Market Outlook December 13, 2019

Index A tale of paradoxes

Visit us at www.sharekhan.com

For Private Circulation only A tale of paradoxes Market Outlook

Summary The Sensex/ Nifty rose to all-time highs recently, despite slowing GDP growth; however rally is divergent as large-cap stocks are doing well even as the broader market continues to struggle The surge in Indian equities is being supported by the strong rally in global equities and strong FII/FPI inflows; an easy monetary policy stance in the US and Europe also seems to favour equities. Broadly, markets are hoping that the worst is over, factoring in a revival in domestic macros in the coming months. Though Q2 earnings were modest, the corporate tax rate cut and a turnaround in corporate-lending banks could boost earnings growth in FY2020 and FY2021. Valuations have turned expensive thanks to the recent run-up in equities making the time ripe for increasing allocation in quality mid-cap companies; we also prefer private corporate lending banks and select stocks in the financials, energy, specialty chemicals, consumer and industrial sectors. Divergence galore: The Indian equity market has been a story of divergences lately. To begin with, the benchmark indices touched new all-time highs recently, while the economy was struggling with a real GDP figure for Q2 at six- year low of 4.5%. Within the market also, there are divergences that are unusual if not unprecedented in nature. For example, large-cap index companies are doing well, whereas the broader market continues to struggle. ‘Growth’ and ‘Quality’ are getting an abnormally high premium, whereas the value of companies with the slightest hint of balance sheet stress is completely beaten down. We believe some of these anomalies will narrow down if not correct, in 2020. Global cues supportive: The recent surge in Indian equities was triggered by the bold policy decision to cut corporate tax rates and aggressively pursue privatisation. However, the global equity rally also significantly added to improvement in sentiments and the market rally has been driven by a strong revival in foreign portfolio inflows into the country. The global scenario seems favourable for equities, given the interest rate cuts in the US and the resumption of quantitative easing in Europe. Finally, the US and China seem to be moving towards some kind of understanding on trade tariff-related issues. Locally, worst could be over: Markets are about looking ahead and not rear-view driving. The equity markets seem to be factoring in an improvement in macroeconomic conditions domestically. They are not assuming a big- bang recovery, but hoping the ‘worst is over’. In addition to an accommodative monetary policy, the government is taking policy measures to address the issue though the fiscal space to do so is getting quite limited. Earnings – Tax cuts and lower bad loan provisioning to boost growth rate: Recent quarterly results were modest and the difficult economic situation does not favour a broad-based recovery in corporate earnings in the immediate term. However, cyclical sectors are showing signs of bottoming out. More importantly, a bulk of the incremental profits of Sensex companies would be contributed by a turnaround in corporate-lending banks like ICICI Bank, Axis Bank and State Bank of India over FY20-21. Besides, the tax rate cuts provide a fillip to earnings growth, resulting in consensus estimates of 10-12% and 25-26% growth in earnings for FY2020 and FY2021, respectively. Outlook – Limited upside in large-cap indices; select investment themes and quality mid-cap stocks to outperform: After the recent run-up, the benchmark indices are not cheap anymore and India trades at substantial premium to the MSCI Emerging Market Index. Consequently, there is a case for increasing allocation in quality mid-cap companies for relatively better returns in the next 12-24 months. Within mid-cap stocks, certain stocks are ‘compounding stories’ that can be bought by clients with a relatively lower risk appetite. Moreover, there are quality companies facing cyclical headwinds and offer a scope for re-rating and substantially higher gains in the next 18-24 months though the near-term outlook remains challenging. Thus, these mid-cap stocks should be brought only by patient investors willing to tide through near-term volatility. Apart from this, we continue to prefer private sector corporate lending banks and select stocks in the financials, energy, specialty chemicals, consumer and industrial sectors. One-year forward PE chart of Nifty MSCI India premium over MSCI EM (1-yr FWD PE)

20 20 18 18 16 14 16 12 10 14 (x) 8 6 12 4 2 10 0 09 10 11 12 13 14 15 16 17 18 19 ------18 19 19 19 19 18 19 18 19 18 19 18 19 18 19 18 18 19 19 18 19 ------Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Jul Jul Jan Jun Jun Oct Oct Apr Apr Sep Feb Sep Dec Dec Aug Aug Nov Nov Mar May May P/E Ratio (1 yr fwd) -2STD -1STD Average +1STD +2STD MSCI India (1-YR FWD PE) MSCI EM (1-YR FWD PE) Source: Bloomberg Source: Bloomberg December 13, 2019 2 Market Outlook

Ride on two horses We have picked up quality mid-cap to semi-largecap companies across our preferred sectors and themes, which offer favorable opportunities to invest for the next 2-3 years. We have divided the picks under two categories namely - “Value Picks” and “Earnings Compounders”. Under the Value Picks investment basket, we have chosen stocks, which are available at reasonable valuations vis-à-vis sectors peers and where we expect earnings to pick in the coming years at significant pace. However, in the near term there could be some volatility in earnings performance as these companies will pass through macro headwinds. Nevertheless, it would be best to accumulate these stocks over the next few months and every weakness would be an investment opportunity for the long term. The second investment basket is “Earnings Compounders”, where we have picked up companies, which are well positioned to ride through the macro challenges and have a track record of delivering healthy earnings growth consistently over a period of time. Further, with multiple opportunities emerging in their respective segments, these companies have the balance sheet strength and market positioning to deliver industry- leading growth rates in the next 2-3 years.

‘‘Value Picks’’ Investment Basket Company CMP (Rs) Price Target (Rs) Aarti Industries 771 976 Bharat Electronics 100 140 Exide Industries 186 241 IPCA Laboratories 1133 1220 Kalpataru Power 422 590 KNR Constructions 246 293 L&T Finance Holdings 116 120 Source: Sharekhan Research, BSE

‘‘Earning Compounder’’ Investment Basket Company CMP (Rs) Price Target (Rs) Astral Poly 1168 1358 Biocon 293 290 Mahanagar Gas 1045 1155 Relaxo Footwears 610 650 Spandana Sphoorty 1192 1340 Trent LTD 505 650 Varun Beverages 700 872 V-Guard Industries 218 285 Vinati Organics 1960 2361 Source: Sharekhan Research, BSE

December 13, 2019 3 Market Outlook

Detailed Arguements

Divergence galore: Dissonance between markets and macro data; narrow rally Investors in equity markets are always looking forward. The Sensex touched a fresh all time high and crossed 41,000 on November 28, 2019, while the GDP-growth has moderated to multi-year low. Real GDP grew for Q2FY20 grew 4.5% y-o-y versus 5.0% y-o-y in Q1FY2020. The current slowdown in the domestic macroeconomic environment is the result of low household incomes, poor job creation and stretched government finances. Despite gloomy economic data, broader indices are at dizzy highs on the back of multiple interventions by the finance ministry in the last two months, including the cut in the corporate tax rate. With the corporate tax rate cut, FPIs/FIIs have turned positive on India despite the deteriorating macroeconomic signals. The dichotomy (dissonance between the markets and macroeconomic environment) is prevailing because the market believes that there would be a reasonable recovery in earnings and economic data over FY2020- FY2022.

Sensex touched all time high GDP growth hit a six-year low

42,000 9 8.1 8.0 41,000 7.7 8 40,000 7.0 7.0 6.8 6.6 39,000 7 6.0 5.8 6 38,000 5.0 37,000 5 4.5 (%) 36,000 4 35,000 3 34,000 2 33,000 1 32,000 31,000 0 19 19 19 19 19 19 19 19 19 19 19 19 19 19 18 18 19 19 ------Jul Jul Q4FY17 Q1FY18 Q2FY18 Q3FY18 Q4FY18 Q1FY19 Q2FY19 Q3FY19 Q4FY19 Q1FY20 Q2FY20 Jan Jun Oct Apr Feb Sep Sep Dec Dec Dec Aug Nov Mar Mar May May

Sensex India Real GDP growth (%)

Source: Capitalline Source: Bloomberg

Large-cap index companies are performing well, whereas the broader market continues to struggle. Institutional investors could be preferring large-cap bets during the subdued economic cycle. Some select large-cap companies are getting abnormally high premium in the current weak environment because these companies have been delivering strong growth/ have robust business models/ and a quality management. The performance of large-cap indices are largely skewed towards the outperformance of 8-10 large companies. When the Sensex has run-up around 13% in the past one year, only three large-cap stocks (Reliance Industries, ICICI Bank and HDFC Bank) have contributed more than 60% of all the gains. The performance of large-cap indices has been neither secular nor broad-based in the past one year; only eight out of 30 Sensex constituents have gained more than 20%. However, the quantum of fall in mid-cap and small-cap companies possibly reflects the weakness in the macroeconomic environment. The market capitalisation of the NSE MidCap index has dropped around 20% since March 2018 and it has been underperforming vis-à-vis the broader indices.

Narrow rally: skewed performance of top 8-10 stocks Midcaps meaningfully underperformed

21,00,000 Bharti Airtel 68% 18,00,000 Bajaj Finance 64% 15,00,000 ICICI Bank 54% 12,00,000 RIL 43% 9,00,000

Kotak Mahindra Bank 36% Rs. crore 6,00,000 Asian Paints 29% 3,00,000 HDFC Bank Ltd 21% 0 18 19 18 19 18 19 18 18 19 19 18 19 18 19 19 19 18 19 18 HDFC 20% 18 19 ------Jul Jul Jan Jun Jun Oct Oct Apr Apr Sep Feb Sep Dec Aug Aug Nov Nov Mar Mar Axis Bank 18% May May

0% 10% 20% 30% 40% 50% 60% 70% 80% Nifty Midcap-100 (mcap)

Source: Capitalline Source: Capitalline December 13, 2019 4 Market Outlook

Global cues supportive: Signs of green shoots in global economy driving capital inflows to India Global indicators, especially the Purchasing Managers’ Indices (PMIs) of the US, China and Japan have improved in November 2019 and hint at a potential recovery in industrial activity. Further, the US Federal Reserve has cut the interest rate in July, September and October to support the economy and its policy statement has signaled that rates would be maintained at current low levels in 2020, which is expected to support economic growth in the US. The European Central Bank (ECB) has also unveiled monetary easing with 10 bps cut in interest rate (for the first time since 2016) to -0.5% and has decided to maintain the rate at current levels till inflation rate below 2%. The US Federal Reserve’s move to hold interest rates steady is also providing comfort to the market. Receding trade tensions between the US and China and signs of some green shoots emerging in the global economy are lending buoyancy to the stock markets. This translates to capital inflows into the emerging market equities, including India.

Performance of global indices in last one-year (%) Strong FPI/FII inflows in November

25,000 Nasdaq Index 25% NIKKEI Index 11% 20,000

S&P 500 Index 19% 15,000 Dow Jones Index 14% 10,000 MSCI World Index 17% DAX Index 21% 5,000 Rs. crore FTSE 100 Index 6% - Hang Seng Index 2.6% -5,000 MSCI AC Asia Pacific Index 12% MSCI India Index 9% -10,000 19 19 19 19 19 19 19 19 ------19* -

0% 5% 10% 15% 20% 25% 30% Jul Jun Oct Apr Sep Aug Nov May Dec

Source: Bloomberg Source: NSDL; Note: * upto Dec 11, 2019

PMI of US, China and Japan improves in Nov-19

60 58 56 54 52 50 48 46 44 17 18 19 16 17 18 17 18 19 17 18 19 17 18 19 17 18 19 ------Jun Jun Jun Oct Oct Oct Apr Apr Apr Feb Feb Feb Dec Dec Dec Aug Aug Aug

US Composite Index Eurozone Composite Index China Composite Index Japan Composite Index

Source: Bloomberg

December 13, 2019 5 Market Outlook

Locally, worst could be over: Government push; hopes for more market-friendly announcements Stock markets are forward-looking machines. The government has recently taken a slew of measures including alternative investment fund for the real estate sector, package to aid the automobile sector, upfront capital infusion in the banking sector to boost lending and improve liquidity and funding to National Housing Bank (NHB) to address various issues in the domestic market. These measures have brought back some confidence in the market. Further, India has witnessed one of the biggest improvements in the World Bank’s Ease of Doing Business rankings, moved up 79 spots since 2014. Though the economy continues to face short term challenges, some leading indicators such as foreign exchange reserves, current account deficit (CAD) and a stable share in global exports are lending comfort to the market.

Improvement in India’s Ease of Doing Business rankings Indian exports as % of world exports remains stable

2018-19 Ranking 2013-14 Ranking 2.0% 0 1.8% 20 40 1.6% 60 80 1.4% 100 1.2% 120 140 1.0% 160 0.8% 180 200 0.6% 0.4%

Overall 0.2% 0.0% Paying Taxes Paying Getting Credit Investors 2001 2002 2003 2004 2006 2006 2007 2008 2009 2010 2011 2011 2013 2014 2015 2016 2016 2017 2018 2019 2005 2012 Dealing with with Dealing Getting electricity Starting a business Enforcing contracts Protecting minority minority Protecting Registering Property Resolving Insolvency construction permits India exports % of world exports Trading across borders

Source: Ministry of commerce, GOI Source: Bloomberg; Sharekhan Research

Forex reserves remained at an all-time high CAD remains flattish

500 0 450 -1 400 350 -2 300 -3

250 (%) $ billion $ 200 -4 150 100 -5 50 0 -6 17 16 15 18 19 12 13 19 16 12 14 ------Jan Jun Q1FY13 Q3FY13 Q1FY14 Q3FY14 Q1FY15 Q3FY15 Q1FY16 Q3FY16 Q1FY17 Q3FY17 Q1FY18 Q3FY18 Q1FY19 Q3FY19 Q1FY20 Oct Apr Feb Sep Feb Dec Aug Nov May

India forex reserves ($ billion) CAD as % of GDP

Source: Ministry of commerce, GOI Source: Bloomberg

The government is taking accommodative monetary policy measures to address the economic slowdown. While the government has reduced corporate taxes and announced multiple sector-specific measures, many believe that it has not directly addressed the widespread weakness in consumption. The market remains hopeful for more market-friendly announcements (including the cut in individual income tax and/or GST rates) by the government. Tax cut to shore up India Inc’s profit: The broader markets have been on a roll since September 20, 2019, when the Finance Minister announced a cut in the basic corporate tax rate from 30% to 22%. Even after the reduction in corporate tax rate, the quarterly results of Q2FY2020 were modest and remained almost in line with our expectations. The recent various measures are likely to support earnings growth in the medium-to-long term growth. However, we see some

December 13, 2019 6 Market Outlook signs of bottoming out of the consumption slowdown from various indicators such as - global food prices, rural inflation, tractor sales, two-wheeler and passenger vehicle sales. Though overall corporate earnings have not shown encouraging growth in Q2FY2020, the tax rate cuts is expected to provide a flip to the earnings growth. Consensus estimates indicate that earnings growth would be at 10-12% and 25-26% for FY2020 and FY2021, respectively. Outlook- Limited upside in large-cap indices; select investment themes and quality midcaps to outperform Since the corporate tax rate cut, broader markets continue to touch new highs every few days despite the gloomy economic indicators. Valuations of the Nifty 50/Sensex are at the high end of the range, both on a one- year forward basis as well as relative valuation compared to MSCI Emerging Market Index. The benchmark Nifty is trading at a ~18x (one-year forward PE basis), which close to +2 STD above historical average valuations and MSCI India Index also trades at significant premium to MSCI EM Index.

One-year forward PE chart of Nifty MSCI India premium over MSCI EM (1-yr FWD PE)

Source: Bloomberg Source: Bloomberg

The NSE Midcap index is currently valued at 15x its underlying earnings on a one-year forward basis, a significant decline from a price-to-earnings multiple of 20x a year ago. The discount in valuation of mid-caps versus large-caps is close to multi-year highs. The domestic funds have increased their allocation in quality mid-cap companies. With a better risk-reward ratio post underperformance, it provides an opportunity for allocation of capital toward quality midcaps for relatively better returns in the next 12-24 months. Among mid-caps, we see that structural growth companies are available at a reasonable valuation with low risk and beaten-down cyclical stocks (given near-term headwinds) which are poised for re-rating could deliver substantially higher returns in the next 18-24 months. We also advise clients to avoid sliding mid-cap stocks where there are corporate governance challenges or other concerns. Apart from this, we continue to prefer private sector corporate lending banks and select stocks in the financials, energy, specialty chemicals, consumer and industrial segments.

AUM of mid-cap funds grows despite correction Midcaps valuation discount to large-caps at highs

1,40,000 50% 25% 45% 20% 1,20,000 40% 15% 1,00,000 35% 10% 5% 80,000 30% 0% 25% 60,000 -5% Rs. crore 20% -10% 40,000 15% -15% 10% 20,000 -20% 5% -25% 0 0% -30% 13 14 15 16 17 18 19 19 ------15 16 17 18 19 15 16 17 18 19 14 15 16 17 18 19 15 16 17 18 19 ------Mar Mar Mar Mar Mar Mar Mar Jun Jun Jun Jun Jun Sep Sep Sep Sep Sep Dec Dec Dec Dec Dec Dec Mar Mar Mar Mar Mar Till Nov Till AUM (crore) Y-o-Y (%) Midcap vs Largecaps PE Prem/(Disc) (%)

Source: AMFI Source: Bloomberg

December 13, 2019 7 Know more about our products and services

For Private Circulation only

Disclaimer: This document has been prepared by Sharekhan Ltd. (SHAREKHAN) and is intended for use only by the person or entity to which it is addressed to. This Document may contain confidential and/or privileged material and is not for any type of circulation and any review, retransmission, or any other use is strictly prohibited. This Document is subject to changes without prior notice. This document does not constitute an offer to sell or solicitation for the purchase or sale of any financial instrument or as an official confirmation of any transaction. Though disseminated to all customers who are due to receive the same, not all customers may receive this report at the same time. SHAREKHAN will not treat recipients as customers by virtue of their receiving this report. The information contained herein is obtained from publicly available data or other sources believed to be reliable and SHAREKHAN has not independently verified the accuracy and completeness of the said data and hence it should not be relied upon as such. While we would endeavour to update the information herein on reasonable basis, SHAREKHAN, its subsidiaries and associated companies, their directors and employees (“SHAREKHAN and affiliates”) are under no obligation to update or keep the information current. Also, there may be regulatory, compliance, or other reasons that may prevent SHAREKHAN and affiliates from doing so. This document is prepared for assistance only and is not intended to be and must not alone be taken as the basis for an investment decision. Recipients of this report should also be aware that past performance is not necessarily a guide to future performance and value of investments can go down as well. The user assumes the entire risk of any use made of this information. Each recipient of this document should make such investigations as it deems necessary to arrive at an independent evaluation of an investment in the securities of companies referred to in this document (including the merits and risks involved), and should consult its own advisors to determine the merits and risks of such an investment. The investment discussed or views expressed may not be suitable for all investors. We do not undertake to advise you as to any change of our views. Affiliates of Sharekhan may have issued other reports that are inconsistent with and reach different conclusions from the information presented in this report. This report is not directed or intended for distribution to, or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction, where such distribution, publication, availability or use would be contrary to law, regulation or which would subject SHAREKHAN and affiliates to any registration or licensing requirement within such jurisdiction. The securities described herein may or may not be eligible for sale in all jurisdictions or to certain category of investors. Persons in whose possession this document may come are required to inform themselves of and to observe such restriction. The analyst certifies that the analyst has not dealt or traded directly or indirectly in securities of the company and that all of the views expressed in this document accurately reflect his or her personal views about the subject company or companies and its or their securities and do not necessarily reflect those of SHAREKHAN. The analyst further certifies that neither he or its associates or his relatives has any direct or indirect financial interest nor have actual or beneficial ownership of 1% or more in the securities of the company at the end of the month immediately preceding the date of publication of the research report nor have any material conflict of interest nor has served as officer, director or employee or engaged in market making activity of the company. Further, the analyst has also not been a part of the team which has managed or co-managed the public offerings of the company and no part of the analyst’s compensation was, is or will be, directly or indirectly related to specific recommendations or views expressed in this document. Sharekhan Limited or its associates or analysts have not received any compensation for investment banking, merchant banking, brokerage services or any compensation or other benefits from the subject company or from third party in the past twelve months in connection with the research report. Either SHAREKHAN or its affiliates or its directors or employees / representatives / clients or their relatives may have position(s), make market, act as principal or engage in transactions of purchase or sell of securities, from time to time or may be materially interested in any of the securities or related securities referred to in this report and they may have used the information set forth herein before publication. SHAREKHAN may from time to time solicit from, or perform investment banking, or other services for, any company mentioned herein. Without limiting any of the foregoing, in no event shall SHAREKHAN, any of its affiliates or any third party involved in, or related to, computing or compiling the information have any liability for any damages of any kind.

Compliance Officer: Mr. Joby John Meledan; Tel: 022-61150000; email id: [email protected]; For any queries or grievances kindly email [email protected] or contact: [email protected]

Registered Office: Sharekhan Limited, 10th Floor, Beta Building, Lodha iThink Techno Campus, Off. JVLR, Opp. Kanjurmarg Railway Station, Kanjurmarg (East), Mumbai – 400042, Maharashtra. Tel: 022 - 61150000. Sharekhan Ltd.: SEBI Regn. Nos.: BSE / NSE / MSEI (CASH / F&O / CD) / MCX - Commodity: INZ000171337; DP: NSDL/CDSL-IN-DP-365-2018; PMS: INP000005786; Mutual Fund: ARN 20669; Research Analyst: INH000006183;

Disclaimer: Client should read the Risk Disclosure Document issued by SEBI & relevant exchanges and the T&C on www.sharekhan.com; Investment in securities market are subject to market risks, read all the related documents carefully before investing.