The Hindu Business Line : Reworking the large-cap portfolio

With the growing fancy for large-caps, and investors wondering how to play the theme, it seemed worth checking out the large-cap recommendations made six months ago.

Are large-cap stocks a safe haven for investors in the backdrop of the sharp run-up in the broad indices? In just six months since we last recommended our large-cap picks (`How to bull one over the bear', June 18), the market has rallied over 40 per cent to touch a new all-time high of 13,800 points.

While it has been widely reported that the latest market rally has been narrow, confined to large-cap stocks, the investing themes and constituents have not been looked at in depth. To drill down to the details, we compared the incremental market capitalisation of 2,300 actively traded stocks between June 14 (when the Sensex plummeted to the low of 8,929 points) and December 1. There were three key findings:

First, the top 50 companies accounted for 67 per cent of the incremental market cap of Rs 12.6 lakh crore (of the overall market cap of Rs 34.8 lakh crore) added during the period. And the top 200 companies contributed to 90 per cent of the incremental market cap, clearly establishing the narrow breadth of this market rally.

Second, of the top 50 companies, the top 10 and the next 10 accounted for 37 per cent and 14 per cent of the incremental market cap respectively, adding up to 51 per cent (of 68 per cent).

Finally, looking at the top 10 companies in terms of market cap, it is apparent that software services (Infosys, Tata Consultancy Services and Wipro), telecom service providers (Bharti Airtel and Reliance Communications) and banking (ICICI Bank) have largely fuelled this market surge.

Interestingly, software and banking were under-performers in the rally until May 10, when the market touched the then all-time closing high of 12,613 points.

Large-caps: A reality check

How to play the large-cap theme, especially after this sharp run-up, must be at the top of investors' minds. Obviously, the robust FII and MF flows, the recent steady increase in trading volumes at the BSE and the NSE and build-up in leveraged positions in the F&O segment have played a significant role in the ramp-up so far. And the India story, fuelled by ambitious growth plans and outbound acquisitions by large-caps continues to gain momentum and appeal with each passing day.

With the growing market fancy for large-caps, however, has also grown the attendant risk of overvaluation. We have held the view that growth at a reasonable price is always good for investors, irrespective of market-cap categorisation. In this backdrop, we decided to review our portfolio of 12 recommendations made on June 18.

Our preferred portfolio then was: Gujarat Ambuja, ITC, BHEL, L&T, ONGC, Infosys, Tata Steel, GlaxoSmithKline Pharma, Maruti Udyog, Grasim, ICICI Bank and Godrej Consumer.

Between June 18 and now, this portfolio has performed in line with Sensex.

Six months may appear a short time to revisit a portfolio, but considering that the valuation of some of these large-caps appears stretched, it is probably an appropriate time to do a reality check. We re-examined the portfolio to see whether it needs to be rejigged/replaced with a new set of stocks reflecting a different sectoral bias than the earlier one.

For the analysis, the top 100 stocks up to a market cap of Rs 5,000 crore were considered. To select stocks for the rejigged portfolio, a whole host of financial variables were considered, including price earnings multiple and price-to-book, apart from fundamentals such as order-book, capex plans and overall industry environment. That apart, growth rates required over the next five years to justify the current market capitalisation were also computed using post-tax earnings and cash flows as a benchmark (see Methodology in Investment World edition dated June 18).

Using the four standard themes of regulatory/policy, defensive, interest-rate-sensitive and global/domestic cyclicals, the rejigged portfolio will now look like this:

Regulatory/Policy Thrust

From the oil exploration and refining basket, the five stocks hogging investor attention are ONGC, Indian Oil, Hindustan Petroleum, Bharat Petroleum and GAIL. Our key pick from this space was ONGC, which under-performed the broad market between June 18 and now. Though the stock appears fairly valued on price-earnings and cash-flow-growth basis, in the light of its indifferent record in finding new oil reserves, high burden of subsidies in a firm global oil price regime and the proposed listing of Cairn Energy, we are removing ONGC from our preferred portfolio. In the light of the recent retail price cuts and hardening global crude prices, we are not comfortable recommending any of the other oil refining/marketing companies either. In the capital goods/infrastructure space, among the half a dozen stocks including BHEL, L&T, Unitech, Bharat Electronics and Bharat Forge considered, L&T remains our prime pick, though it is somewhat stretched in valuations as it needs to clock growth rates of over 29 per cent in cash-flows over the next five years to justify its current market cap. In our view, however, apart from strong fundamentals, the unlocking of value in subsidiaries (similar to M&M) through listing will also be a key trigger in the coming years.

In the power and utilities sector, among Siemens, ABB, NTPC, GMR and Tata Power, NTPC is our key pick (that will replace ONGC), with its strong capex plans including ultra mega power projects, apart from the long-term power capacity boost from the recent Indo-US nuclear deal. ABB also figures as a good long-term choice.

Defensive pack

In software services, the sharp run-up in prices has left investors gasping for breath. We remain bullish on the offshoring momentum and growth trajectory of Infosys, our prime pick since June 18. But a 60 per cent rise in price since then has forced us to switch our choice from Infosys to Wipro in the preferred portfolio. The second half of 2006-07 is likely to help Wipro outpace some of its frontline peers in earnings and market performance.

In the pharma pack, we plan to replace GlaxoSmithKline Pharma (See Stock Insight) with Sun Pharma. Among the six pharma stocks under consideration, Sun Pharma appears to be a good pick for the present.

And in the FMCG space, Godrej Consumer, one of the underperformers in the preferred portfolio is being dropped from the new portfolio, as are other stocks from the large-cap space. ITC, another underperformer (which may not strictly fall in this category) has been retained as it is remains a good story for the long term for a patient investor.

Interest-rate sensitive

In the banking arena, ICICI Bank continues to our preferred choice, even though the stock has spiralled over 90 per cent since June 18. We are also quite sanguine about the prospects of State Bank of India, among public sector banks, using book value as a criterion for picking stocks.

Among the key auto stocks, such as Tata Motors, Ashok Leyland, Bajaj Auto, Maruti Udyog, Hero Honda, and Mahindra and Mahindra, our preferred choice remains Maruti Udyog. Though this stock has been an under-performer relative to the broad market, its structurally sound story will improve its valuations, going forward.

Global and domestic cyclicals

Though Tata Steel was the preferred pick last time around, we are removing it from our portfolio in the light of the bidding war that has started for European steel giant, Corus along with Brazil's CSN. Among other metal stocks, Hindalco appears undervalued at current price levels, but the turbulent metal prices are forcing us to avoid recommending this stock.

Among cement stocks, while we remain bullish on the prospects of Gujarat Ambuja Cements, we feel that a switch to ACC is preferable as it is relatively better placed to deliver higher returns in the medium term.

Preferred portfolio

From 12 stocks, we have cut the portfolio to eight picks. They are:

Picks retained: ICICI Bank, L & T, Maruti Udyog and ITC

New Picks: Wipro, ACC, Sun Pharma and NTPC

More Stories on : Insight | Stocks | Stock Markets

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page