Indian markets valuation still not cheap: Kotak Institutional Equities

In an interview with ET Now, Sanjeev Prasad, ED & Co Head, Kotak Institutional Equities, talks about the current economic scenario and market trends. Excerpts:

ET Now: Keeping in view the surprise rally that we have seen last week, do you think macro headwinds have somewhat eased off and we are looking at better valuations?

Sanjeev Prasad: The people are expecting that the interest rates and inflation will peak out somewhere in September-October and remain at high levels for some time before easing off. Second thing is that we have seen some improvement in governance as well. About a month back valuation had become somewhat more attractive, I would say in a more relative sense, but if you compare with other emerging markets, India is still not very cheap. So that was a case which we highlighted in early part of June that you had a few silver linings in respects of valuations after the correction seen in the first five months.

We have seen about 12% correction and we were seeing some improvements at least in terms of the macro, in terms of stabilisation may be not in terms of improvement. I guess that is what broke the rally. But if you ask me from here on, things are going to be a lot more challenging because to some extent the market is already factoring in some amount of stabilisation and the macro and some improvement in governance; and for the market to rally further, we require continuous improvement in both these factors.

ET Now: What are your thoughts on BHEL? Do you think yesterday’s selling was slightly over done?

Sanjeev Prasad: We have seen this whenever a divestment announcement takes place, there is some amount of shorting which happens within the stock and people expect to buy at lower level whenever the FPO takes place. So that is part of a course now and the government needs to revisit how it wants to do the divestment programme, whether needs to have such a extended and grown out procedure for selling stock. When it comes to divestment in a stock like BHEL, everybody knows the story and the best to do it is to do it when overnight transactions get it out in the way. Like in a block deal, many other private companies sell the shares on a block deal basis. So the government announces and the market has sufficient buying to react to it.

All sorts of game start in the F&O segment and then stocks pay the price. Look at the classic example of SAIL, the stock has gone down from 200 at the time of announcement divestment to 140 and still there are no signs of divestments. So either you do it or you do not. You just do not have an announcement and keep sitting on it. Coming back to fundamentals of the stock, we are looking at about Rs 135 EPS for 2012, which means the stock is trading at recent valuation in the context of historical valuations. But having said that we are not very positive on the stock in the long term, for the simple reason, at some point of time in the next one or two years, the earnings numbers for this company will probably peak out because beyond a certain level you cannot have continuous power generation addition in the country. At maximum, we can expect about 20 gigawatt of capacity addition in India in any given year and that is also big.

If you take the BHEL share, let’s say, about 60-65%, then you are looking at about 12-13 gigawatt and that is the maximum you can hope for. So basically, it looks like the stock will continue de-rate over a period of time as the revenue numbers start to stabilise and also the earnings numbers which means eventually at some point of time in the next two, three, four years, the stock starts trading at in a much lower multiple just based on at present revenue numbers and bottom line starts trading more on export basis.

ET Now: Coming to oil and gas, Reliance has finally agreed to drill more wells. There are also reports coming out that perhaps RGTIL may be on the block. Do you think this would somewhat will lift the sentiment which has been so gloomy up until now for Reliance Industries?

Sanjeev Prasad: Not at all. As far as RGTIL is concerned, Reliance does not own any stake over there. It is a private company owned by the major shareholders. So that does not really matter. As far as drilling these three wells and production numbers are concerned, it does not look like they are going to ramp up in a big hurry from the KG-D6 block. Because by the time you complete these wells and connect the whole systems and all the stuff, it is going to be at least 15-18 months down the line. The numbers we are hearing from Niko, which is a 10% partner in that block, it looks like production numbers will continue to decline for some more time.

We have given some guidance of 45 million cubic meters per day for the current fiscal year compared with 56 which was the average last year and about 53 in the fourth quarter, and current production is somewhere about 47 million cubic meters per day. So there is no improvement over there. The second shock which came out on this Niko’s annual information report was a big decline in the oil reserves numbers. I do not know what happened over there, but just because of some technical revision oil reserves have been cut by something 90% which is a complete shocker. The kind of oil number being talked about in production terms for 2012 is something like 14000 barrels per day. You will still continue to see earnings downgrades as far as Reliance is concerned for fiscal 2012 and may be even going into fiscal 2013 if you do not see any improvement on the E&P side.

As far as refining and chemicals part is concerned, again we are not very bullish over there. Last year fourth quarter was a very excellent quarter both for chemicals and refining, and compared to that chemical margins have softened, refining margins are somewhat stable. So I do not really see any near term catalyst in the stock. If you look at our own numbers for fiscal 2012, we are looking at about Rs 68 EPS. For a commodity company, if you have a Sterlite and Tata Steel which are trading at 8 to 9 PE, so why would I give this company 11-12 multiple in that case? So the stock will continue to languish until and unless it see some dramatic improvement in the commodity cycles, namely chemical and refining side, or you see some positive news flow on the E&P side, and neither of which are expected in a hurry.

ET Now: So what could lead the next rally as Reliance is looking toppy, ONGC has potential to underperform ahead of its FPO, State Bank of India is looking rather rusty and Infosys is fairly priced?

Sanjeev Prasad: We are all struggling with that because all the consumer names have become fairly expensive now. Peter, Hindustan Lever which is almost 30 times now on 2012 number and ITC which is 26-27 times or your Titan, Nestle. Nestle is now 40 plus. I do not how much more multiple expansion you are going to see in these names and money continues to sort of chase the so-called defensives; but honestly, if you ask me what is defensive about a stock which is trading 30 plus, I do not know. On the other side infrastructure names, people still do not want to revisit given the rather gloomy investment scenario as of now. So unless and until you see an extended period of soft commodity prices and inflation and interest rate starting to come off which can only happen towards may be the second quarter of next calendar year. So we are several quarters away from that.

Our view is that you will see interest rate and inflation starting to peak out in the next three-four months, but it does not mean that things will start coming off immediately, they will probably remain at elevated levels for some time, which I do not think is positive backdrop for the investment cycle at least. So if you ask me it is very tough to take a call as to what will drive the market next, you have to see a positive confluence of several factors including some improvement in global investment sentiment. But the problem with that is whenever that happens you will probably still see commodity prices rallying; and whenever you see the prices rallying, I am not very sure India can really perform in that kind of macro environment situation.

ET Now: Your reports say that you are bullish on private banks. Which are your top picks?

Sanjeev Prasad: Clearly, HDFC Bank and ICICI Bank. HDFC Bank is just a great franchise and delivering 30% earnings growth year after year. Even though it is on the expensive upside, it is at least a company which I can invest and not worry too much about what is going to happen to the earning numbers and book in terms of NPA etc. So, I am quite comfortable even with somewhat stretched valuations out there. ICICI Bank, given the fact that company has not done any lending, I do not think they will be a victim to a bad NPA cycle, which is expected in two years’ time, given all the infrastructure problems which we are seeing in the country as of now. And whenever the bank starts lending again, you would see a dramatic improvement in the ROE given the fact that they have built the liability side quite well.