Equity Strategy: Infrastructure Outperformance Taking Shape

BMI View: While we are bearish towards the benchmark Sensex index, we continue to see attractive investment opportunities across Indian infrastructure equities. This sector remains depressed in terms of price and valuation and is likely to outperform over a multi-year time horizon as India's investment cycle gradually turns up (early signs of which are already appearing). We believe that the BSE Capital Goods Index, in particular, is set for major upside over the medium term, as financial risks dissipate and earnings prospects improve in 2014.

Since early November, BMI has been outright bearish towards India's Sensex index, the benchmark listing of the country's 30 largest companies by market capitalisation. Our rationale for adopting this view was both technical and fundamental in nature. Technically speaking, market momentum had started to wane and the bourse appeared to be carving out a major triple top reversal pattern ( see chart). Fundamentally, despite a backdrop of sluggish economic growth, the Sensex was amongst the most expensive indices across the region, trading at 18.4x trailing earnings and 2.6x book value. Little has changed since then for us to reassess our downbeat stance. We are currently up 1.7% in our regional asset class strategy, and see scope for further downside in the Sensex over the coming months towards trendline support at 18,500 (which would represent implied losses of 9.4% from current levels).

That said, we also reiterated at the time that the Sensex is not the be all and end all of India's equity market. In fact, in our strategy note 'Can The Sensex Continue To Defy The Odds?' dated November 1, we championed the case for infrastructure stocks. This sector was not suffering from the valuation premium seen in the benchmark bourse; on the contrary, it was trading at a historical discount. To be sure, the BSE Capital Goods Index has been on a tear, clocking spectacular returns of 40.4% since its August 28 low.

Bearish Benchmark
India - Benchmark Sensex Index

BMI View: While we are bearish towards the benchmark Sensex index, we continue to see attractive investment opportunities across Indian infrastructure equities. This sector remains depressed in terms of price and valuation and is likely to outperform over a multi-year time horizon as India's investment cycle gradually turns up (early signs of which are already appearing). We believe that the BSE Capital Goods Index, in particular, is set for major upside over the medium term, as financial risks dissipate and earnings prospects improve in 2014.

Since early November, BMI has been outright bearish towards India's Sensex index, the benchmark listing of the country's 30 largest companies by market capitalisation. Our rationale for adopting this view was both technical and fundamental in nature. Technically speaking, market momentum had started to wane and the bourse appeared to be carving out a major triple top reversal pattern ( see chart). Fundamentally, despite a backdrop of sluggish economic growth, the Sensex was amongst the most expensive indices across the region, trading at 18.4x trailing earnings and 2.6x book value. Little has changed since then for us to reassess our downbeat stance. We are currently up 1.7% in our regional asset class strategy, and see scope for further downside in the Sensex over the coming months towards trendline support at 18,500 (which would represent implied losses of 9.4% from current levels).

Bearish Benchmark
India - Benchmark Sensex Index

That said, we also reiterated at the time that the Sensex is not the be all and end all of India's equity market. In fact, in our strategy note 'Can The Sensex Continue To Defy The Odds?' dated November 1, we championed the case for infrastructure stocks. This sector was not suffering from the valuation premium seen in the benchmark bourse; on the contrary, it was trading at a historical discount. To be sure, the BSE Capital Goods Index has been on a tear, clocking spectacular returns of 40.4% since its August 28 low.

Constructive Capital Goods
India - BSE Capital Goods Index

Despite these major moves, the investment case for Indian infrastructure stocks remains compelling. Firstly, financial risks have started to dissipate, with the Indian rupee regaining a measure of stability in recent weeks (what is more, we hold a constructive stance towards the currency over the medium term). The retreat of major macroeconomic concerns is clearly a positive for cyclical stocks.

Secondly, political uncertainty is starting to crystallize. Momentum is building behind the campaign of opposition leader Narendra Modi ahead of next year's general elections according to latest polling. An opposition Bharatiya Janata Party (BJP)-led coalition would be a net positive for policy execution and political risk, in our view, given its more pro-market and business-friendly leanings.

Change In Fortunes?
India - Index of Eight Core Industries & Industrial Production, % chg y-o-y

Thirdly, there are signs that the investment story is witnessing early signs of a cyclical pick-up. India's Index of Eight Core Industries - an infrastructure activity proxy which includes production of steel, cement and electricity - expanded by a robust 8.0% year-on-year (y-o-y) in September, the fastest pace in 12 months. While we are looking for confirmation of this upswing in the coming months' data, it is worth noting that this index provides a useful leading indicator of wider industrial production trends ( see chart).

Room To Run
India - Sensex, BSE Capital Goods Index & Ratio (bottom)

The above factors, combined with the still-attractive valuations on offer, mean that we continue to maintain a preference for infrastructure stocks over the benchmark index. To be sure, the ratio of the BSE Capital Goods Index over the Sensex remains in a multi-year downtrend, a trend that we believe may well reverse course in 2014 as macroeconomic risks continue to soften and earnings prospects improve thereafter. We do note the possibility for volatility, however, in the run-up to the elections given that the results remain far from certain. Indeed, Indian equities as a whole have been prone to violent moves during election season. After the 2004 election, the Sensex fell 17% in two trading sessions, and the opposite occurred in 2009 with the market surging 17% in the two days following the vote.

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This article is tagged to:
Sector: Country Risk, Infrastructure
Geography: India
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