indian equities-cyclicals poised for strong recovery

Indian Equities: Cyclicals poised for strong recovery 27 February 2015

� What’s the Gist – With macrolead the recovery, however timing of recovery analysis, Banks are best positioned among cyclicals to leaddelay on its way to recovery. Investors are advised to stay heavily invested in cyclicals discussed in this report, with strong bias towards Banks and Auto sectors.

� Macro- economic outlook remains positivefrom December levels, is still within RBI’s tolerance levelremain weak, inflation is more than likely expected to remain muted. Additionally, growing, has still shown signs of weakrate further to stimulate growth in the economy

� Fundamentals signaling bottoming

and correlated to economic cycleearnings improve significantly. Currently, mportfolio are in reasonably good shape fundamentally. As of 3QFY15, (Key Performance Indiout with most indicators are either at or just below the trough cycle average levels seen in the last down cycle period.

� Valuations indicate up

for cyclical sectors, relative valuation multiples (like P/E, P/B, EV/EBITDA) can also suggest the reversals or the enmultiples are at relatively higher levels cperiods. With macro-economic indicators already pointing towardscurrent high trailing multiples

�Azharuddin A Mansiya

CFA Level 3 Candidate, June 2015

Phone: +91 9930307208

E-mail: [email protected]

Blog: http://alphaniveshap.blog.com

Cyclicals poised for strong

With macro-economic conditions gradually improving, cyclical sectors will , however timing of recovery will differ across sectors. According to

s are best positioned among cyclicals to lead, while Cement could face some delay on its way to recovery. Investors are advised to stay heavily invested in cyclicals discussed in this report, with strong bias towards Banks and Auto sectors.

economic outlook remains positive – Inflation at 5.1% in Jan-from December levels, is still within RBI’s tolerance level. With crude oil pricremain weak, inflation is more than likely expected to remain muted. Additionally, growing, has still shown signs of weakness, which only advocates RBI to continue to cut repo rate further to stimulate growth in the economy.

Fundamentals signaling bottoming of cycle – Cyclical sectors’ business is highly sensitive and correlated to economic cycle. As macro-economic conditions improve, cyclical sector earnings improve significantly. Currently, most of the cyclical sectors discussedportfolio are in reasonably good shape fundamentally. As of 3QFY15, the fundamental KPIs (Key Performance Indicators) of respective sectors suggest that the earnings have bottomed out with most indicators are either at or just below the trough cycle average levels seen in the last down cycle period.

Valuations indicate up -cycle in sight – Valuations are driven by fundamentalsrelative valuation multiples (like P/E, P/B, EV/EBITDA) can also suggest

the reversals or the end of cycles. Generally, trailing (last 1-year or 4-quarters) valuation multiples are at relatively higher levels compared to peak cycle or deep into down

economic indicators already pointing towards start of trailing multiples look supportive and indicate beginning of up

Azharuddin A Mansiya CFA Level 3 Candidate, June 2015

Phone: +91 9930307208

[email protected]

http://alphaniveshap.blog.com

economic conditions gradually improving, cyclical sectors will differ across sectors. According to my

while Cement could face some delay on its way to recovery. Investors are advised to stay heavily invested in cyclicals discussed in this report, with strong bias towards Banks and Auto sectors.

-2015, although rose crude oil prices continue to

remain weak, inflation is more than likely expected to remain muted. Additionally, IIP although ness, which only advocates RBI to continue to cut repo

Cyclical sectors’ business is highly sensitive economic conditions improve, cyclical sector

discussed in model the fundamental KPIs

that the earnings have bottomed out with most indicators are either at or just below the trough cycle average levels seen in the

fundamentals. However, relative valuation multiples (like P/E, P/B, EV/EBITDA) can also suggest

quarters) valuation ompared to peak cycle or deep into down-cycle

start of growth phase, the indicate beginning of up-cycle.

� Indian Equities: Cyclicals poised for strong recovery

� | Azharuddin A Mansiya 27 February 2015

Table of Content

1. Best Positioned Sectors --------------------------------------------------------------------------03

2. Macro Economic Outlook -------------------------------------------------------------------------04

3. Fundamentals signaling bottoming of cycle -----------------------------------------------06

4. Valuations indicating cyclical upturn ---------------------------------------------------------10



Best Positioned Sectors

Sector scores: The cyclical sectors have been analyzed and evaluated based on three parameters, 1) macro-economic sensitivity, 2) fundamentals and 3) valuations. The sectors are rated on the scale of 1 to 5 on each parameters with 1 being the worst and 5 being the best. Overall, Banks and Autos are the best positioned sectors and investors are advised to remain heavily invested in these sectors relative to other cyclical sectors.

Macro-Economic: Banks are the best positioned sector to be benefited for any favorable change in macro-economic conditions going forward. Interest rate cuts will be most beneficial for banks and has direct positive impact relative to other cyclicals.

Fundamental: Most of the sectors are in reasonably good position fundamentally as of 3QFY15 included in model portfolio. However, cement sector still appears to be struggling a bit largely due to pressure on cement pricing as post monsoon demand recovery has been slower than expected.

Valuation: Banks are best placed among the cyclicals in terms of valuations. Current market prices appear to have discounted negative sentiments regarding NPA situation reported during recent earnings results. After the recent correction in the bank stocks, the risk-reward trade-off looks attractive.

Investment conclusion: Investors are advised to remain invested in the below cyclical sectors with strong bias towards banks and auto and add positions at every correction seen prices whenever possible, as these two sectors are expected to outperform in near term. Although, I am overweight on cement sector, however will advise investors to remain moderately invested in cement, relative to other overweight cyclical sectors as the share prices could see short-term underperformance largely due to weak earnings and negative sentiment around the recent freight hike announced in the railway budget.

Source: Proprietary analysis



Macro Economic Outlook

Inflation continues to remain low… – Inflation, measured with CPI (Consumer Price Index) had been trending downwards till December. However, it has rose to 5.1% as of January 2015, although still within RBI’s tolerance level. While this recent rise in inflation has largely been the result of higher food prices, easing in crude oil prices has kept the rise of CPI in check. The continuous fall in crude oil prices has helped instilling the confidence that there are remote chances of inflation hitting back to record highs . With Global economy remaining fragile (Euro area struggling, Chinese economy cooling off), commodity prices including crude oil are expected to remain weak in the near future. This will be beneficial for India as falling crude oil will help to stabilize CPI at lower levels.

Source: RBI, as per new series with base year 2012.

…and Industrial output remains weak… – Index of Industrial Production (IIP) is an indicator used to measure the combined economic output of the goods manufactured by various industries and sectors in India. A higher IIP number indicates growth in economic activity supported by demand for goods produced. Industrial growth in December slowed down to 1.7% compared to 3.8% in November, largely due to low consumer durables and mining output, reflecting sluggishness in the economy.

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

11.0%

12.0%

Jan

12

Ap

r 1

2

Jul 1

2

Oc

t 1

2

Jan

13

Ap

r 1

3

Jul 1

3

Oc

t 1

3

Jan

14

Ap

r 1

4

Jul 1

4

Oc

t 1

4

Jan

15

CP

I

Exhibit 2: Inflation trend



Source: RBI

…which calls for further easing in interest rates – RBI had cut repo rate (the rate at which RBI lends to banks) by 25 basis points to 7.75% in January 2015, first cut since January 2014. With inflation now sustaining at lower levels and growth struggling to pick-up, RBI is expected to further cut rates, with next rate cuts expected post budget.

Source: RBI, note: CPI series with base year 2012.

-10%

-5%

0%

5%

10%

15%

Ap

r 2

00

8

Oc

t 2

00

8

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9

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9

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0

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01

1

Oc

t 2

01

1

Ap

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01

2

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t 2

01

2

Ap

r 2

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3

Oc

t 2

01

3

Ap

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01

4

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t 2

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4

IIP

-3m

ma

yo

y

Exhibit 3: IIP

IIP

7.0%

7.3%

7.5%

7.8%

8.0%

8.3%

8.5%

8.8%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

11.0%

12.0%

Jan

12

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r 1

2

Jul 1

2

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t 1

2

Jan

13

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r 1

3

Jul 1

3

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3

Jan

14

Ap

r 1

4

Jul 1

4

Oc

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4

Jan

15

Re

po

ra

te

CP

I

Exhibit 4: Repo rate vs Inflation

CPI Repo rate



Fundamentals signaling bottoming of cycle

Cyclicals to lead the recovery cycle: Falling interest rates generally stimulates the economy and it is the key factor in improving cyclical businesses. In view of the government’s mandate on growth through investments in infrastructure, anticipation of interest rate cut cycle and improving macro-economic conditions, cyclical sectors are best placed to see recovery in their earnings.

Fundamentals improves…with a lag: Business fundamentals and earnings of cyclical industries like banks, autos, capital goods, consumer durables, infrastructure, etc generally tend to pick up with a lag of few quarters after macro-economic conditions start to improve. In context of the current economic situation of India, Inflation (including crude oil prices), Interest rates and IIP are the key macro-economic indicators that will dictate the path of recovery. With all the key indicators currently in a favorable state and pointing towards gradual improvement, cyclicals appear to be positioned to witness earnings recovery sooner than later.

In context of the model portfolio designed at the beginning of 2015 in my report Indian Equities: Seeking Multi-year Alpha, we will discuss how each of the cyclical sectors are positioned in terms of their fundamentals and what could be the quantum of recovery expected as macro improves.

Banks: Interest rate is the most important driving factor of banking industry as the business of banks involve selling of loans and borrowing of deposits which are priced at a certain interest rate. This makes banks as one of the most sensitive sectors to changes in interest rates. Generally, banks’ earnings react in about 1-2 quarters post changes in interest rates as illustrated in exhibit 5.

The three most important fundamental indicators for banks are NPA (Non Performing Asset), NIM (Net Interest Margin) and ROA (Return of Assets). NPA signifies bank’s asset quality and its future health of balance sheet, which is the most critical factor in gauging its performance. NIM and ROA indicates bank’s profitability and efficiency. Banks’ NPAs have improved when interest rates are cut and deteriorated when increased. However, banks have managed to improve NIMs and ROA throughout but at the cost of their asset quality.

As of 3QFY15, NPAs have further deteriorated, largely for the public sector banks while private banks have more or less maintained their NPAs. As it stands, looking ahead as interest cut cycle resumes, the fundamentals are expected to only get better as NIMs and ROA have already started improving while NPA appear to have bottomed out.

Source: Company data, RBI. Note: NPA trend is a calculated score, with less than 0 indicating better asset quality and vice versa. Note: above data is composed based on the bank stocks included in model portfolio..



Auto: Auto demand, especially 4-wheelers is supported by lower interest rates as consumers generally go for financing the purchase of their cars. As illustrated in exhibit 6, the KPIs for auto sector suggests that fundamentals improve significantly as interest rates are cut and deteriorate when rates go up. However, the impact starts to translate onto fundamentals only after 2-3 quarters post the start of rate cut cycle.

As of 3QFY15, the sector seems to be placed comfortably in terms of volume growth and EBITDA margins (both above long term averages). However, ROEs are still lagging, far below the rate increase cycle period average. I believe the ROEs will improve significantly as volumes improve further.

Source: Company Data, RBI. Note: above data is composed based on the Auto stocks included in model portfolio

Consumer Durables: India’s consumer durables demand is driven by consumer spending which is influenced by size of disposable income of middle class population. As inflation decreases and interest rate reduces, share of disposable income in total income increases which improves affordability for consumer durable goods like AC, Refrigerator, TV, etc.

Interest rate changes in the economy drives profitability of consumer durable companies and impacts their earnings in 3-4 quarters post interest rate cut. As illustrated in exhibit 7 by analyzing key fundamental indicators, company earnings improve and remain strong during the interest rate cut cycle and struggle during the interest rate hike period.

As of 3QFY15, revenues grew by 9% yoy (below long term average growth of 19%) for portfolio covered companies while EBITDA margins was below its long term average, although above the average level seen during the rising interest rate period . Nevertheless, as macro-economic state of the economy improves, consumer durables demand will likely improve which will drive its profitability as seen in the past rate cut cycles.

Source: Company data. Note: above data is composed based on the Consumer durables stocks included in model portfolio



Capital Goods: Capital goods industry is one of the immediate beneficiaries of the onset of the investment cycle in an economy. As investments in heavy machinery and capital goods infrastructure increases, revenues for capital goods companies improve, driving overall fundamentals of the sector. This relationship is well supported by the movement in Capital goods IIP (Index of Industrial Production) and its impact on overall fundamentals of the companies operating in this space.

Generally, recovery in capital goods sector take about 4-5 quarters post the start of rate cut cycle as illustrated in exhibit 8. In the recent past, during the interest cut cycle of 3Q09-4Q10, fundamentals of this sector improved only from 2Q10 onwards (~ 4 quarters after first instance of rate cut, once IIP growth picks up). During this period, companies registered strong outperformance (as indicated by its fundamental indicators) compared to low growth period and as well as its long term average.

As of 3QFY15, fundamentals of companies in the capital goods sector (model portfolio companies) are still below the low growth period averages despite relatively better IIP growth. With government focused on kick starting investment cycle in key areas of defense manufacturing, railways, and manufacturing sectors, outlook for capital goods remain positive.

Source: Company Data, RBI. Note: above data is composed based on the Capital goods stocks included in model portfolio

Cement: Demand for cement in India is driven by housing and infrastructure development. However, for last few years, demand from infrastructure space has been absent as government spending on infrastructure projects has stalled. As government spending increases on infrastructure projects and GDP revives, cement demand accelerates, improving earnings for the sector.

Although, the revival cycle generally takes around 3-4 quarters before the industry fundamentals turns around. As shown in exhibit 9, cement demand (volumes and pricing) improves significantly during growth phase of the economy, driving the earnings and enhancing shareholders’ returns significantly.

As of 3QFY15, fundamentals for cement sector suggests that the demand has bottomed-out, as volumes have grown at a slower pace, indicating imbalance in supply-demand situation. Additionally, cement prices have remained soft due to weak infrastructure demand. However, the demand condition is expected to improve once infrastructure projects restarts (Budget will be the key event to lay the path for infrastructure projects), improving pricing environment.



Source: Company Data, RBI. Note: above data is composed based on the Cement stocks included in model portfolio



Valuations Indicating Cyclical upturn

Trailing valuation multiples are at the highest lev els…: Valuation multiples including P/E, P/B and EV/EBITDA for cyclical sectors, generally trade at the higher levels during the up-cycle as compared to their long-term averages during the down-cycle. This is because the stock prices rise in anticipation of recovery while the respective denominators (EPS, Book value and EBITDA) of the valuation multiples for the past period are at lower levels as business fundamentals remain poor due to business cycle downturn.

…while forward valuation multiples can be at lower levels: As macro-economic conditions improve, business cycle gradually recover which improves business fundamentals for the coming quarters, significantly lowering valuation multiples (as denominators in form of EPS, Book value and EBITDA rise up).

Banks: The sector has traded at a trailing P/B of 2.5x on an average since FY07 while at 2.2x next two quarters (NTQ) forward P/B. During the falling interest rate period, trailing P/B significantly comes down from the higher levels seen during the high interest rates period and forward P/B even lower. Additionally, the book value (BV) improves significantly during the recovery period, as asset quality (NPA) improves and earnings recover, which drives up the stock price.

The market is expecting strong recovery in the earnings along with significant drop in NPA numbers as quality of loans improve with improving business conditions in the economy. However, market is carrying a cautious approach for public sector banks, which has contained the stock prices of banking sector as model (banks) portfolio and BSE Bankex are both up just 1% YTD 2015.

Looking ahead, as rate cut cycle gains momentum and government taking decisive steps to improve the balance sheet of public sector banks, the sector can see exponential growth in earnings and improvement in asset quality which will drive up the share prices. Additionally, the sector can also witness a re-rating of valuation multiples as the key fundamentals NIMs and ROA are already better than the historical averages.

Source: Company Data, BSE India, RBI.. Note: above data is composed based on the bank stocks included in model portfolio

Auto: The sector has traded at a Last twelve month (LTM) trailing P/E of 18.7x on an average since FY07 while at 15.8x next twelve month (NTM) forward P/E. During the rate cut cycle, trailing P/Es are generally higher than the average while forward P/E remain lower for the reasons explained earlier. Additionally, the earnings (EPS) improve significantly during the recovery period, which can drive up the stock price.

The market is expecting strong recovery in the earnings for Auto sector as reflected by model (auto) portfolio, which is up 11% while BSE Auto index is up 5% YTD 2015.



Looking ahead, as rate cut cycle continues, and auto demand picks up, there can be exponential growth in earnings (as seen in last rate cut cycle period) which will drive up the share prices.

Source: Company Data, BSE India. Note: above data is composed based on the Auto stocks included in model portfolio.

Consumer Durables: The sector has traded at a trailing P/E of 15.4x on an average since FY07 while at 13.3x next twelve month (NTM) forward P/E. During the rate cut cycle, trailing P/Es are generally higher than during rising rate cycle period while forward P/E remain lower for the reasons explained earlier. Additionally, the earnings (EPS) improve significantly during the recovery period, volumes increase and margins improve, which drives up the stock price.

The market is expecting a strong recovery in the earnings along with a surge in volumes which will improve margins. The stock prices of the consumer durables sector in model portfolio are modestly up at 1% compared to BSE consumer durables index at 8% YTD 2015.

Looking ahead, as rate cut cycle begins, and demand picks up, there can be exponential growth in earnings as seen in last rate cut cycle, which will drive up the share prices.

Source: Company Data, BSE India. Note: above data is composed based on the Consumer durables stocks included in model portfolio

Capital Goods: The sector has traded at a trailing EV/EBITDA of 14.5x on an average since FY07 while at 12.6x next twelve month (NTM) forward P/E. During the recovery period, earnings (EBITDA) significantly improve, as infrastructure activity kick starts leading to demand for capital goods which spurs up the volumes and thus improves margins for this sector.

The market is expecting a strong recovery in the earnings along with a surge in volumes. The stock prices of the capital goods sector in model portfolio are modestly up at 6% on average compared to BSE Capital goods index at 13% YTD 2015.



Looking ahead, a strong budget is expected from the perspective of infrastructure spending, which will bring back demand for capital goods, resulting in exponential growth in earnings (EBITDA) as seen in the last cyclical up-turn period which will see the sector enter into a sustainable growth period of 2-3 years.

Source: Company Data, BSE India, RBI.. Note: above data is composed based on the Capital goods stocks included in model portfolio

Cement: The sector has traded at a trailing EV/EBITDA of 7.9x on an average since FY07 while at 7.0x next twelve month (NTM) forward EV/EBITDA. As the economy recovers, cement demand picks up with volumes surging exponentially supporting cement price hikes announced by the companies.

The market is expecting significant recovery in the earnings along with exponential growth in volumes and sustainable rise in cement prices supported by demand from government spending on public infrastructure. However, market is carrying a cautious approach as thus far there has not been a real pick up seen in cement volumes and the prices have remained muted with next possible trigger being the concrete measures taken in the upcoming budget for revival in infrastructure spending. The cement sector in model portfolio is up 1% YTD 2015.

Looking ahead, as economy recovers gradually along with key initiatives by government to begin infra spending, there can be significant growth in volumes and pricing which will drive up earnings which could see multifold jump in share prices.

Source: Company Data, BSE India, RBI.. Note: above data is composed based on the Cement stocks included in model portfolio



Disclaimer: The views mentioned in this report are based purely on my own independent analysis, research and understanding. None of the content including data and views are based on any of the research reports of any brokerage houses. Model portfolio composition is dynamic in nature and is subject to change as per the changes in the macro-economic situations and risks associated. Investors are requested to take advice before acting upon any investment ideas mentioned in this report.

indian equities-cyclicals poised for strong recovery

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