017 2019

ROE

rf (8+ yrs. G-sec yield)

19.5%6.4%

Best

Base

Worst

July 28, 2014

7


Book equity and margins: In terms of the above fundamentals, we have backed out a book equity growth of nearly 17% FY15-19 in our base case, while our best case accounts for 19% appreciation in book value growth. EBIT margins in our base case have improved nearly 40bps annually from 16.4% in FY14 to 18.5% in FY19. This is conservative looking at the EBIT margin boom in FY05-08 (FY09 was impacted by the one-off US sub-prime crisis), wherein we witnessed a 60 bps annual progression from 19.7% in FY04 to nearly 22% in FY08. We expect the strong boost in margins to be driven by better operating leverage. Given the healthy revenue projections, we estimate that majority of incremental top-line should percolate down to profits (thereby increasing margins) as companies degree of operating leverage (DOL) has over the past couple of years remained fairly solid.

FY Nominal Sales

Growth

EBIT Growth

OL at start of the year

Margin Progres-sion till end of

the year

2004 23.3% 46% 1.98 3.1%

2005 37.0% 37% 1.00 0.0%

2006 20.5% 10% 0.47 -1.8%

2007 30.1% 40% 1.34 1.4%

2008 30.6% 49% 1.59 2.7%

2009 20.3% -16% -0.80 -6.7%

2010 5.2% 26% 4.96 3.0%

2011 20.6% 19% 0.92 -0.2%

2012 26.9% 15% 0.55 -1.7%

2013 -2.4% -3% 1.09 0.0%

2014 15.5% 29% 1.90 0.1%

Earnings: Growth had remained particularly buoyant during FY05-08 (excluding the weak FY09) primarily boosted by expanding EBIT margins. Consequently, FY05-08 recorded a stellar 38.5% earnings CAGR. In our best case, we model a 30% earnings CAGR (NIFTY earnings to reach INR 1,533 by FY19) mainly powered by improving EBIT margins (75 bps CAGR) and improving asset turnover (3.2 percent point CAGR FY15-19) as we expect the latter to strongly recover to prior historic levels of nearly 90%.

Outlook on fundamentals for FY15-19

Figure 5: Relation between DOL and margin progression Table 8: DOL and margin progression

Source: ArthVeda, Reuters. Note: DOL = % change in EBIT/% change in sales.

-8%

-6%

-4%

-2%

0%

2%

4%

-2

-1

0

1

2

3

4

5

6

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

EBIT Margin Progression (% points, RHS)

DOL (LHS)

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Earnings NIFTY Price Index

FY Best Base Worst

2014 410

2015 513 476 433

2016 689 622 548

2017 908 790 677

2018 1,220 998 842

2019 1,533 1,192 974

Sales: We find that w.r.t our reference period from FY05-09, sales growth has progressed with a CAGR of 27.5%. While this was a period of exceptional performance thanks majorly due to the favourable domestic macro-economic conditions particularly at the start of that period, we take a conservative stance even in our best case scenario modelling a FY15-19 CAGR sales growth of nearly 23.4%.

Figure 6: Book equity growth comparison Figure 7: EBIT margins performance

Figure 8: Earnings growth comparison Figure 9: Sales growth comparison

Source: ArthVeda, Reuters

2005

2006 2007

2008

2009

0%10%20%30%40%50%60%

2015 2016 2017 2018 2019

Best Base Worst Historic

20052006 2007

2008

2009

0%

5%

10%

15%

20%

25%

2015 2016 2017 2018 2019


2005

2006

2007 2008

2009-20%

0%

20%

40%

60%

80%

2015 2016 2017 2018 2019


2005

2006

2007 2008

2009

0%

10%

20%

30%

40%

2015 2016 2017 2018 2019



Table 9: Index earnings FY15-19

July 28, 2014

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Valuations OutlookThe valuation gap between 2004 and 2014 is huge. Markets were a lot more pessimistic back in 2004 after the formation of UPA government. However, the good news is that over the next 3 years (FY05-07), Indian economy grew at a real GDP CAGR of close to 10%, perhaps the highest ever growth for the Indian economy.

As per our analysis of the historical long-run of P/E, P/BV, P/Sales, EV/EBITDA, EV/EBIT, EV/Sales and EV/Assets, we forecast base case valuation multiples in-line with their long term medians. In our best case scenario, we remain conservative and assign the top-quartile valuation multiples as market multiples. While for the worst case scenario, we assume the bottom quartile valuations as trading multiples.

Scenarios Statistics P/E P/BV P/Sales EV/EBITDA EV/EBIT EV/Sales EV/Assets

Current (10-July) 18.0x 2.8x 1.9x 11.1x 13.7x 2.3x 1.6x

Best Top Quartile 20.1x 3.5x 2.4x 12.1x 15.1x 2.7x 2.0x

Worst Bottom Quartile 12.2x 2.5x 1.5x 7.6x 9.2x 1.8x 1.4x

Base Median 15.9x 3.0x 1.8x 10.0x 12.4x 2.2x 1.7x

Min 7.5x 1.6x 0.8x 5.1x 6.1x 1.0x 1.0x

Max 28.6x 6.0x 4.3x 17.0x 20.8x 4.6x 3.4x

Table 10: A look at valuations and our assumptions


Figure 10: Historical P/E Figure 11: Historical P/BV

Figure 12: Historical P/Sales Figure 13: Historical EV/EBITDA

5x

10x

15x

20x

25x

30x

1x

2x

3x

4x

5x

6x

7x

0.5x1.0x1.5x2.0x2.5x3.0x3.5x4.0x4.5x5.0x

4x6x8x

10x12x14x16x18x

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Target Index Levels: Based on our prior fundamental projections and valuation multiple forecasts, we arrive at estimates for NIFTY TRI and NIFTY50 price index for the years FY15-19. For each year we have 3 scenarios base, best and worst for which we forecast price levels on the average of the results obtained from the above 7 valuation metrics.

Figure 14: Historical EV/EBIT Figure 15: Historical EV/Sales

Figure 16: Historical EV/Assets

The final confluence of fundamentals and valuations RETURNS!

Figure 17: NIFTY TRI estimates


5x7x9x

11x13x15x17x19x21x23x

0x

1x

2x

3x

4x

5x

1.0x

1.5x

2.0x

2.5x

3.0x

3.5x 5x15x25x

Valuation Multiple Top Quartile

Bottom Quartile Median

Min Max

Current/FY14

Table 11: NIFTY TRI FY15-19 forecasts

Targets Best Base Worst

2014 8,740

2015 13,691 10,412 7,603

2016 17,451 13,066 9,493

2017 22,349 16,254 11,665

2018 29,219 20,441 14,392

2019 36,677 24,688 16,936

36,677

24,688

16,936

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

2003 2005 2007 2009 2011 2013 2015 2017 2019

Worst

Base

Best

July 28, 2014

11


Figure 18: NIFTY50 price estimates

Figure 19: Sensex estimates

Source: ArthVeda. Note: Sensex projections calculated on the basis of historical relationship between Sensex and NIFTY 50 prices.

Market returns summarized below for our scenarios: Best Case: Market returns during our reference period were clearly driven by fundamentals. Barring a poor FY09 (during which markets were impacted by sub-prime crisis in the US) which witnessed a multiple de-rating, TRI (i.e. NIFTY index with dividends reinvested) returns were a handsome 30% CAGR FY05-08. This is very much in-line with our current best case forecasts, where we model a robust 30% p.a. return on NIFTY TRI till FY19. This is driven by a 28% p.a. price appreciation (from NIFTY50 index, 27% from Sensex) and a 1.6% p.a. dividend yield (as of 10-July).

Figure 20: NIFTY Dividend yields Figure 21: NIFTY50 Price returns Figure 22: NIFTY TRI returns


Table 12: NIFTY 50 FY15-19 forecasts


2014 6,704

2015 10,324 7,830 5,695

2016 12,973 9,658 6,968

2017 16,366 11,804 8,386

2018 21,058 14,583 10,124

2019 26,038 17,320 11,681

Table 13: Sensex FY15-19 forecasts


2014 22,386

2015 33,928 25,731 18,717

2016 42,634 31,741 22,900

2017 53,787 38,792 27,559

2018 69,206 47,927 33,272

2019 85,571 56,921 38,388

26,038

17,320

11,681

0

3,000

6,000

9,000

12,000

15,000

18,000

21,000

24,000

27,000

2003 2005 2007 2009 2011 2013 2015 2017 2019

Best

Base

Worst

85,571

56,921

38,388

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000

2003 2005 2007 2009 2011 2013 2015 2017 2019

Best

Base

Worst

-20%

0%

20%

40%

60%

2015 2016 2017 2018 2019

Best Base Worst

-20%

0%

20%

40%

60%

80%

2015 2016 2017 2018 2019

Best Base Worst

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

2015 2016 2017 2018 2019

Best Base Worst

July 28, 2014

12


Base Case: Our current base case forecasts, model a robust 20% p.a. return on NIFTY TRI till FY19. This is driven by a 18% p.a. price appreciation (from NIFTY50 index, 17% from Sensex) and a 1.8% p.a. dividend yield (as of 10-July).

Worst Case: Our worst case forecasts, model a 11% p.a. return on NIFTY TRI till FY19. This is driven by a 9% p.a. price appreciation (from NIFTY50 index, 8% from Sensex) and a 2.1% p.a. dividend yield (as of 10-July)..

Returns Best Base Worst

NIFTY TRI 29.9% 20.0% 11.3%

NIFTY 50 28.0% 18.0% 9.0%

Sensex 27.1% 17.1% 8.3%

Better than the best: Should we see a further contribution from a valuation re(de)-rating in our best(worst) case, we have modelled a stronger(weaker) bull(bear) case wherein we expect valuations to re(de)-rate to average levels of their top(bottom) quartiles from their top(bottom) quartile levels i.e. we expect a 13-28% further upside in valuation multiples from our best case and a 14-27% further downside from our worst case. Under these better than best and worse than worst conditions, we expect the following returns as detailed below.

Scenarios Better than Best Best Base Worst Worse than Worst

P/E multiple 22.8x 20.1x 15.9x 12.2x 9.7x

NIFTY 50 Price Index 31,099 26,038 17,320 11,681 9,030

Sensex 1,02,204 85,571 56,921 38,388 29,676

Active management may not always yield sustainable results : While it is the imperative of fund managers to beat the market returns and thereby achieve even higher capital growth than the market, research across the globe and across timeframes suggest that majority of (active) fund managers fare poorly in even achieving benchmark returns over long run. Investment in benchmark indices such as Nifty 50 and Sensex, therefore, looks like the best bet for an average investor to create long term wealth.

though rules-based value investing philosophy stands tried and tested: It is possible to beat the markets with lower risks if one follows a sound investment philosophy and avoids the pitfalls of active fund management rules based value investing. A rules-based approach eliminates the behavioural biases which are the major causes of underperformance of active mutual fund managers. A value investing philosophy is known to create wealth over the long term while beating the markets and is followed by the likes of great investors such as Warren Buffet, Peter Lynch and John Templeton.

ArthVedas flagship equity investment strategies Alpha L50 and Alpha L10 adopt the same principles of investing discussed above. Going by past historical outperformance of L50 and L10 in our reference period, we expect that their returns should likely beat the markets for FY15-19 as well. For FY15-19, we summarize the results as shown.

How to ride the bull?

Table 14: Projected Market Returns CAGR FY15-19 (as of 10-Jul-14)

Source: ArthVeda

Table 15: Snapshot of target index levels

Source: ArthVeda

July 28, 2014

13


Returns CAGR FY15-19

Best Base Worst

NIFTY 50 Price Index 31.2% 20.9% 11.7%

Sensex 30.8% 20.5% 11.4%

Alpha L50 33.8% 23.5% 14.5%

Alpha L10 41.8% 31.6% 22.5%

We acknowledge that market levels can be volatile responding to news (noise) flow and in the long run, they revert to underlying business fundamentals. Consequently, it would be prudent for an investor to remain invested in the market as long as fundamentals look promising, with possible exits at scenarios such as unsustainable bubble periods.

Key risks to our views: Our thesis rests on the foundation of improving fundamentals driven primarily by a recovery in the Asset turnover ratio and a healthy improvement in EBIT margins. A recovery in these may not materialize over the next 5 years if a) pent-up demand in the economy over the past couple of years does not kick in resulting in depressed capacity utilization, lower revenues (lower asset turnover) and lower EBIT margins and b) there occurs a slowdown in the global economy and global external shocks which may impact NIFTY 50 companies given their increasing global character and global dependence.

A focus on fundamentals rather than speculation: We reiterate that our base case alone represents a fairly strong outlook scenario (we forecast a 18% FY15-19 price return (as of 10-July) on NIFTY 50 price index vs long run historical 14% FY05-14 returns) and has its foundations on robust fundamental forecasts rather than speculation on absolute price levels.

To yet again quote Buffett:

Focus on the future productivity of the asset you are considering. If you dont feel comfortable making a rough estimate of the assets future earnings, just forget it and

move on. No one has the ability to evaluate every investment possibility. But omniscience isnt necessary; you only need to understand the actions you undertake. If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so.

-Warren Buffett

Source: 2013 annual letter to Berkshire Hathaway shareholders

Source: ArthVeda, Reuters Note: Alpha strategy returns have been forecasted on the basis of past historical outperformance vs benchmark indices.* It is consequently mandatory to see Disclaimer section.

Table 16: Performance scenarios for markets and ArthVeda Alpha strategies

*

July 28, 2014

14


About ArthVeda

ArthVeda Capital is the equities vertical of ArthVeda Fund Management Pvt. Ltd. At ArthVeda, we specialize in creating investment solutions which are designed to generate high risk-adjusted returns for Ultra HNIs, Pension Funds and Family Offices.

Value investing approach: ArthVeda believes in value investing as followed by renowned investors like Warren Buffett, Peter Lynch, Ben Graham, John Templeton etc.

Introducing Smart Beta equity investing in India: Smart beta investing is the most popular trend of the decade. Total AUM tracking these strategies has crossed USD 500 bilion and is growing at 60% per year.

Research driven approach: Very strong research and product development team having qualified professionals from premier Indian (IITs, IIMs, ISB) and foreign universities (Columbia University USA, EDHEC France, ESC Toulouse France) and having CFA and FRM charters.

Products delivering best in class returns over long periods of time.

ArthVeda Fund Management Pvt. Ltd. is in the business of asset management with a focus on alternative investment funds covering asset classes such as real estate, infrastructure, fixed income, traded markets, agriculture, debt and unlisted equities. ArthVeda is an associate company of Dewan Housing Finance Ltd (DHFL). DHFL is the third largest housing finance company in India and is listed on the Bombay Stock Exchange and National Stock Exchange.

The objective of ArthVeda is to manage funds (designed by our in-house research team) that offer ample opportunities for extracting alpha, i.e. high risk-adjusted returns, from asymmetric risk-return opportunities. The company believes in Value Investing and predominantly follows this principle in all its investment-decisions across asset classes. ArthVedas investor-focused approach is guided by its belief in transparency and high standards of corporate governance.

DisclaimerThis document is not an offering document for any securities or units of any kind and should not be seen as solicitation for investments. The document is intended for illustration and information purposes for intended user only. Further, the contents of this document are provisional and may be subject to change.

This document is produced solely to the specified recipient for the purpose of its internal use. This document may not be transmitted, reproduced or made available to any other person. The information contained herein is proprietary and confidential and may not be disclosed to third parties or duplicated or used for any purpose other than the purpose for which it has been provided. Any unauthorized use, duplication or disclosure of this document is prohibited by law.

Certain information included in this document is based on information obtained from sources considered to be reliable, however, the accuracy of such information cannot be guaranteed and further such information may be incomplete or condensed. No liability is assumed for the relevance, accuracy, or completeness of the contents of this document.

This document is subject to the more detailed information specified in the disclosure documents and client service agreement. Investors must read and agree to the contents of the documents, including all risks highlighted therein, prior to making any investment related decisions. Before making an investment, each potential investor should make its independent assessment and inquiries.

Document may include predictions, estimates or other information that might be considered forward-looking while these forward-looking statements represent our current judgment on what the future holds, they are subject to risks and uncertainties that could cause actual results to differ materially. Investors are cautioned not to place undue reliance on these forward-looking statements.

Neither ArthVeda Fund Management Ltd., nor any person connected with it, accepts any liability arising from the use of this material. The recipient of this material should rely on their investigations and take advice from their professional advisors opinion, if any, expressed are our opinions as of the date appearing on this material only. We endeavour to update the material on a regular basis. However there is no regulatory compulsion for us to do so.

Past historical equity market returns are not a guarantee of and may not reflect future performance. Actual results may differ materially from those suggested by the forward looking statements due to risk or uncertainties associated with our expectations with respect to, but not limited to, exposure to market risks, general economic and political conditions in India as well as other countries globally.

Investments in equity markets are subjected to market risk and there is no guarantee that the investment objective of the strategy will be achieved. Please read the strategy related documents (Disclosure and Client Service Agreement) carefully. Investors should consult their tax and investment advisors before investing.


Wealth from Wisdom

ArthVeda Fund Management Pvt. Ltd.Grd. Floor, HDIL Towers, Anant Kanekar Marg, Bandra (E),

Mumbai 400051, Maharashtra, IndiaContact no.: +91 22 67748558/500; Fax: +91 22 67748585

Email: [email protected]

www.arthvedacapital.com

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