2015 Outlook - In a World Driven By Central Banks

Looking through the Dust Storm

Merry Christmas! Santa has come ringing bells for oil importing countries much before X-Mas with gift of almost 50% fall in crude oil prices.  However, the pace of fall in crude prices should ring alarm bells for 'stability' in the short term.  And yes, it did so for Bank of Russia! On 16th December - just four days after the scheduled policy meeting when Bank of Russia raised the policy rates by 100bps - the central bankers hurried for an early morning (1a.m.) emergency meeting and further raised the policy rate by a whopping 650bps to 17.25%. The event reminds us of Black Swan which, once rare, have started frequenting more often now-a-days. Alas! Whether it's a Black Swan, we will come to know only post-facto. One thing for sure, after much of a calm for the whole of 2014, the world has suddenly been covered under cloud of uncertainty and volatility. In this note we have attempted to see through this dust storm and find that, there is no immediate cliff but a short road ahead (my guess is the world will borrow 12-18 months) and that's it is!

Oil at $60! What does it mean to the World and India?

The decline in crude prices is a major boon for oil importing countries on many fronts - lower cost of living, improved consumer sentiments, easing inflation, lower cost of capital, stronger currency and last but not the least, lower current and fiscal deficit for these countries. Clearly, India is one of the biggest beneficiaries of the falling commodity prices. On the other hand, lower oil prices pose major challenges for oil exporting countries from Middle East, Russia and Venezuela the exact opposite would hold true - depreciating currencies, dwindling budget deficit, soaring inflation and higher cost of living. Collectively, these oil exporters account for less than 9% of world GDP (excluding Canada and Mexico as energy sector contribution is not significant to their GDP) and hence mathematically should not derail the world growth story. The cascading effect, however, could lead to some nasty outcomes.  The construction boom in Middle East and global Oil & Gas Capex would be the direct casualties while banks with heavy exposure to these sectors/regions could be the indirect casualties (SocGen's exposure to CIS stands at a staggering Eur24bn or ~60% of its equity). We believe that global economy and financial system is much stronger today and will successful tide over these challenges. The bigger problem is brewing elsewhere.

Welcome to the World of Deflation

	CPI Inflation	Core Inflation*		CPI Inflation	Core Inflation*
US	0.3%	0.1%	Europe	0.3%	0.7%
UK	1.0%	1.2%	- Germany	0.6%	1.1%
Japan	2.1%	2.2%	- France	0.3%	- 0.2%
Canada	2.4%	2.2%	- Italy	0.2%	0.5%
China	1.4%	1.3%	- Spain	- 0.4%	-0.3%
Australia**	2.3%	2.1%	- Sweden	- 0.3%	0.6%

*Core Inflation excludes Food and Energy **as of Sep’14

If we have to simplify the things, with Crude Oil & CRB index as guideposts, there is clearly enough evidence that the animal called inflation seems to be dead, at least for a foreseeable future. Whether the crude will settle at $55, $60 or $70, is anybody's guess. One thing is reasonably sure that it won’t be back to $100 any time soon. CRB index (global commodities’ indicator) is closer to 2008 lows in a world which has moved ahead 6 years. US 10-yr Treasury yields have declined by 30%+ in a year when Fed had wound up QE and experts are discussing timing of first rate hike. The current inflation in most of the countries which would drive global monetary policies is in the range of 1-2% (see Table above) and unless there is dramatic price rise across the asset classes, inflation will continue to slow down gradually to negative zone. And that’s a problem.

Why does Inflation matter?

Price Stability is one of the most important mandates for policy makers world over. Bank of England defines price stability as Government’s inflation target of 2%. European Central Bank states that the primary objective of ECB’s monetary policy is to maintain price stability and target inflation rates of below, but close to 2%. US Fed as well as BoJ also maintain same 2% inflation target. This struggle and desire to maintain a LOW and STABLE inflation environment is for the fact that manageable low inflation is critical for the steady growth of global economy. Inflations at manageable level is also critical for equity investors as it is a key source of corporate pricing power. The economy, as measured by GDP, is mainly composed of wages, indirect taxes and corporate earnings*. In general, wages are linked to inflation benchmarks while corporate earnings are driven by consumption demand.  Falling prices lead to both, lower wages and lower corporate profits and can push economy in a depressive spiral. A question one should ask is, if inflation is manifestation of growth (demand > supply) then isn’t a falling inflation concealing a slowing world ahead? It is! Inflation matters because lack of it can derail the global growth story. Worst, there are not many bankers out there or for that matter Corporates, who have much of prior experience or a clue as to how to respond to a deflationary environment. Deflationary impact on investment and debt are even crippling.

 (*Resource Cost Income Approach Equation:  GDP= wages + rents + corporate profits + interest + Indirect taxes + Depre + Net Income of Foreigners. As a thumb rule wages and corporate profits account for 80-85% of GDP)

In a low inflation and faltering growth will continue to keep interest rate low and fuel market rally

Managing (strong and stable) growth, inflation and currency are the key tasks of a Central Bank. Unfortunately, these are interlinked in such a way that not all of three can be achieved at the same time. Depending upon which one of these three is at a greater risk, goal post for a Central Banker keeps changing.  Given the complexity of equation, most of the market participants fail to keep up with the changing dynamics and therefore fail to see consistency in actions of policy makers. RBI Governor, back home, has refused to drop the interest rates despite inflation falling in the comfort zone. Apart from the fact that he wants more time to conform the fall in inflation is more permanent than temporary, I fear, the Governor, is worried about Fed action on interest rate,  in near term – any hint of or actual rate hike by Fed will send US Dollar in a sharp upward spiral and emerging market currencies could be the biggest casualties. Basically, his goal post could then shift from reigning Inflation to defending Rupee and if things go bad on that front, he won’t cut the rates.

Let’s look at the world of Central Bankers on these three parameters.

Country	GDP Growth	Inflation	Fx	Goalpost	Policy Action
US	Strong - Ahead of expectation, not a cause of worry for Fed	Dangerously poised to derail recovery in economy	Strengthening – not a cause of concern on its own but for inflation	Inflation – up it to targeted 2%	Continue with current low interest rates and don’t let USD appreciate much
European Union	Faltering – if not addressed urgently could lead economy back to recession	Way below target	Depreciating aga USD	Growth – Steer economy away from danger of deflation	Keep interest rates low Plus add stimulus
Japan	GDP decline in Q3 has put economy back in recession	Successfully  upped to 2%+	Depreciating sharply – architected by policy initiatives	Currency – Continue JPY devaluation to up growth & inflation	Continue with Abenomics – increased bond purchases and stimulus
China	Growth below target @ 7% and softening further	Not a problem	Appreciating against competing nations	Growth – Add stimulus and defend Fx competitiveness	Lower the interest rates to support growth and RMB

US is the only country which has stood out over the past 1 year in terms of any signs of sustainable improvement – GDP has bounced back to 3% plus and unemployment down to . However, in an increasingly interwoven world US rates will continue to be guided by competing interest rates, Europe in particular. The table above aptly bring out that lower interest rates would continue in the world and so the support to equity markets, in terms of both – higher valuations due to lower discounting factor (lower capital cost) and higher fund flows due to relative attractiveness compared to other asset classes.

Risks for the world economy going into 2015 will be lower than expected growth rate. If the same gets translated into lower earnings then it could be a dangerous as the onus could shift entirely on lower discounting rate and further stimulus by Central banks to support the market rally. It not only difficult but actually hazardous to peak into the future but still we would do it as a roadmap is necessary to guide through to the destination. If there be storms on the way better be prepared just to improve the chances for survival. That said, to conclude, expect growth to be lower, markets to get support for a while from lower rates/stimulus but then eventually fade away by late 2015 or early 2016. Hopefully India will survive this dust storm and will eventually realize its potential.

Back home, Indian economy still in a cyclical recovery phase & Modi holds the Key

Back home, Indian economy is still not out of woods and consumption continues to be weak. On the other hand, Investments from private sector won’t pick up till current capacity underutilization normalizes and infrastructure sector policy reforms are well addressed by the Government. So ball is now clearly in Prime Minister, Mr. Modi’s court. The good part, India is perhaps the biggest winner in the current oil turmoil. With inflation under control, the government along with RBI can now turn full attention to growth and reforms. Given the lack of majority in Rajya Sabha, timing of these reforms could be tricky and there could be delays but the direction of the change is clear. One aspect however seems to have gone unnoticed. Last week, we visited one of the nearby Government offices and were stunned to see the stark difference around the office premises – the usually dusty premises were neat and clean, dumped old furniture and old files had vanished; there was a certain sense of pride, purpose and professionalism in the air boosting the productivity. We believe, the behavioral change which Modi is driving is far difficult to achieve and has a far reaching consequences, the most important being improvement in productivity and reduction in wastage of valuable resources.

Near-term India equity market could be choppy

The recent equity correction is welcome as it keeps market out of valuation risk-zones and offers better buying opportunities for us. Still, at the current levels of 27400, BSE Sensex trades at 15.9x FY16, which is not cheap. Our recent interaction with management of portfolio companies and in general at investor conference leads us to believe that Consumption continued to slowdown post festival period and has impacted demand negatively across the category – credit growth to industry has slowed down to 7.8% in October 2014 compared to 15.9% last year; credit to services has slowed down to 8.9% compared to 21.7% last year. Though companies will benefit from falling inflation, we believe, there is a risk of negative surprise to Q3 earnings expectations.  

Longer term India now clearly differentiated and on the verge of a secular bull market

On 1^st October 2003, Dominic Wilson and Roopa Purushothaman at Goldman Sachs published their Global Economics paper, ‘Dreaming with BRICS: Path to 2050’. The report moved the global investment flows towards the potential of these four economies but with little differentiation amongst each of them. However over a period these markets have started getting differentiated as global investors’ learning curve and confidence matured over the last one and half decade. The same has been reflected in a more emphatic pricing of these markets.  During 2014, there is stark dispersion in performance* of BRIC markets - India is up 20%+ while Russia is down 48%; China is flat while Brazil is down 18%.  The wide dispersion suggests a clear segregation of individual markets and we believe this trend will continue to build upon.

Indian equity market undoubtedly has far richer mix of better managed and profitable companies – IT, Financials, Consumer Staples, Pharma and Auto companies with ROEs of (15%-30%) account for 2/3^rd of the market. The current weight of India in Emerging Markets Benchmarks is 6.5% compared to 20.4% for China and 14.5% for South Korea. Like the domestic equity participation (a meager 3-4% of savings), global investor allocation to India both direct as well as indirect through higher weight for India in benchmarks is also set to rise secularly. To sum up, with a strong leadership and political stability at the center, accelerated consumption from booming middle class and government effectively plugging in the missing pieces of puzzle – manufacturing and infrastructure – the foundation for multi-year bull market is well under formation. Stay put and add more!

 (*As of 19^th Dece 2014, MSCI Share price index in USD terms)

Arvind vs Raymond - a classic comparison

Over the last 6 months shares of Arvind Mills have almost doubled whereas the stock price of another textile leader Raymond has barely inched up by 30%.

Raymond is an iconic brand with dominant market share and an impregnable consumer franchise. Raymond also owns all its brands.

On the contrary, Arvind is more of B2B business. Its branded foray is essentially JVs or in-licensing arrangement with foreign brands. 

Intuitively, we all know that Raymond has a superior franchise, sticky channel and stronger distribution, its a focused and stable business model. But the share price over the last six month of the 2 stocks have just defied this logic.

The main reason behind such a strong move in Arvind's share price is essentially a clear communication by the company management about the growth and improved profitability. 

In various communications which are available on the company website the company targets to triple its topline to Rs.18000crs by FY18 which implies roughly 30% annual cagr.

At the same time, company also talks about the margin expansion and desire to improve RoCE to 20% plus.

Its but natural that such projections make the stock look quite cheap at current prices and hence the heady run up in the stock.

However this reminds me of a very interesting thought put forth by a leading value investor. He said, "P&L investing often goes wrong as the business environment is so volatile today; projections turn out to be way below expectations. However, instead of earnings we focus on balance sheet buying 30 cents in a dollar at bottom of the cycle; asset values don't change as drastically and often increase with inflation." 

Taking a clue from this legend, I though lets evaluate the two businesses as these are today. The analysis lends necessary support to the intuitive disconnect that Raymond despite being a stronger and consumer facing franchise is not so recognized by the market. 

The analysis throws that Raymond is not only deeply undervalued relative to Arvind but its a revelation for value investors eyes as the core business is essentially available free. And given the Raymond management has gone on record with its intent to unlock the value in immovable property its a matter of time that the stock will have a 'catalyst' in place.

Arvind shareholders will definitely make money if management does achieve what its targeting, but the journey is one up hill and a mammoth task. For investors margin of safety is very low.

Raymond on the other hand is subject to same set of macro environment with each of its textile businesses as Arvind is - its branded textile fabric, B2B denim and branded apparel business franchise are superior to Arvind growing at similar pace. But the stock offers great margin of safety as the core business is available essentially free when one builds in value of hidden assets which offers very high margin of safety to investors.  

No points guessing which stock one should load up.

Buy SBBJ

State Bank of Bikaner and Jaipur or SBBJ as most commonly known is the market leader in the state of Rajasthan. The bank has a phenomenal grip on the home turf with ~35-36% deposit share and 25-30% advances market share. 

New leadership to drive profitable growth

SBBJ has a new stewardship under Mr. B Sriram who joined as Managing Director in February 2013. Mr Sriram comes from SBI where he was Delhi Circle Chief General Manager looking after  the states of Rajasthan, Uttarakand, Delhi and with a large presence in Western UP and parts of Harayana. Our interaction with Mr Sriram reveals that he is a very level headed banker and possesses strong leadership qualities to prosper this bank ahead. Given his sharp understanding of the products and strong focus on asset quality we believe there is right management in place.

Strong platform for high double digit growth 

The state of Rajasthan offers tremendous growth opportunities for the bank. During 2012 it was one of the fastest growing state with over 20% GDP growth which has slowed sharply during FY13 as entire economy has slowed down to low single digit growth. Nonetheless the future holds strong promise. Average per capita deposits as well as average per capita credit is half of the national averages and way below even neighboring states.

This means that Rajasthan will continue to have above average deposit growth rate for next decade compared to other states of India. On credit side, its a difficult call, nonetheless, it is safe to assume that at least consumer credit growth will be higher than the rest of the country due to lower penetration combined with expectations of higher per capital income growth. A pro-business state government is certain positive factor for credit growth. But unlike deposit SBBJ would not be heavily relying on Rajasthan for credit growth. A large part of the advances growth comes on the back of parent SBI, which offers an opportunity to its associate to participate in consortium. SBBJ has the freedom to choose the business and it independently studies every proposal before deciding to participate. The lower level of NPAs - 3.6% compared to 6% for SBI - clearly indicates that the bank has been much more prudent in credit assessment and is not blindly participating consortium. On the positive side, the option to participate in consortium allows to optimise the business acquisition cost for the bank.

In Rajasthan all its nearly a banker to the Government - maintains all salary accounts of government employees as well as enjoys income from all the government transactions. It is also very strong in cross selling of insurance and mutual fund products of the parent to its customers which is further adding to fee income. Overall however there is a lot to be done on fee side but management appears to be clueless about how to build this part of the business.

Asset quality has been a cause of concern with Gross NPAs at 3.62% and Net NPAs at 1.9%. It also has a large restructured book of Rs.4300crs i.e. almost 6% of loan book. On the good part, slippages from the restructured books are restricted to ~10% and most of that book continues to be current. 

Bank maintains adequate capital with Tier I at 9.1% and total at 12.2%....good enough for 20% growth in balance sheet. RoAs are respectable at 0.96% and RoEs are also respectable at 15%. 

At current market cap of Rs.3056crs (CMP - Rs.436) the stock trades at 0.8x FY14 and 0.7x FY15 book of Rs.4084crs and Rs.4820crs respectively. On p/e terms the stock looks even cheaper at 4x FY13 profits of Rs.730crs

Dividend yield at current prices is very good at 3.7%

The merger with SBI could accelerate the gains as indepedent valuation would most probably lead to swap ratio at 8x earnings or 1.2-1.5x book (SBI trades at 1.8-2x) which means you would double money. There is hardly any downside from the current levels.

Strong BUY !!!

Buy Dabur India

Company Description

Dabur India is one of the leading FMCG companies in India with a very strong brand recall & leadership position in some of the niche segments. Its leading brands are Vatika, Anmol, Babool, Red Toothpaste, Real fruit juices, Chyawanprash, Dabur Honey, Hajmola, Odonil, Odomos, Sanifresh, Gripe Water, Janam Ghunti and Lal Tel. It also exports to various countries and is particularly strong in Middle East & Egypt. Exports account for 1/5th of turnover and are major drivers for growth growing at 35-40%. The company has also ventured into speciality retail with its Beauty & Wellness stores.

Investment Thesis & Valuation

The company is poised to grow at 15-20% with operating leverage enabling 20%+ bottom line growth.

At the CMP of Rs.89 the stock trades at 18x FY10 EPS of Rs.5

The Stock has seen a low of Rs74 in the current market fall but has bounced back sharply. The low is just to see our downside from the current levels. But the point is if you are willing to invest in this stock for next 2 years you can safely get a return of 20-25% per annum. Considering the current state of the market and risk-reward for the investment, one should definitely allocate some portion of his assets to Dabur.

Business Analysis

Dabur has organised businesses in three main divisions -
i) Consumer Care Division
ii) Consumer Health Division
iii) International Business Division

Consumer Care Division is further organised into various Strategic Business Units (SBUs) namely -
i) Hair Care - Amla & Vatika are the leading brand here with Anmol at lower end
ii) Baby & Skin Care - Gilabari, Lal Tail, Gripe Water & Janam Ghunti
iii) Oral Care - Red Toothpaste, Babool, Meshwak - all growing at healthy pace
iv) Health Supplements - Chyawanprash, Honey, Chywanprash Junior
v) Digestives & Candies - Hajmola, Hingoli, Pudin Hara are major brands here
vi) Home care - Odonil is leader, Sanifresh picking up, Odomos is posied to take off
vii) Foods - Real is the market leader, Activ and homemade are other sizable brands

New Launches

Come October the company will launch pan-India 2 more products in Health Supplement category - Chyawanprash Junior and ChywanPrakash. Chyawanprash Junor is malt food supplement for kids which will compete against likes of Bournvita, Hrolicks and Complan. The differentiation for this product will be natural herbs added into it.
It also lauch more products under its Real brand in fruit juice category. Dazzl which is launched in Home Care category will be taken pan-India. New products are slated to be launched in Skin care category in 4Q09. New products to contribute 6-7% to total revenue.

Consumer Health Division is mainly into the sale of Ayurvedic OTC products. The business has potential to grow at 15-20% on long term mainly as more & more people turn to ayurvedic products.

In retail they already have 7 stores (2 at NCR, 2 at Bangalore, 2 at Hyderabad and 1 at ). They have a plan to open 350 stores over next 5 years. A store area could range from of 1000 to 3000 sq ft depending upon location would offer healthcare, cosmetics, baby care, personal care and general merchandise. Its branded as 'newu'.

Acquisitions -
One more axis of growth which i have not touched is acquisitions. In past company has successfully acquired & integrated Balsara. Management has mentioned categorically about inorganic route of growth but not much has happened since Balsara. I believe we would see an acquisition from Dabur sooner than later.

Overall, its a solid defensive play in the current turbulent markets with 20-25% compounded return potential.

Performance Check of Banking Recos

Jun-26 Sep-19 Gain/(Loss) Low after Jun-26 Notional Loss at Low Notional Gain from Low
HDFC Bank 1050 1300 23.8% 903 -14% 44.0%
Axis Bank 676 709 4.9% 580 -14% 22.2%
KMB 514 630 22.6% 420 -18% 50.0%
BOI 243 283 16.5% 193 -21% 46.6%
Nifty 4315 4245 -1.6% 3816 -12% 11.2%


Not so bad performance as banking stocks have not only outperformed Nifty by a wide margin but also have given handsome absolute returns...

Indian bank stocks have been hammered mercilessly since January this year and most of them are now trading at 2008 lows. The interest rate scenario remains hawkish with a clear northward bias and hence bearish view on the bank stocks would continue to prevail over this period. So why should one then look at banking stocks for investments?

The answer to above question lies in answer to below mentioned question...

THE MILLION $ QUESTION - "How much of the higher interest scenario, loan book slowdown and pessimism has already been factored into prices?"

If you ask me almost 85-90% has already been factored into the prices. And thats one of the main reasons that the stocks actually bounced back on Wednesday (the day after announcement of CRR and Repo rate hike).

There is nothing risk-free in the markets. So it would be foolish to assume that banking stocks will not go down if the market goes down. What one should look at is optimizing risk-return rewards i.e. taking lower risk of downside vis-a-vis upside potential. And the risk return reward is currently hugely in favor of the banks. Why am I saying so?

The reason why i am saying that concerns and risks are priced in banking stocks and you have better risk-return reward is that they are going very cheap on valuations vis-a-vis growth prospectus.

Despite of higher interest scenario, though not at 8-9% India's GDP will still continue to grow at 7% which is good enough to grow loan demand at 15-20%+ for PSU and private banks respectively. Deposit growth continues to be robust at 20% plus and with current stock market condition would probably improve further as lot of people are preferring to go on cash. Most of the private sector banks have got down duration (a measure of sensitivity of debt/g-sec investment portfolio to interest rate movements) to close to 1-2. This will result much lower MTM (mark-to-market) losses on their investment portfolio this time. On a whole there would not be much slippages in NIMs (Net Interest Margins), lower MTM losses and lower NPA (non-performing assets) provisions than what market has already built in the prices.

Look at FY09 P/B valuation table below to realise how badly these stocks have been battered...

Axis Banks 2.4x
BoB 0.8x
BoI 1.7x
Canara 0.9x
HDFC Bank 2.4x
Kotak Bank 1.6x
SBI 1.6x
UBI 0.9x
ICICI Bank 1.2x
PNB 1.2x
IDBI 0.8x
OBC 0.6x
* Kotak bank and ICICI Bank's valaution are for core business after adjusting for other businesses like life insurance, asset management, broking etc.

These valautions as I said above are for current year i.e. FY09 and abysmally low....classic expample of iirational exuberance and therefore provide a great opportunity for GARP investor - an investor seeking growth at resonable price (price means valuaion).

But dont buy anything and everything. I will suggest a basket approach with banks with higher RoEs and higher growth.

So make a basket of the following banking stocks -
1. HDFC Bank - 20-30% growth 18-20% RoE (concerns on CBoP merger priced in)
2. Axis Bank - 30% growth 20%+ RoE (great franchisee...concerns on retirement of P.J.Nayak priced in)
3. Kotak Mahindra Bank - too cheap and best acquisition candidate alongwith Yes Bank in 2009, high equity market exposure already price in at 1.6x P/B for a ripe pvt sector bank
4. Bank of India - 20-30% growth, 20%+ RoE, only PSU bank showing clear signs of breaking berucratic shackles and becoming one like a pvt sector bank....will regain higher re-rating.

I will keep other PSUs and ICICI bank out (though ICICI Bank is really tempting me on valuations) for their poor growth and RoEs (ICICI Bank RoE is a low 12%).

So value investor go ahead and invest in banking stock with the above basket approach.

Keep watching this space for detailed valuation on these banks