Indian Equities-Cyclicals poised for strong recovery

Indian Equities: Cyclicals poised for strong
recovery
27 February 2015
What’s the Gist – With macro
lead the recovery, however timing of recovery
analysis, Banks are best positioned among cyclicals to lead
delay on its way to recovery. Investors are advised to stay heavily invested in cyclicals
discussed in this report, with strong bias towards Banks and Auto sectors.
Macro-economic outlook remains positive
from December levels, is still within RBI’s tolerance level
remain weak, inflation is more than likely expected to remain muted. Additionally,
growing, has still shown signs of weak
rate further to stimulate growth in the economy
Fundamentals signaling bottoming
and correlated to economic cycle
earnings improve significantly. Currently, m
portfolio are in reasonably good shape fundamentally. As of 3QFY15,
(Key Performance Indi
out with most indicators are either at or just below the trough cycle average levels seen in the
last down cycle period.
Valuations indicate up
for cyclical sectors, relative valuation multiples (like P/E, P/B, EV/EBITDA) can also suggest
the reversals or the en
multiples are at relatively higher levels c
periods. With macro-economic indicators already pointing towards
current high trailing multiples
Azharuddin A Mansiya
CFA Level 3 Candidate, June 2015
Phone: +91 9930307208
E-mail: a.a.mansiya@gmail.com
Blog: http://alphaniveshap.blog.com
Cyclicals poised for strong
With macro-economic conditions gradually improving, cyclical sectors will
, however timing of recovery will differ across sectors. According to
s are best positioned among cyclicals to lead, while Cement could face some
economic outlook remains positive – Inflation at 5.1% in Jan-
from December levels, is still within RBI’s tolerance level. With crude oil pric
remain weak, inflation is more than likely expected to remain muted. Additionally,
growing, has still shown signs of weakness, which only advocates RBI to continue to cut repo
rate further to stimulate growth in the economy.
Fundamentals signaling bottoming of cycle – Cyclical sectors’ business is highly sensitive
and correlated to economic cycle. As macro-economic conditions improve, cyclical sector
earnings improve significantly. Currently, most of the cyclical sectors discussed
portfolio are in reasonably good shape fundamentally. As of 3QFY15, the fundamental KPIs
(Key Performance Indicators) of respective sectors suggest that the earnings have bottomed
last down cycle period.
Valuations indicate up-cycle in sight – Valuations are driven by fundamentals
relative valuation multiples (like P/E, P/B, EV/EBITDA) can also suggest
the reversals or the end of cycles. Generally, trailing (last 1-year or 4-quarters) valuation
multiples are at relatively higher levels compared to peak cycle or deep into down
economic indicators already pointing towards start of
trailing multiples look supportive and indicate beginning of up
Azharuddin A Mansiya
CFA Level 3 Candidate, June 2015
Phone: +91 9930307208
a.a.mansiya@gmail.com
http://alphaniveshap.blog.com
economic conditions gradually improving, cyclical sectors will
differ across sectors. According to my
while Cement could face some
-2015, although rose
crude oil prices continue to
remain weak, inflation is more than likely expected to remain muted. Additionally, IIP although
ness, which only advocates RBI to continue to cut repo
Cyclical sectors’ business is highly sensitive
economic conditions improve, cyclical sector
discussed in model
the fundamental KPIs
that the earnings have bottomed
fundamentals. However,
relative valuation multiples (like P/E, P/B, EV/EBITDA) can also suggest
quarters) valuation
ompared to peak cycle or deep into down-cycle
start of growth phase, the
indicate beginning of up-cycle.

Indian Equities: Cyclicals poised for strong recovery
Page 2 | Azharuddin A Mansiya 27 February 2015
Table of Content
1. Best Positioned Sectors--------------------------------------------------------------------------03
2. Macro Economic Outlook-------------------------------------------------------------------------04
3. Fundamentals signaling bottoming of cycle-----------------------------------------------06
4. Valuations indicating cyclical upturn---------------------------------------------------------10

Best Positioned Sectors
Sector scores: The cyclical sectors have been analyzed and evaluated based on three parameters, 1)
macro-economic sensitivity, 2) fundamentals and 3) valuations. The sectors are rated on the scale of 1 to
5 on each parameters with 1 being the worst and 5 being the best. Overall, Banks and Autos are the best
positioned sectors and investors are advised to remain heavily invested in these sectors relative to other
cyclical sectors.
Macro-Economic: Banks are the best positioned sector to be benefited for any favorable change in
macro-economic conditions going forward. Interest rate cuts will be most beneficial for banks and has
direct positive impact relative to other cyclicals.
Fundamental: Most of the sectors are in reasonably good position fundamentally as of 3QFY15 included
in model portfolio. However, cement sector still appears to be struggling a bit largely due to pressure on
cement pricing as post monsoon demand recovery has been slower than expected.
Valuation: Banks are best placed among the cyclicals in terms of valuations. Current market prices
appear to have discounted negative sentiments regarding NPA situation reported during recent earnings
results. After the recent correction in the bank stocks, the risk-reward trade-off looks attractive.
Investment conclusion: Investors are advised to remain invested in the below cyclical sectors with
strong bias towards banks and auto and add positions at every correction seen prices whenever possible,
as these two sectors are expected to outperform in near term. Although, I am overweight on cement
sector, however will advise investors to remain moderately invested in cement, relative to other
overweight cyclical sectors as the share prices could see short-term underperformance largely due to
weak earnings and negative sentiment around the recent freight hike announced in the railway budget.
Source: Proprietary analysis

Macro Economic Outlook
Inflation continues to remain low… – Inflation, measured with CPI (Consumer Price Index) had been
trending downwards till December. However, it has rose to 5.1% as of January 2015, although still within
RBI’s tolerance level. While this recent rise in inflation has largely been the result of higher food prices,
easing in crude oil prices has kept the rise of CPI in check. The continuous fall in crude oil prices has
helped instilling the confidence that there are remote chances of inflation hitting back to record highs .
With Global economy remaining fragile (Euro area struggling, Chinese economy cooling off), commodity
prices including crude oil are expected to remain weak in the near future. This will be beneficial for India
as falling crude oil will help to stabilize CPI at lower levels.
Source: RBI, as per new series with base year 2012.
…and Industrial output remains weak… – Index of Industrial Production (IIP) is an indicator used to
measure the combined economic output of the goods manufactured by various industries and sectors in
India. A higher IIP number indicates growth in economic activity supported by demand for goods
produced. Industrial growth in December slowed down to 1.7% compared to 3.8% in November, largely
due to low consumer durables and mining output, reflecting sluggishness in the economy.
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
11.0%
12.0%
Jan12
Apr12
Jul12
Oct12
Jan13
Apr13
Jul13
Oct13
Jan14
Apr14
Jul14
Oct14
Jan15
CPI
Exhibit 2: Inflation trend

Source: RBI
…which calls for further easing in interest rates – RBI had cut repo rate (the rate at which RBI lends
to banks) by 25 basis points to 7.75% in January 2015, first cut since January 2014. With inflation now
sustaining at lower levels and growth struggling to pick-up, RBI is expected to further cut rates, with next
rate cuts expected post budget.
Source: RBI, note: CPI series with base year 2012.
-10%
-5%
0%
5%
10%
15%
Apr2008
Oct2008
Apr2009
Oct2009
Apr2010
Oct2010
Apr2011
Oct2011
Apr2012
Oct2012
Apr2013
Oct2013
Apr2014
Oct2014
IIP-3mmayoy
Exhibit 3: IIP
IIP
7.0%
7.3%
7.5%
7.8%
8.0%
8.3%
8.5%
8.8%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
11.0%
12.0%
Jan12
Apr12
Jul12
Oct12
Jan13
Apr13
Jul13
Oct13
Jan14
Apr14
Jul14
Oct14
Jan15
Reporate
CPI
Exhibit 4: Repo rate vs Inflation
CPI Repo rate

Fundamentals signaling bottoming of cycle
Cyclicals to lead the recovery cycle: Falling interest rates generally stimulates the economy and it is
the key factor in improving cyclical businesses. In view of the government’s mandate on growth through
investments in infrastructure, anticipation of interest rate cut cycle and improving macro-economic
conditions, cyclical sectors are best placed to see recovery in their earnings.
Fundamentals improves…with a lag: Business fundamentals and earnings of cyclical industries like
banks, autos, capital goods, consumer durables, infrastructure, etc generally tend to pick up with a lag of
few quarters after macro-economic conditions start to improve. In context of the current economic
situation of India, Inflation (including crude oil prices), Interest rates and IIP are the key macro-economic
indicators that will dictate the path of recovery. With all the key indicators currently in a favorable state
and pointing towards gradual improvement, cyclicals appear to be positioned to witness earnings
recovery sooner than later.
In context of the model portfolio designed at the beginning of 2015 in my report Indian Equities: Seeking
Multi-year Alpha, we will discuss how each of the cyclical sectors are positioned in terms of their
fundamentals and what could be the quantum of recovery expected as macro improves.
Banks: Interest rate is the most important driving factor of banking industry as the business of banks
involve selling of loans and borrowing of deposits which are priced at a certain interest rate. This makes
banks as one of the most sensitive sectors to changes in interest rates. Generally, banks’ earnings react
in about 1-2 quarters post changes in interest rates as illustrated in exhibit 5.
The three most important fundamental indicators for banks are NPA (Non Performing Asset), NIM (Net
Interest Margin) and ROA (Return of Assets). NPA signifies bank’s asset quality and its future health of
balance sheet, which is the most critical factor in gauging its performance. NIM and ROA indicates bank’s
profitability and efficiency. Banks’ NPAs have improved when interest rates are cut and deteriorated when
increased. However, banks have managed to improve NIMs and ROA throughout but at the cost of their
asset quality.
As of 3QFY15, NPAs have further deteriorated, largely for the public sector banks while private banks
have more or less maintained their NPAs. As it stands, looking ahead as interest cut cycle resumes, the
fundamentals are expected to only get better as NIMs and ROA have already started improving while
NPA appear to have bottomed out.
Source: Company data, RBI. Note: NPA trend is a calculated score, with less than 0 indicating better asset quality and vice versa. Note: above data is composed based on the
bank stocks included in model portfolio..

Auto: Auto demand, especially 4-wheelers is supported by lower interest rates as consumers generally
go for financing the purchase of their cars. As illustrated in exhibit 6, the KPIs for auto sector suggests
that fundamentals improve significantly as interest rates are cut and deteriorate when rates go up.
However, the impact starts to translate onto fundamentals only after 2-3 quarters post the start of rate cut
cycle.
As of 3QFY15, the sector seems to be placed comfortably in terms of volume growth and EBITDA
margins (both above long term averages). However, ROEs are still lagging, far below the rate increase
cycle period average. I believe the ROEs will improve significantly as volumes improve further.
Source: Company Data, RBI. Note: above data is composed based on the Auto stocks included in model portfolio
Consumer Durables: India’s consumer durables demand is driven by consumer spending which is
influenced by size of disposable income of middle class population. As inflation decreases and interest
rate reduces, share of disposable income in total income increases which improves affordability for
consumer durable goods like AC, Refrigerator, TV, etc.
Interest rate changes in the economy drives profitability of consumer durable companies and impacts
their earnings in 3-4 quarters post interest rate cut. As illustrated in exhibit 7 by analyzing key
fundamental indicators, company earnings improve and remain strong during the interest rate cut cycle
and struggle during the interest rate hike period.
As of 3QFY15, revenues grew by 9% yoy (below long term average growth of 19%) for portfolio covered
companies while EBITDA margins was below its long term average, although above the average level
seen during the rising interest rate period . Nevertheless, as macro-economic state of the economy
improves, consumer durables demand will likely improve which will drive its profitability as seen in the
past rate cut cycles.
Source: Company data. Note: above data is composed based on the Consumer durables stocks included in model portfolio

Capital Goods: Capital goods industry is one of the immediate beneficiaries of the onset of the
investment cycle in an economy. As investments in heavy machinery and capital goods infrastructure
increases, revenues for capital goods companies improve, driving overall fundamentals of the sector. This
relationship is well supported by the movement in Capital goods IIP (Index of Industrial Production) and
its impact on overall fundamentals of the companies operating in this space.
Generally, recovery in capital goods sector take about 4-5 quarters post the start of rate cut cycle as
illustrated in exhibit 8. In the recent past, during the interest cut cycle of 3Q09-4Q10, fundamentals of this
sector improved only from 2Q10 onwards (~ 4 quarters after first instance of rate cut, once IIP growth
picks up). During this period, companies registered strong outperformance (as indicated by its
fundamental indicators) compared to low growth period and as well as its long term average.
As of 3QFY15, fundamentals of companies in the capital goods sector (model portfolio companies) are
still below the low growth period averages despite relatively better IIP growth. With government focused
on kick starting investment cycle in key areas of defense manufacturing, railways, and manufacturing
sectors, outlook for capital goods remain positive.
Source: Company Data, RBI. Note: above data is composed based on the Capital goods stocks included in model portfolio
Cement: Demand for cement in India is driven by housing and infrastructure development. However, for
last few years, demand from infrastructure space has been absent as government spending on
infrastructure projects has stalled. As government spending increases on infrastructure projects and GDP
revives, cement demand accelerates, improving earnings for the sector.
Although, the revival cycle generally takes around 3-4 quarters before the industry fundamentals turns
around. As shown in exhibit 9, cement demand (volumes and pricing) improves significantly during growth
phase of the economy, driving the earnings and enhancing shareholders’ returns significantly.
As of 3QFY15, fundamentals for cement sector suggests that the demand has bottomed-out, as volumes
have grown at a slower pace, indicating imbalance in supply-demand situation. Additionally, cement
prices have remained soft due to weak infrastructure demand. However, the demand condition is
expected to improve once infrastructure projects restarts (Budget will be the key event to lay the path for
infrastructure projects), improving pricing environment.

Source: Company Data, RBI. Note: above data is composed based on the Cement stocks included in model portfolio

Valuations Indicating Cyclical upturn
Trailing valuation multiples are at the highest levels…: Valuation multiples including P/E, P/B and
EV/EBITDA for cyclical sectors, generally trade at the higher levels during the up-cycle as compared to
their long-term averages during the down-cycle. This is because the stock prices rise in anticipation of
recovery while the respective denominators (EPS, Book value and EBITDA) of the valuation multiples for
the past period are at lower levels as business fundamentals remain poor due to business cycle
downturn.
…while forward valuation multiples can be at lower levels: As macro-economic conditions improve,
business cycle gradually recover which improves business fundamentals for the coming quarters,
significantly lowering valuation multiples (as denominators in form of EPS, Book value and EBITDA rise
up).
Banks: The sector has traded at a trailing P/B of 2.5x on an average since FY07 while at 2.2x next two
quarters (NTQ) forward P/B. During the falling interest rate period, trailing P/B significantly comes down
from the higher levels seen during the high interest rates period and forward P/B even lower. Additionally,
the book value (BV) improves significantly during the recovery period, as asset quality (NPA) improves
and earnings recover, which drives up the stock price.
The market is expecting strong recovery in the earnings along with significant drop in NPA numbers as
quality of loans improve with improving business conditions in the economy. However, market is carrying
a cautious approach for public sector banks, which has contained the stock prices of banking sector as
model (banks) portfolio and BSE Bankex are both up just 1% YTD 2015.
Looking ahead, as rate cut cycle gains momentum and government taking decisive steps to improve the
balance sheet of public sector banks, the sector can see exponential growth in earnings and improvement
in asset quality which will drive up the share prices. Additionally, the sector can also witness a re-rating of
valuation multiples as the key fundamentals NIMs and ROA are already better than the historical
averages.
Source: Company Data, BSE India, RBI.. Note: above data is composed based on the bank stocks included in model portfolio
Auto: The sector has traded at a Last twelve month (LTM) trailing P/E of 18.7x on an average since FY07
while at 15.8x next twelve month (NTM) forward P/E. During the rate cut cycle, trailing P/Es are generally
higher than the average while forward P/E remain lower for the reasons explained earlier. Additionally,
the earnings (EPS) improve significantly during the recovery period, which can drive up the stock price.
The market is expecting strong recovery in the earnings for Auto sector as reflected by model (auto)
portfolio, which is up 11% while BSE Auto index is up 5% YTD 2015.

Looking ahead, as rate cut cycle continues, and auto demand picks up, there can be exponential growth
in earnings (as seen in last rate cut cycle period) which will drive up the share prices.
Source: Company Data, BSE India. Note: above data is composed based on the Auto stocks included in model portfolio.
Consumer Durables: The sector has traded at a trailing P/E of 15.4x on an average since FY07 while at
13.3x next twelve month (NTM) forward P/E. During the rate cut cycle, trailing P/Es are generally higher
than during rising rate cycle period while forward P/E remain lower for the reasons explained earlier.
Additionally, the earnings (EPS) improve significantly during the recovery period, volumes increase and
margins improve, which drives up the stock price.
The market is expecting a strong recovery in the earnings along with a surge in volumes which will
improve margins. The stock prices of the consumer durables sector in model portfolio are modestly up at
1% compared to BSE consumer durables index at 8% YTD 2015.
Looking ahead, as rate cut cycle begins, and demand picks up, there can be exponential growth in
earnings as seen in last rate cut cycle, which will drive up the share prices.
Source: Company Data, BSE India. Note: above data is composed based on the Consumer durables stocks included in model portfolio
Capital Goods: The sector has traded at a trailing EV/EBITDA of 14.5x on an average since FY07 while
at 12.6x next twelve month (NTM) forward P/E. During the recovery period, earnings (EBITDA)
significantly improve, as infrastructure activity kick starts leading to demand for capital goods which spurs
up the volumes and thus improves margins for this sector.
The market is expecting a strong recovery in the earnings along with a surge in volumes. The stock prices
of the capital goods sector in model portfolio are modestly up at 6% on average compared to BSE Capital
goods index at 13% YTD 2015.

Looking ahead, a strong budget is expected from the perspective of infrastructure spending, which will
bring back demand for capital goods, resulting in exponential growth in earnings (EBITDA) as seen in the
last cyclical up-turn period which will see the sector enter into a sustainable growth period of 2-3 years.
Source: Company Data, BSE India, RBI.. Note: above data is composed based on the Capital goods stocks included in model portfolio
Cement: The sector has traded at a trailing EV/EBITDA of 7.9x on an average since FY07 while at 7.0x
next twelve month (NTM) forward EV/EBITDA. As the economy recovers, cement demand picks up with
volumes surging exponentially supporting cement price hikes announced by the companies.
The market is expecting significant recovery in the earnings along with exponential growth in volumes and
sustainable rise in cement prices supported by demand from government spending on public
infrastructure. However, market is carrying a cautious approach as thus far there has not been a real pick
up seen in cement volumes and the prices have remained muted with next possible trigger being the
concrete measures taken in the upcoming budget for revival in infrastructure spending. The cement
sector in model portfolio is up 1% YTD 2015.
Looking ahead, as economy recovers gradually along with key initiatives by government to begin infra
spending, there can be significant growth in volumes and pricing which will drive up earnings which could
see multifold jump in share prices.
Source: Company Data, BSE India, RBI.. Note: above data is composed based on the Cement stocks included in model portfolio

Disclaimer: The views mentioned in this report are based purely on my own independent analysis, research and understanding.
None of the content including data and views are based on any of the research reports of any brokerage houses. Model portfolio
composition is dynamic in nature and is subject to change as per the changes in the macro-economic situations and risks
associated. Investors are requested to take advice before acting upon any investment ideas mentioned in this report.

Indian Equities-Cyclicals poised for strong recovery

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