India_Equity_Strategy_2016

Paul M. Kitney, PhDBALLINGAL INVESTMENT [email protected]+852 2733 1000 (Main)+852 2733 1031 (Direct)+852 6975 8444 (Mobile)

The Animal Spirits Report - Asia Pacific Investment StrategyOctober 10, 2016

ANIMAL SPIRITS™ REPORT: India Equity Strategy -Upgrade to Overweight as Patel’s Dovish Arm TwistsInvestment Conclusions – Tactical View (3-6 Months)1. Animal Spirits prefers an "overweight" stance on Indian equities.2. Our macro baseline scenario is positive on emerging markets (EM) in Q4, 2016. We see improvement in commodities demand-supply balances, a normalization of inflation expectations and a Fed that is prepared to run the US economy "hot" for longer to allow the former to develop. All of these are positive for EM.3. iShares MSCI India ETF (INDA US) is an ETF play on the MSCI India index.4. In sectors, we are "overweight" financials, consumer discretionary and energy. We "underweight" utilities, consumer staples.5. Our focus list of themes include a) the consumer; b) energy; and c) crop yield enhancement.6. Animal Spirits top picks are: Tata Motors Ltd (TTMT IN), Housing Development Finance (HDFC IN) , Reliance Industries Ltd (RIL IN) , Oil & Natural Gas Corp Ltd (ONGC IN) and UPL Ltd (UPLL IN).Summary of Our Investment Thesis - "Overweight" India• Valuation (negative) - Indian equities are richer than the EM peer group but earnings growth is superior and current multiples are not stretched relative to historic norms• Earnings (positive) - The momentum of earnings growth is strong and approaching peak cycle rates. Earnings revisions in India are leading the EM peer group.• Economic Policy (positive) - Monetary policy is more accommodative than we expected as the Monetary Policy Committee (MPC) appears to be running the RBI with a view to a more liberal inflation target.• Macro (neutral) - Consumption continues to perform well as the "demographic dividend" playbook would suggest but near-term there is likely to be front-loading ahead of the Q1 2017 GST implementation. Investment spending still is soft but we see fiscal policy flexibility freeing up once the GST is in place and showing some results. This should pave the way for a new infrastructure-led investment cycle.INDIA EQUITY STRATEGY OUTLINE1. Valuation Analysis2. Earnings Profile3. Economic Policy4. Macroeconomic Drivers5. Summary of Investment Thesis6. Investment Conclusions

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ANIMAL SPIRITS • BALLINGAL INVESTMENT ADVISORS1

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1. VALUATION – Richer than the EM peer group but earnings growth is superior and current multiples are not stretched relative to historic normsIt is difficult to make a convincing case that Indian equities offer great value. We pair India against China, Asia ex-Japan and Global Emerging Market (EM) MSCI indices in Table 1 and it is clear on most measures there is a premium in India. The most stark is price-to-book, where at just under 3 times, India is trading at almost twice the China or EM multiple, while its ROE is only marginally higher than its closest regional “comp”, China. In fact, the EBIT margin in China is higher than India, while trading on lower multiples, based on several measures.There is, however, some rationale for the “India Premium” and that is earnings growth. India’s growth profile is not influenced by the global economic cycle to any great degree. Earnings are driven ostensibly by domestic factors and the impressive double digit earnings growth outlook for both 2016 and 2017 outshines the double digit decline in the current fiscal year, expected in China. Corporate balance sheets are also unlevered with only 67 percent net debt to equity, in comparison with the peer group (Table 1). Therefore, by taking on some leverage there is upside to ROE in Indian corporates, which theoretically supports a higher valuation. While there is some appearance of a valuation premium currently versus EM peers, higher growth notwithstanding, Indian equity valuations are not particularly high relative to their own history. Figure 1 shows that presently both price-to-book and EV/EBITDA multiples in India are at their 15 year averages or slightly below. Nevertheless, on balance, we assign a slightly less than pass grade on valuation for India in our country evaluation matrix (Table 2).Table 1 - India Valuations and Financials with Large Emerging Market Comps

Source: MSCI, Bloomberg, Ballingal Research. Note: Data as of 10/5/2016. Note: We included MSCI Asia ex-Japan as a regional benchmark, despite being a blend of EM and DM. Earnings estimates are based onBloomberg consensus

ANIMAL SPIRITS • BALLINGAL INVESTMENT ADVISORS

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Figure 1 - India Historic Price-to-Book (PBR) and EV/EBITDA Ratios

Source: MSCI, Bloomberg, Ballingal Research. 2. EARNINGS PROFILE – The momentum of growth is strong and approaching peak cycle growth rates. Earnings revisions are leading the EM peer group.We have made mention the above average performance of earnings growth in India, relative to EM peers. In Figure 2, it is clear that earnings momentum is positive and is approaching growth levels seen at the peak of previous profit cycles. Figure 2 – India Earnings Growth History and Forecast (Net Profit)

Source: MSCI, Bloomberg, Ballingal Research. Note: Data as of 10/5/2016, Bloomberg Consensus Estimates


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There are two observations from Figure 3 as the discussion now moves on to earnings revisions. The first is that India has led its EM peers in both the current earnings cycle and the earnings revision cycle. The second is that India has avoided the downside in earnings revisions that both China and EM have faced during the revision cycle. This is a slightly different to a discussion of the volatility of earnings per se. Rather it points to some downside resilience in the recent pattern of Indian earnings. In our opinion this is largely due to lower relative dependence of the earnings structure in India to global sectors. Both the Indian growth model and the earnings profile is driven by domestic demand. As argued earlier, this partly explains the “India Premium” since it helps describe a “better quality of earnings”. Consequently, India scores well in our country evaluation scorecard (Table 2). Figure 3 – India Earnings Revisions versus Regional and Global EM Peers

Source : MSCI, Bloomberg, Ballingal Research, Data as of 9/23/2016. Note: Earnings revisions are based on a 3 period moving average of monthly changes in FY 2016 net profit estimates

3. ECONOMIC POLICY – Patel has his dovish arm twisted by the MPCThe first policy move by the new Reserve Bank of India governor, Urjit Patel to lower the policy rate by 25 basis points, confounded the consensus view that he was an inflation hawk. We carefully examine the press release for the "Fourth Bi-monthly Monetary Statement, 2016-17 Resolution of the Monetary Policy Committee (MPC), Reserve Bank of India (October 4, 2016)" and draw our own conclusions.


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Prior to this MPC release, Animal Spirits had held back our enthusiasm about Indian equities based on the expectation that the hawkish rhetoric of incoming governor Patel would imply a more strict interpretation of inflation targeting by the RBI. However, the language below indicates something different.• Unlike the previous "Rajan Show", monetary policy is being driven by the MPC and not by the governor alone, at least during the early stages of Patel's tenure.• A more liberal approach to inflation targets is being set with the 2-6 percent "medium term" range. This is somewhat different from earlier indications that the mid-point of this range, namely 4 percent was the 2018 target. The statement below clearly displays this intent.• An accommodative monetary policy provides more leeway for fiscal restraint or reform (including the introduction of the goods and services tax (GST)).

The MPC has given itself leeway to remain accommodative based on:(a) A perception of a weaker external economic environment with specific risks associated with Brexit, Chinese debt, protectionist policies and the diminished credibility of global monetary policy.

(b) The RBI viewpoint that oil prices will not be a source of inflationary pressure near term (Animal Spirits disagrees).


“Global growth has been slowing more than anticipated though 2016, with weak investment and trade damping aggregate demand. Meanwhile, risks in the form of Brexit, banking stress in Europe, rebalancing of debt-fuelled growth in China, rising protectionism and diminishing confidence in monetary policy have slanted the outlook to the downside (page 1).”

“Crude prices rose to a recent peak in Q2 of 2016, mostly on supply disruption in various parts of the world…OPEC announced intentions of cutting back on supply; but, the upturn has been curbed by higher inventories (page 1).”

“The decision of the MPC is consistent with an accommodative stance...with the objective of achieving consumer price inflation (CPI) inflation at 5 percent by Q4 of 2016-17 and the medium-term target of 4 percent within a band of +/- 2 percent, while supporting growth (page 1).”

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(c) Signs are positive that the post-monsoon harvest will alleviate food inflation concerns.

(d) Softer industrial production (manufacturing) also helps justify monetary policy easing.

(e) Strong emphasis that food price inflation is a key policy swing variable.

Animal Spirits view on India monetary policy - Tactically positive but strategically risky• For our tactical 3-6 month view, the monetary policy outlook is easier than expected and pushes our rating on policy in India to positive.• However, there are risks of an abrupt tightening in 2017 H2 as we see upside to global inflation expectations over the coming quarters, which should adaptively shift up realized inflation, driven by the oil price base effect and signs that excess supply is rebalancing in liquid fuels. See“ANIMAL SPIRITS REPORT 1: Macro Backdrop - Base Jumping the Fed with Oil and Inflation Expectations” and ”ANIMAL SPIRITS Update: OPEC Fuels Base Effect - Oil, Inflation & The Fed, Yields, Financials and EM”.


“On the domestic front, the outlook for agricultural activity has brightened considerably…Kharif sowing has surpassed last year’s agreage…estimates of kharif food grains production for 2016-17 by the Ministry of Agriculture have been placed at a record level…(page 2).”

“The industrial sector…suffered a manufacturing-driven contraction in early fiscal year Q2, after a sequential deceleration in gross value added…(page 2). “

“The committee expects the strong improvement in sowing, along with supply management measures, will improve the food inflation outlook…a downward shift in the momentum of food inflation…holds the key to future inflation outcomes…This has opened up the space for policy action (page 3).”

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4. MACROECONOMIC DRIVERS - GST Introduction in April 2017 should help smooth the pattern of Indian growth but near term "front-loading" provides upside risks to consumption, inflation, and equity prices as the RBI will run "hot" until the GST "teething" is completeThe demographic dividend in India is a secular driver of consumption and the single biggest boost to the domestic demand-driven growth profile. The near term pattern of consumption and consumer sentiment is tracking the longer-term theme as seen in Figure 4. Animal Spirits applaud the direction of taxation reform towards a broad based GST in India, which is scheduled to be implemented in April 2017. The benefits include the simplification of the taxation system, greater compliance and should stimulate foreign direct investment. Importantly, it should provide a broader taxation base to help fund other segments of the economy, when required. In particular, despite recent injections of government spending to help stimulate private sector investment, gross fixed capital formation (Figure 4) still remains in the doldrums.Longer term, we envisage a greater use of public money spent on infrastructure projects that will require private sector collaboration and should see the divergence in the figure below reverse somewhat. Near-term Animal spirits expects that there will likely be some "front-loading" of consumption ahead of the implementation of the GST, so expects this divergence to continue over coming months. Moreover, we believe that the "surprise" rate cut is being used to keep monetary policy accommodative during the teething stages of GST implementation to avoid macroeconomic disruption. Consequently, we see upside risk for consumption, inflation (also due to oil-led inflation expectations argument) and equities near term.Figure 4 - Divergence of Indian Consumption and Investment Patterns

Source: Mastercard Advisors, Bloomberg, Indian Central Statistical Association, Ballingal Investment Advisors. Notes: Quarterly data, constant 2011-12 prices for gross fixed capital investment data. Note: Mastercard Asia Pacific Consumer Confidence Index used for sentiment indicator.


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5. SUMMARY OF INVESTMENT THESIS - "Overweight" India• Valuation (negative) - Indian equities are richer than the EM peer group but earnings growth is superior and current multiples are not stretched relative to historic norms• Earnings (positive) - The momentum of earnings growth is strong and approaching peak cycle rates. Earnings revisions in India are leading the EM peer group.• Economic Policy (positive) - Monetary policy is more accommodative than we expected as the MPC appears to be running the RBI with a view to a more liberal inflation target.• Macro (neutral) - Consumption continues to perform well as the "demographic dividend" playbook would suggest but near-term there is likely to be front-loading ahead of the Q1 2017 GST implementation. Investment spending still is soft but we see fiscal policy flexibility freeing up once the GST is in place and showing some results. This should pave the way for a new infrastructure-led investment cycle.6. INVESTMENT CONCLUSIONSMacro, Index, and Sector Views• Animal Spirits prefers an "overweight" stance on Indian equities.• Our macro baseline scenario is positive on emerging markets (EM) in Q4, 2016. We see improvement in commodities demand-supply balances, a normalization of inflation expectations and a Fed that is prepared to run the US economy "hot" for longer to allow the former to develop.• iShares MSCI India ETF (INDA US) is an ETF play on the MSCI India index, which is our preferred benchmark for India.• In sectors, we are "overweight" financials, consumer discretionary and energy. We "underweight" utilities, consumer staples.• Our focus list of themes include a) the consumer; b) energy; and c) crop yield enhancement.• Animal Spirits top picks are: Tata Motors Ltd (TTMT IN) , Housing Development Finance (HDFC IN), Reliance Industries Ltd (RIL IN), Oil & Natural Gas Corp Ltd (ONGC IN) and UPL Ltd (UPLL IN)


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Themes and Top Picks• The Consumer - Tata Motors Ltd (TTMT IN) and Housing Development Finance (HDFC IN) - As discussed in Section 4, the long-term outlook for consumption in India is driven in large part by demographic factors and is well known. Near term, the pattern of strong consumer sentiment is likely to persist (Figure 4) due to the combination of both easy monetary policy and front-loading of consumption ahead of the forthcoming GST introduction in April 2017.

Tata Motors Ltd (TTMT IN) is selected here as a key consumer discretionary thematic play. It is trading at 12.07 times earnings and 4.85 times EV/EBITDA (FY 17, Bloomberg Estimates). The secular growth of the Indian auto market, together with rapid sales of luxury brands (Jaguar-Land Rover (JLR)) in emerging economies, including China, is attractive in our opinion. JLR will benefit from currency translation effects of the weaker pound associated with Brexit (Tata Motors, Analyst Presentation, August 26, 2016, page 15). According to this report, JLR sells 80 percent outside the UK (Europe 24 percent, China 19 percent, US 19 percent), while 40 percent of components are sourced from the EU with the balance largely accounted for by the UK. Housing Development Finance (HDFC IN) - Housing affordability (median property prices divided by annual income) using large Indian metro city data is 4.1 times in 2016, down from 5.9 times in 2000, according to HDFC (June 2016, Analyst Presentation). With 66 percent of the population under 35 and mortgage penetration a single-digit percentage of GDP, there is secular growth in the housing market as the "demographic dividend" plays out. Near term, NIMs are set to rise as the RBI has recently cut the policy rate and Animal Spirits foresees a global uplift in bond yields over the period of November 2016 to May 2017, driven by base effects in the oil market and its link with the formation of inflation expectations. See ”ANIMAL SPIRITS Update: OPEC Fuels Base Effect - Oil, Inflation & The Fed, Yields, Financials and EM”. This is a large cap play on Indian housing and our preferred consumer related financial idea in India.


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Themes and Top Picks• Energy - Reliance Industries Ltd (RIL IN) and Oil & Natural Gas Corp Ltd (ONGC IN) - Given our scenario of improved pricing power in the liquid energy space over the coming months, Animal Spirits expects to see an uplift to margins in both upstream and downstream energy companies, including petrochemicals over this period.

Reliance Industries Ltd (RIL IN) is our top pick in India in the downstream energy space and is trading at 12.83 times earnings and 1.29 times book (FY17, Bloomberg consensus estimates). Oil & Natural Gas Corp Ltd (ONGC IN) is our preferred upstream energy pick in India and is priced at 12.92 times earnings and 1.18 times book (FY17, Bloomberg consensus estimates).

Crop Yield Enhancement - UPL Ltd (UPLL IN) - A secular theme is a global need to improve farm productivity, due to both expanding populations and rising incomes in emerging economies. UPL is an Indian play on this theme as they manufacture, distribute and export off-patent agrochemicals as well as manufacturing herbicides, fungicides, and fumigants. Based on the Q1 FY17 data from the UPL investor presentation, 29th July 2016, 30 percent of sales are derived from India, with the balance exported to Latin America (20 percent), Europe (16 percent), North America (18 percent) and Rest of the World (16 percent). The shares currently trade at 17.94 times earnings (FY17, Bloomberg Estimates).


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Table 2 - Animal Spirits APAC Equity Tactical Views (3-6 Months)

Source: Ballingal Research, MSCI, Bloomberg. Note: Benchmark used is MSCI AC Asia Pacific Index. Note on symbols in table: single green (positiveview) , double green (very positive view), red (negative view), double red (very negative view), blue (neutral)


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