Will Indian companies be able to deliver the expected profit growth? That's the top of the mind question for investors after disappointments in June quarter numbers and the recent market turmoil. Earnings could be downgraded in some sectors, but the situation is certainly not as bad as 2008, says Mr Manishi Raychaudhuri, Head of Research, BNP Paribas Securities India . Mr Raychaudhuri also shares his views on the tightrope walk between cash-rich companies and the premium you pay for them. Excerpts:

A lot of parallels are now being drawn between the 2008 market correction and the present one. Would you say this time around it is more driven by domestic issues than global concerns?

If you look at what has happened over the last two-three weeks the decline in Indian markets was driven more by the global concerns than India-specific factors. The best way to judge this is to simply draw a chart of Indian stock price movements say MSCI India; and on the same scale plot MSCI China, MSCI Asia Ex-Japan, MSCI Korea and so on. You will find the movements are very similar. In fact, export-oriented markets such as Taiwan and Korea have fallen more, which indicates that the concern is more about global demand slowing down and export-dependent economies getting weaker. India, which is more of a domestic market, has outperformed. So the recent movements have by and large been driven by global factors.

Given the just-ended earnings season, is it clear that another set of earnings downgrades may have to happen. What levels for the Sensex are you looking at for this fiscal and the next?

Yes, I personally think from the current as well as the consensus estimates in Bloomberg, there is a potential for earnings estimates to come down. To give an example, for FY-12, on Sensex we currently have an EPS of Rs 1,232, based on our estimates. And I think consensus on Bloomberg is similar – at around Rs 1,225-1,230.

And we think the base case scenario should be at least 3-4 per cent lower than this. So that should be just shy of Rs 1,200. If the situation gets aggravated further, it could come down to Rs 1,150. We are talking of about 8 per cent downgrade from the current levels. Our own earnings estimates have come down by 4 per cent this year. We started the year at about Rs 1277 for FY-12 and it has already declined to about Rs 1,232.

Similarly, for FY-13, our EPS estimate at the beginning of the year was at Rs 1,497 and then down to about Rs 1480 and in the worst case it could be down to around Rs 1320-1,325. The base case is not that bad, but the worst case could be about 10-15 per cent lower.

What could constitute the worst case scenario and could it be a repeat of the 2008 downgrades?

First, I would like to point out that the worst case this time may not be as bad as the worst case the last time – in 2008. If you look at the entire duration of the bear market, right from January 2008 to March 2009, earnings estimates for FY-09 were revised by about 23 per cent and for FY-10 they were revised by about 31 per cent. But this time around it could be 8-10 per cent in FY12 and about 12-15 per cent in FY13 in the worst case.

There are two main reasons: one, the companies are not as leveraged as they used to be. Even in the traditionally leveraged sectors, the debt-to-equity ratio is possibly half of what it used to be.

Second, if you look at the driver variables, they are not really coming down from the high levels as they did in late 2007 or early 2008. For example, in 2006 and 2007, bank credit growth was 30-35 per cent. From there it came down to about 15 per cent in late 2008. This time, bank credit growth would possibly decline from 20 per cent to 14-15 per cent. The gradient is not that high.

Similarly for commodity prices; oil came down from $150 to about $45 a barrel. Steel was somewhere close to $1,200 a tonne. This time it was $700-800 at the peak. So none of these commodity prices is anywhere close to previous peaks; the only exception could be copper. So that is why I think that the decline in earnings estimate may not be as sharp as we had seen in the 2008-2009 period.

Now coming back to what could constitute the worst case, I would think further downside in commodity prices, which would in turn be triggered by further downside to consumer demand in developed markets.

How hard will the Sensex be hit by a commodity downturn, gives its high weights to sectors such as oil and gas and metals?

Commodity producers be it metals, oil or chemicals constitute around 30 per cent of the earnings and market-cap of the Sensex. If you take a thumb rule that commodity earnings come down by around 20 per cent, then that would theoretically lead to about a 6 per cent downside to market's earnings estimates.

Having said that, different commodities have different nuances, particularly in India, because of the regulatory environment that they operate in. Take the case of oil — it constitutes about 4-5 per cent, mostly through ONGC. If oil prices do come down, while globally all exploration and production companies would suffer in terms of their earnings estimates going down, ONGC would actually gain as their earnings estimates will be going up. So there is a paradox.

Overall, the downward revision would depend on how much the commodity prices come down, but it may not be as severe as some of the other commodity intensive markets.

Locally has the slowdown in the investment cycle percolated to the consumer segment, given that consumer stocks continue to do well? If a slowdown is visible, how does one play the theme?

It depends on which side of consumer you look at. When you say consumer stocks have done relatively well, you mean the consumer staples. Yes, as the demand profile on that side tends to be relatively more defensive, those stocks have outperformed in a market decline. And investors would expect that, since many of these companies are cash proxies and not correlated to rate cycles even while consumer discretionaries may suffer.

Having said this, many of these consumer staples as a consequence of this significant out performance have now become quite expensive.

If you look at the other side of the consumer - the discretionaries – predominantly autos – there are signs of slowdown visible in certain sub-segments such as passenger cars. Two-wheelers continue to be robust as the linkage between demand and interest rate is not as pronounced as it is for commercial vehicles and passenger cars.So the way to play these consumer stocks is to find a combination of the relatively defensive revenue streams and relatively benign valuations.

Another angle that one should look at is to identify the commodity beneficiaries as most of these consumer stocks are users of commodities. So for two-wheelers, the critical inputs are aluminium and steel. For many of the consumer staples companies, it could be soft commodities such as palm oil and for companies like Asian Paints, it could be raw materials linked to the petrochemical chain.

So when input costs decline, they tend to gain in terms of the growth margins. But in some cases, the pressure on the demand and top line could be so high that it negates the benefit of improved margins. So the trick is to identify the relatively stable demand and stable revenue streams and combine that with the commodity decline advantage.

If one were to look for value buys, is it wise to look at sectors such as capital goods and infrastructure?

In capital goods or infrastructure one has to be highly selective. True, they have underperformed hugely and many of these beaten down stocks offer good value. But at the same time, many of them suffer from significant earnings risk also. So what appears as good value right now may suddenly become expensive because of potential earnings downgrade.

If you look at this whole universe of capital goods, engineering infrastructure and so on, you could divide them into two halves. Under the first half, you will have companies that are well-managed, well-governed and which have been de-rated purely because of the external environment – from the fact that the capex cycle have decelerated significantly.

And the second half would be those companies where the market has significant concerns about the way the company is being run, or about corporate disclosures or cases where promoters pledged shares significantly. The best way to play today is to focus on the first half of companies, where if the external environment improves, you will have maximum returns.

What are the sectors that can see a possible earnings downgrade from here?

I would think possibly banks - where our estimates and consensus seem too high. Particularly, the public sector banks that suffer from concerns about non-performing loans. I would also think some of the commodity companies such as metals may be downgraded.

The list includes even some of the consumer companies that find it difficult to pass on the price increases. Of course in those cases, the commodity price decline could help them. It would be a combination of global cyclicals and domestic cyclicals like banks.

FII flows appear erratic. How do you see the trend panning out?

It's going to be almost impossible to predict how FII flows will be till the end of this year. We would think in the long term, India would possibly command 25-30 per cent of the entire flows that comes into Asia Ex-Japan; which was the trend for the last ten years except 2010 which was an exceptional case of India receiving almost 50 per cent of the FII flows.

The good part about FII flows in to India potentially, is that most FIIs are now underweight on India. So the net takeaway is that India is not really over-owned in the scheme of things. And therefore if FIIs want to concentrate on growth at some point of time, they will have to come back to India.

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