Financial services is the best way to play India structural story
Deepak Ramachandra, BofAML
Apr 27, 2018 | Source: ET
Market Outlook: The markets are expected to remain somewhat volatile this year. We believe there is a limited upside from here on and that is what the clients are looking out for. While the macros have slightly worsened, a lot of that is externally driven. Oil prices are moving up and simultaneously we have global tightening happening, driven by the Fed. There are geopolitical risks and EM currencies are under pressure due to potential global trade issues. Most importantly, we are going into an election year in India. Global investors are questioning the uncertainties around elections and are looking for on-the ground political sentiment. The March quarter was probably the last quarter where we will have the low base effect of demonetization. As we continue to see earnings downgrades and more are likely to come, the market valuations have come off, but they are not yet at cheaper attractive levels. The financial sector, which is most liked and traded by foreigners, has been beaten down by various problems. There are concerns around asset quality and governance. All of this has a bearing on the sentiment of global investors.
Near term view: It would be hard for the market to push beyond a point. The only good thing is that domestic flows are still very supportive and hence we would still have an underlying support for the market. The question to be answered is if the fundamentals of the companies will come through. There are some positive signals coming. The monsoon is expected to be normal and may be, oil starts coming off. If this happens then we may have a moderate rally, but not like the ones we have seen in the last two years. All eyes are also on state elections. All of this puts investors in a wait and watch mode ahead of the real game changer — the Lok Sabha polls in May 2019.
On FII flows: We are already off the high valuation levels of 18-18.5 times’ earnings; but at 16-17 times, it is still not cheap given the earnings expectations. Month to date, FIIs have been net sellers. Investors are finding opportunities more attractive elsewhere in emerging markets. Among the EM pack, India is finding a smaller proportion of the incremental flows.
India positioning by foreign investors has lightened. They are still overweight but not as overweight as they used to be. There could be risk to slightly lower weightage to India, especially throughout this year and you could see a shift of money away from India to some of the other markets. We have definitely seen a reduction in interest and activity levels from foreign investors. At the moment, foreigners are just sitting on the positions that they have. They are not committing any new incremental money to new ideas but they want to wait out the volatility.
What should investor do? Being cautious and defensive is advisable for investors this year. The structural drivers of the India story haven’t changed — it remains a great domestic consumption story. If you are a long-term investor, you should be looking at opportunities to accumulate high quality stocks in sectors that still continue to give structural growth. But investors with a 12-month strategy must go for a defensive play with high earnings visibility and RoEs.
The concerns are around populist measures being taken on the rural side. The Budget was kind of an indication of that. The real concern is – where to find the excess revenue to support the rural spends. Only time will tell the answer what the government eventually does. However, we like rural exposed plays on the back of increased rural spends by the government.
On RBI’s policies on banking system: The feedback from investors around RBI policies has been mixed. Having welcomed the move to clean up bank balance sheets, they are now concerned with some leniency being offered on recognition, and allowing banks to spread out their mark to market losses over four quarters. Foreign investors are concerned about the worsening BoP, potential spike in inflation from oil prices and MSP hikes, and hence are not expecting an interest rate cut this year.
Despite concerns around asset quality, the financial services space remains the best way to play the India structural story. The current volatility allows investors to buy some high-quality banking franchise. We like rural-focused stocks. The IT services space is defensive and high quality, and there is some momentum for revenue pick up there. We also like sectors that are beneficiaries of the shift from unorganised to the organised market.
On IT & Telecom Sector: The growth of the previous era of IT may not come back, but there are enough tailwinds, largely from a rebound in demand on the back of US tax reforms. This will grow the toplines. Also, there is enough work that’s being done by some of the large IT companies in automation, and there is an added tailwind for margins from FX and operating leverage. Telecom remains challenging and there are very few takers for it. The sector remains tough because the competitive intensity is extremely high with no signs of abating and there are very few players to pick from.
On private banks: Investors are surely concerned on the governance issues and some lending processes, but again these are specific to a couple of banks. But the way private banks are run vis-à-vis public banks, the preference would always be for the former. We continue to see investor interest in large as well as medium scale private banks, despite the recent issues around asset quality. We have seen ‚value buying‛ in some of these troubled names. With the deadline approaching for resolution of a lot of the NCLT cases, investors are looking at the extent of haircuts banks need to take and then speed up the balance sheet cleaning procedures. Retail loan growth continues to be strong and if there is some uptick in corporate loan book, then you could have a very strong story in the private banks.