indian equities-seeking multi-year alpha

Indian Equities: Seeking 06 January 2015

� What’s the Gist – While year 2014 saw markets rally on the back of hope 2015 brings an amazing opportunity for Investors in Indian equities to witness real revival of the economy and participate in a multiwhich I believe will play out over the next few yearsportfolio with a goal of generating alpha consistently over the next 5 years.

� Theme 1: Falling Inflation leads to Lowering lately (CPI at 4.4% in Nov), largely due to easincoupled with low IIP growth presentsAutos are the top picks among the sectors.

� Theme 2: Revival in Economic activities leading to recovery in GDP

cut cycle begins, credit growth picks up which kick starts manufacturing and other economic activities in an economy. Thus GDP growth revives. Infrastructure, Cement and Capital goods among other.

� Theme 3: Implementation of

government has been focused on bringing in new reforms and policies to get the economy back on growth track. The governmentamendment of Land acquisition bill,Insurance FDI (Foreign Direct Investment) limit, GST (Goods and Sales tax) and Labour law reforms are yet to be amended or approved. However, the government is likely to impmajority of these reforms in the first half of its 5benefited are the Power, integrated power producers for self use like steel, metals and cement, Insurance companies and Industrial sector.

� Theme 4: Global Commodities

economic growth remains sluggish as China (2due to slowing investments and credit tightening. Euro zone economy remains fragile as they continue to struggle to find way out of financial crisis hit back in 2008. However, prices remaining low coupglobal economy (ex China) is expected to gradually improve, which will see recovery in global commodity prices as demand resumes.

�Azharuddin A Mansiya

CFA Level 3 Candidate, June 2015

Phone: +91 9930307208

E-mail: [email protected]

Indian Equities: Seeking Multi-year Alpha

While year 2014 saw markets rally on the back of hope 2015 brings an amazing opportunity for Investors in Indian equities to witness real revival of the economy and participate in a multi-year bull market. This report discusses four themes which I believe will play out over the next few years and accordingly have designed a model portfolio with a goal of generating alpha consistently over the next 5 years.

Theme 1: Falling Inflation leads to Lowering of Interest rates – Inflation has been falling lately (CPI at 4.4% in Nov), largely due to easing food prices. Recent slump in crude oil priccoupled with low IIP growth presents a perfect case for RBI to cut interest rates. Banks and Autos are the top picks among the sectors.

Revival in Economic activities leading to recovery in GDPcut cycle begins, credit growth picks up which kick starts manufacturing and other economic activities in an economy. Thus GDP growth revives. Prefer cyclical sectors including Infrastructure, Cement and Capital goods among other.

e 3: Implementation of key government reforms and policies government has been focused on bringing in new reforms and policies to get the economy

The government has already began with the coal blocks allocation and dment of Land acquisition bill, While other major reforms like Mineral ore mining,

Insurance FDI (Foreign Direct Investment) limit, GST (Goods and Sales tax) and Labour law reforms are yet to be amended or approved. However, the government is likely to impmajority of these reforms in the first half of its 5-year tenure, I believe. Major sectors to get benefited are the Power, integrated power producers for self use like steel, metals and cement, Insurance companies and Industrial sector.

Commodities cycle recovers as global economy reviveseconomic growth remains sluggish as China (2nd largest economy) continues to slowdown due to slowing investments and credit tightening. Euro zone economy remains fragile as they continue to struggle to find way out of financial crisis hit back in 2008. However, prices remaining low coupled with easing of monetary policies by respective central banks, global economy (ex China) is expected to gradually improve, which will see recovery in global commodity prices as demand resumes. Sectors like metals and Oil & Gas will benefit.

While year 2014 saw markets rally on the back of hope of revival, year 2015 brings an amazing opportunity for Investors in Indian equities to witness real revival of

year bull market. This report discusses four themes and accordingly have designed a model

portfolio with a goal of generating alpha consistently over the next 5 years.

Inflation has been falling ecent slump in crude oil prices

cut interest rates. Banks and

Revival in Economic activities leading to recovery in GDP – As interest rate cut cycle begins, credit growth picks up which kick starts manufacturing and other economic

Prefer cyclical sectors including

– The new Modi government has been focused on bringing in new reforms and policies to get the economy

the coal blocks allocation and hile other major reforms like Mineral ore mining,

Insurance FDI (Foreign Direct Investment) limit, GST (Goods and Sales tax) and Labour law reforms are yet to be amended or approved. However, the government is likely to implement

year tenure, I believe. Major sectors to get benefited are the Power, integrated power producers for self use like steel, metals and

as global economy revives – Global largest economy) continues to slowdown

due to slowing investments and credit tightening. Euro zone economy remains fragile as they continue to struggle to find way out of financial crisis hit back in 2008. However, with crude oil

led with easing of monetary policies by respective central banks, global economy (ex China) is expected to gradually improve, which will see recovery in global

ectors like metals and Oil & Gas will benefit.

� Indian Equities: Seeking Multi-year Alpha

� | Azharuddin A Mansiya 6 January 2015

Table of Content

1. Theme 1: Falling Inflation leads to Lowering Int erest rates ---------------------------03

2. Theme 2: Revival in Economic activities leading to recovery in GDP -------------06

3. Theme 3: Implementation of key government reform s and policies ---------------09

4. Theme 4: Global Commodities cycle recovers as gl obal economy revives -----10

5. Multi-year Alpha portfolio: Sectors ------------------------------------------------------------13



Theme 1: Falling Inflation leads to Lowering of Int erest rates

As Inflation starts to ease… – Inflation, measured with CPI (Consumer Price Index) has been trending downwards for past four months and it stands at 4.4% as of November 2014, which is within RBI’s tolerance level. While this recent easing in inflation has largely been the result of lower food prices, recent dramatic drop in crude oil prices have only accelerated the declining trend. As Global economy remains 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 (used as raw material in key products which also forms major component in CPI) will help to stabilize CPI at lower levels.

Source: RBI

…probability of interest rate cut by RBI increases – RBI, who uses interest rates as one of the tools to control inflation, has kept repo rate (the rate at which RBI lends to banks) at 8% since January 2014 after series of hikes in 2013. This has helped in controlling inflation to some extent, however it has come at the cost of slowing growth of the economy. As illustrated in Exhibit 2, when inflation starts to ease, RBI cuts interest rates with the lag of few months, however 2013 was an exception where despite high inflation, RBI had reduced and kept rates lower due to slow economic growth (which was more like stagflation) during the period.

With inflation now easing and growth struggling to resume, RBI is expected to cut rates sooner rather than later, with earliest rate cuts expected post budget in 2015.

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Exhibit 1: Inflation trend



Source: RBI

As interest rates reduce, credit growth picks-up…. – Bank credit growth has been slowing since 2011 soon after repo rate hikes. As per the data published for September month by RBI, credit growth has slowed down below 10% yoy for the first time in 5 years. As per Exhibit 3, credit growth has picked up when rates have stayed below 7%. Slowing inflation rate and weak IIP growth presents a classic scenario for RBI to cut rates to kick start credit growth and gradually the economic activities.

Source: RBI

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Exhibit 2: Repo rate vs Inflation

CPI Repo rate

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Exhibit 3: Credit growth vs Repo rate

Credit growth Repo rate



…leading with interest sensitive consumer loans – Auto demand, especially 4-wheelers is supported by lower interest rates as consumers generally go for financing the purchase of their cars. As the below chart suggests, auto loans pick-up when repo rates are reduced and vice versa. Auto loans were up in October by 21% yoy, driven largely by festive demand. However, as rates are expected to be reduced in near future, demand for autos will pick-up soon.

Source: RBI

Playing the theme – The first half of 2015 will see the start of interest rate cut cycle in the economy and to play this trend I suggest taking exposure into Banking and Auto sector by investing regularly in the first 6 months to earn maximum returns. Banking and Auto stocks generally outperform broader market during the interest rate cut cycle (Exhibit 5). Among banks, private sector banks are preferred due to better asset quality and capitalization ratios. However, investors with high risk appetite can consider investing in public sector banks (PSBs) as government works towards resolving their balance sheet issues beginning 2015. Additionally, PSBs are trading at cheaper valuation than their private sector peers. Among the autos, prefer to invest in 4-wheelers segment with domestic exposure followed by commercial vehicles. For retail investors to play this trend, I suggest to take mutual fund route by investing in Bank and Auto sector/focus funds. For conservative investors, investing in long-term debt funds is preferred over bank fixed deposits and PPFs as the return generated will be far superior in debt funds.

Source: RBI, BSE India

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Exhibit 4: Auto loans growth vs Repo rate

Auto loans Repo rate



Theme 2: Revival in Economic activities

Falling interest rates encourage demand for loans… – Interest rates hold key to ignite engine of growth in an economy. Presently RBI has kept repo rates constant at 8% since the start of 2014 which has led to constant falling loan growth in manufacturing sector from the high of 33% yoy in Jan-2014 down to 18% yoy in Oct-2014. As interest rates starts to fall (as discussed in theme 1), demand for loans to finance manufacturing activities will accelerate, as illustrated in exhibit 5.

Source: RBI

…leading to improvement in Industrial output – 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. While IIP growth is driven by the demand situation in the economy, credit growth in manufacturing sector acts as a leading indicator of potential future growth in IIP output.

As indicated in exhibit 6, IIP improves with increasing loan growth, since manufacturers need finance to create capacities for production and other operational needs. With credit growth poised to pick-up, IIP will soon recover, improving the growth outlook in the economy.

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Exhibit 5 : Repo rate vs Manufacturing sector loans

Manufacturing sector loans Repo rate



Source: RBI

Recovery in IIP will boost GDP – Gross Domestic Product (GDP) is a measure of total economic output produced in form of physical goods as well as services in a country. It an indicator of overall growth situation in a country. A strong IIP growth suggests eventual revival in overall economic growth improving GDP growth. Historically, when IIP growth resumes, GDP growth revives almost simultaneously (Exhibit 7). As IIP growth is expected to bounce back, GDP revival will soon follow. However, the quantum of growth will depend on interest rate cuts along with other macro-economic factors including government reforms and global factors.

Source: RBI

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Exhibit 6: IIP vs Mfg sector loans

IIP Manufacturing sector loans

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Exhibit 7: GDP growth vs IIP

GDP IIP



Playing the theme – IIP growth resumes within 2 quarters while GDP takes 3 to 4 quarters to revive post the first instance of meaningful rate cut. During this course of revival, core industrial sectors like capital goods, consumer durables segment and construction activities will lead the recovery cycle. As consumer spending gradually rises with improving GDP, consumption driven industries like food, clothing, travel, entertainment and allied sectors will gather the growth momentum. For investors seeking to generate alpha on their portfolios, it is advisable to remain overweight on capital goods, cement and consumer durables sectors. Retail investors can best benefit by investing in mutual funds focused on these specific sectors. The maximum alpha can be derived from this theme is by investing before the growth revives and staying invested through the entire growth cycle.

Source: BSE India



Theme 3: Implementation of Key Government Reforms a nd Policies

With new government comes new reforms… – Policy reforms are much needed to ensure that India transitions out from stagflation to an environment of higher growth and lower inflation. Indeed, the decisive (Lok Sabha) election outcome suggests that the new government will be able to implement reforms at a faster than previously expected pace. Easing land acquisition rules, raising foreign investment limits in insurance and pension sector, introducing a country-wide goods and services tax (GST), privatization of coal sector and a separate labour law for small factories are few of the major reforms the new government is looking to implement in its tenure.

…with new reforms comes new hurdles… – The government had lined up an ambitious legislative agenda for the just concluded Parliament session. The long-pending insurance legislation to raise the cap on foreign investment to 49 percent from 26 percent, and another bill to replace a decree to overhaul the coal sector, were considered low-hanging fruits that PM. Modi hoped to push through parliament's winter session, but it did not make much headway because of its lack of strength in the Rajya Sabha.

…and with new hurdles comes new solutions – After failing to see the key bills passed in Rajya sabha, government is now likely to opt for the ordinance route to take some of that forward – insurance, coal and mining. The Union budget is expected to provide a big push forward in terms of drawing up framework for key policy reforms that the government is proposing to get the economy back on track. Two things that they need to be pushed in 2015 are GST and revival of mining activity. These two are very critical. Infrastructure sector needs a huge facelift.

Playing the theme – The new Modi government is focused on infrastructure development and economic growth. In order to achieve this goal, the government has taken some steps in the right direction and are looking more than willing and capable of achieving it. To this end, they have already laid the plan for auctioning of coal mine blocks. Insurance FDI bill and Mining bill to auction iron ore mines will be cleared ordinance route. GST (Goods and Sales tax) is also expected to be implemented as early as FY17. All these reforms will improve the business conditions and fundamentals which in turn will improve their productivity once the economy revives. The key sectors to benefit include Power, Metals, Insurance and Manufacturing Industries. Investors are advised to begin investing in Metals and power, followed by core industrial sectors.

Source: BSE India, RBI



Theme 4: Global Commodities cycle recovers as globa l economy revives

China is dragging global growth down… – China’s slowdown is being led by a decline in spending on infrastructure and housing. And, of course, if there is a slowdown in Chinese growth and demand for raw materials and such, that's going to be another massive shake to the global economy.

…and Euro zone is further adding to the pain – With growth of just 0.2% in the third quarter of 2014 and an annual inflation rate of 0.3% in November, Eurozone problems of slowdown and deflation seems to have prolonged their stay. With a backdrop of weak growth, low oil prices and general lack of inflationary pressures, the ECB’s (European Central Bank) battle against deflation looks to continue well into 2015.

However, lower Oil price helps stimulate demand… – In the summer of 2014, a barrel of Brent crude was trading at $115 a barrel. By Christmas it could be obtained for barely half that price. The big drop in the oil price is positive for global growth. It puts more spending power in the hands of consumers and it cuts costs for businesses. Global growth should gradually pick up as lower Oil prices should be able to tame inflation which in turn should enable central banks to ease monetary policy to stimulate growth. However, this would affect governments, such as Russia, Venezuela and Iran, that can only balance their books if the oil price is at $100 a barrel or more.

…which can be further nurtured through monetary mea sures… – ECB is expected to announce further easing measures in form of QE in 2015 to stimulate demand. However, the recovery will be gradual, probably after second half of 2016.

Rapid growth in China supported the world economy during the recession, but it was created on investments and supported by debt, neither of which is healthy. The fact that fixed asset investment growth dropped to 16.1% from 20% in 2013 while retail sales remained more or less stable (growth was down by 1.3%), suggests that demand is finally beginning to catch up with supply. Indeed, consumption now accounts for a record 48% of China’s GDP. This is really good news as China’s economy gradually transitions away from investment driven to consumption driven and in the process, cuts down on public debt.

…Leading to recovery in commodity prices – As Global economy growth recovers, demand for commodities picks-up, driving their prices up. Rising commodity prices, especially crude oil will reverse the inflation cycle, i.e. inflation will start to rise (refer exhibit 10, 11 and 12).



Source: IMF

Source: IMF

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Exhibit 10: World GDP vs Crude Oil

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Exhibit 11: World GDP vs Metals Prices

World IMF World Metals Index



Source: IMF

Playing the theme – It will take couple of years before the global growth picks-up and I see this theme playing out from 2017 onwards. As commodity prices start to recover supported by growth, inflation will start moving upwards, prompting central banks to start tightening interest rates. In such a scenario, commodity producing sectors and defensive sectors tend to outperform. Investors are advised to move out of their long term debt investments and start increasing investments towards metals, oil&gas sectors, followed by defensive sectors like Pharma and FMCG.

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Exhibi 12: World Inflation vs Crude oil

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Multi-year Alpha Portfolio – Sectors

Year 2015 – Remain bullish on sectors like Autos, Banks and Consumer durables as I see onset of theme 1 in the year 2015. Additionally, Cement is expected to outperform, as construction demand picks-up due to infrastructure development in the country. Remain bearish on metals, oil & gas and steel sectors due to global commodity downturn cycle.

Year 2016 – Remain bullish on sectors like Autos, Banks, Consumer durables, Capital goods and Cement as theme 1 continues to play on along with the onset of theme 2 and partial visibility of benefits of theme 3. Continue to remain bearish on metals, oil & gas and steel sectors due to global commodity downturn cycle. Additionally, I believe FMCG sector will tend to underperform the cyclical sectors.

Year 2017 – Remain bullish on sectors like Autos, Banks, Capital goods, Cement, Infrastructure, Steel and Power as Theme 2 plays out while benefits of theme 3 continues. Remain bearish on FMCG and Pharma sector on their relative underperformance to cyclicals.

Year 2018 – Remain bullish on commodity linked sectors like Metals, Steel and Oil & Gas as Theme 4 plays out. Remain bearish on Cement and Power sector as they will be trading at or near peak of their cycle.

Year 2019 – Remain bullish on defensive sectors like FMCG, IT and Pharma as Theme 4 continues to play out and as the cyclical peak out. Remain bearish on all cyclical sectors as inflation rises, pushing interest rates upward, slowing the credit growth.

Note: Overweight = Sector will outperform broader market (BSE Sensex), Neutral = Sector will perform in line with the broader market and Underweight = Sector will underperform the broader market.



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.

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