Outlook: Sensex in 2010

I have updated the quant report for Sensex; it can be viewed on the quant report page on www.maxkapital.com. Unlike the Sp500, the Sensex quant report has not been rolled to 2010 because I measure valuation with reference to fiscal not calendar years.

It's good to gaze into the crystal ball as we approach the new-year! For 2010 the quant report has a bear value of 6,433, a fair value of 9,972, a historic multiple based value range of 20,535 to 23,959, a moderated range of 11,966 to 15,954 and a fearless range of 15,624 to 20,832. All of these values are justifiable; the market value which will ultimately prevail is based on market psychology and expectations.

Earnings Expectations

I terms of expectations, on earnings we closed fiscal 2009 with operating earnings at Rs 766. Fiscal 2010 is expected to close at Rs 930. For fiscal 2011, I am looking for Rs 1,041. An increase of 21% on 2009 does appear at first glance more hope than anything else and we all know where the slope of hope leads. Yet, I remain comfortable with Rs 930 as an achievable earnings target. The number might appear optimistic when compared with 2008 and 2009, and I see the earnings risk as high after considering that it is just over the six year median earnings levels of Rs 712. But a high earnings risk is fairly consistent with a high growth economy. I feel comfortable with Rs 930 because I expect robust reversion to six year median levels by the December quarter for Sensex cyclical stocks. At the same time, the Sensex defensives can be expected to demonstrate continuance of growth which was not particularly hurt by the earnings recession in India. Unlike the US where I expect robust growth in earnings only in the second half of 2010, in India I expect to see robust growth during the second half of fiscal 2010.

Economic Expectations

1. GDP has risen to positive growth on both nominal and real levels; in nominal terms it is at 8% now. Global GDP growth has returned to a fast clip and growth expectations have commenced their upgrade cycle. 
2. CPI while rising is at 11.5% compared with decade average levels of 5.3%. This is an area of concern. In the coming months there is reason to expect some relief; much of the inflation comes from volatile food costs and with a good Rabi crop and a reasonable monsoon in 2010, CPI can be expected to moderate. And in any event core CPI, excluding volatile food and energy costs remains contained. Over the economic cycle, I do expect elevated inflation compared with historic levels of inflation.
3. The yield curve is now rapidly approaching normality with the 10 year note at 7.3% compared with decade average levels of 7%. The 2 year note trades at 5.8%; 1.5% below the 10 year note leaves the curve rapidly approaching normality. The RBI rate remains at low levels of 3.25% but expectations for a rate rise are increasing rapidly. Everything is pointing towards an above average interest rate and inflation rate cycle.
4. The spread between Aaa and Aa bonds is at 0.7% which is consistent with decade averages. The risk is being aggressively priced compared with decade averages; the spread between Aaa rated paper and the 10 year treasury is at 0.7% compared with 1.1% decade averages. Aa paper is at 1.4% compared with 1.8% as the decade average. Risk aversion has receded to a level where it can be considered a threat to market valuations. Nonetheless, I suspect a very significant reason for cheap pricing of debt is low demand for credit as entities seek to repair over-leveraged balance sheets by raising equity. At the same time, demand for debt is being sourced using cheaper foreign debt. This is a big positive.
5. Despite weak risk pricing, Aa paper is inexpensive; it is yielding 8.7% compared with 8.8% average over the decade. Aaa paper is yielding 8% compared with 8.1% decade averages. With rate spreads at low levels, as interest rates at the short end of the yield curve rise, rates at the long end can be expected to rise too. If this occurs it is positive; a flattening of the yield curve led by the long end of the curve rising slower than the short end would be potentially bearish, but not too bearish provided by demand for credit is being met from foreign sources.

Overall, I feel very comfortable that the Indian economy is fit for a robust self sustaining recovery led by the private economy. Downside risks do exist, deleveraging by government, introduction of capital gains tax, rising interest rates, competition for market allocations from IPO's and government sale of PSU stakes are some reasons why markets could remain subdued next year. Another global crisis caused by deterioration on US commercial real estate is another cause for concern. A continuing crisis on US consumer credit is also possible; starting 2010 and through 2011, the mortgage rates coming up for resets rises exponentially and with that rises risk. If job creation resumes by mid 2010, the crisis is likely to be manageable; otherwise institutions might need to turn back to governments for further capitalization soon after paying back significant bail-out packages recently. The good news is that capital to maintain reasonable balance sheets has been raised from the private capital markets; re-dilution by further governmental intervention would be bad for shareholders but not necessarily for the economy. On the other hand, barring another crisis, foreign in-flows could serve to keep India valuations elevated; growth markets with strong earnings visibility are in short supply. Over-all, I expect resource rich countries such as Brazil, Russia, South Africa, Australia, Canada to have leading capital markets with strong participation from India and China.

Valuation
At 17,402, the markets are not cheap. But an expensive market is not a reason to sell during the early stages of a cyclical expansion. The markets are not terribly expensive, Sensex trades at a relative PE of 0.93 to the SP500, this compares with 0.85 over 10 years. However on a PE6 basis, relative value is 1.56 compared with 1.53 over 10 years. Since the Sensex has a heavier weight-age to cyclical stocks relative to SP500, the valuation relative to US is reasonable.
As of now, while prices seem expensive at 17,402, a Rs average cost investor who has bought throughout fiscal 2010 has achieved entry valuations very consistent with historic averages. During bullish years, prices in the late part of a fiscal year are always ahead of year averages as the market evolves towards a brighter future.

At levels of over 19,300 I would get concerned and potentially start reducing over-weights to equity to build liquidity.

During 2010, I would expect a Rs average cost investor to purchase at 18,000 levels with markets ranging between 15,600 and 20,800. I would look for 22,600 as a peak market level and 15,600 as a trough. By fiscal 2014, provided the world does not plunge into another crisis, I have a fairly high confidence in Sensex at 34,000 with the next cycle trough coming in at 17,000 levels.

	Current Price	10 Yr Median	FY10 Annual Avg Price
PE Ratio Current Year	18.71	16.49	16.25
PE Ratio Prior Year	22.73	19.40	19.74
PE Ratio Forward Year	16.71	14.15	14.51
PE 6 Ratio Current Year	24.43	31.69	21.22
PE 6 Ratio Prior Year	28.49	24.75	24.75
PE 6 Ratio Forward Year	22.59	20.37	19.62
Relative PE	0.93	0.85
Relative PE 6	1.56	1.53

Outlook: SP500 in 2010

I have updated the quant report for SP500; it can be viewed on the quant report page on www.maxkapital.com.

It's good to gaze into the crystal ball as we approach the new-year! For 2010 the quant report has a bear value of 591, a fair value of 963, a historic multiple based value range of 1,477 to 1,542, a moderated range of 1,156 to 1,542 and a fearless range of 1,215 to 1,620. All of these values are justifiable; the market value which will ultimately prevail is based on market psychology and expectations.

Earnings Expectations

I terms of expectations, on earnings we closed 2008 with operating earnings at $49.50. 2009 is expected to close at $56. I am looking for $75 on operating earnings. An increase of 33% on 2009 does appear at first glance more hope than anything else and we all know where the slope of hope leads. Yet, I remain comfortable with $75 as an achievable operating earnings target. The number might appear optimistic when compared with 2008 and 2009, but I see the earnings risk as normal after considering that it is just over the six year median earnings levels of $72. I am looking for a subdued start to the year with earnings averaging $17.50 in the first two quarters and then accelerating to $20 per quarter as earnings growth accelerates as job creation starts contributing to growth in the second half of 2010. As can be expected, much of the earnings growth will be triggered by cyclical stocks returning to core earnings levels instead of recession suppressed levels.

Economic Expectations

1. US GDP has returned to positive growth on both nominal and real levels. Global GDP growth has returned to a fast clip even while long term US growth expectations remain subdued. Bear in mind that over 40% of SP500 revenues come from outside the US; thus profits growth could remain well ahead of US growth. In addition, the impact of rising SP500 earnings on US consumers can provide upside surprises; the wealth effect will come into play once stability returns and is perceived to have returned.
   
2. CPI while rising remains contained at 1.8% compared with decade average levels of 2.6%. Inflation expectations are also well contained; the spread between TIPS and treasuries are indicative of 1.9% inflation over 5 years rising to 2.2% over 10 years. Excess capacity together with slow growth expectations associated with deleveraging are expected to keep inflation contained. Even if inflation expectations rise as I expect they will, the present interest rate spreads provide considerable scope for credit expansion even while rates rise in response to inflation.
   
3. The yield curve remains steep with the 10 year note at 3.4% compared with decade average levels of 4.8%. The 2 year note trades at 0.9%; 2.5% below the 10 year note leaves the curve very steep. The feds fund rate remains at negligible levels and is expected to stay there a while yet.
   
4. The spread between Aaa and Aa bonds is at 1.1% which is consistent with decade averages. Yet, risk is still being sensibly priced compared with decade averages; the spread between Aaa rated paper and the 10 year treasury is at 1.8% compared with 1.2% decade averages. Aa paper is at 2.9% compared with 2.3% as the decade average. Risk aversion has not receded to a level where it can be considered a threat to market valuations.
   
5. Despite sensible risk pricing, Aa paper is inexpensive; it is yielding 6.3% compared with 7.1% average over the decade. Aaa paper is yielding 5.2% compared with 6% decade averages. There is scope for rates to rise without killing demand; there is also scope for rate rises to be moderated with shrinkage of rate spreads.
   

Overall, I feel very comfortable that the US economy is fit for recovery through mid 2010. In my view, job creation by mid 2010 can be expected and this greatly increases the odds of a self sustaining recovery led by the private economy.

The long term level for 10 year treasuries is 5.5%. I suspect we are in a rising rate cycle. If the 10 year treasuries rise to over 6.25%, the risk of steep declines in market value increases significantly. Competition from a competing asset class must not be ignored and if the 10 year treasuries do yield over 6.25%, it must be matched with high earnings growth expectations to justify market levels. This is more likely to be a 2011 risk.

Longer term threats continue; slower growth associated with deleveraging by governments and consumers must be expected. Above average inflation coming with monetary stimulus injected to trigger the recovery must also be expected. Slower growth once fiscal stimulus is withdrawn must also be expected. The world is in a bit of a mess at present and as it extracts itself from the mess, shorter and more volatile economic cycles are likely. Value is likely to prevail over growth for some time.

Valuation

In my view values are not expensive at 15X 2010 earnings expectations; particularly when considering yields in the bond market.

For 2010, I expect a re-test of fair value with markets falling to 960 to 980 levels. As confidence in earnings builds, I expect markets to rise; in my view 1,350 is a likely peak value for 2010 with 1,250 as the most likely target for end 2010.

Sector Watch: Telecom

Happy Christmas & New Year to readers; I will likely continue blogging during 2010 when I plan on starting with an over-view of the Blackstone India Fund followed with a quant analysis of each of the disclosed largest holdings.

I will close out the sector watch series with the Telecom sector.

Telecom as a sector underperforms from the market bottom to the recession end. It also underperforms for six and twelve month periods following recession end. And it has happened.

Sometimes, it pays to throw sector watching out of the window and buy value. At this point in time, we are in a situation where dividend yields are attractive on a historic basis and I expect dividends to grow. Valuations are attractive. The sector is oversold. Buy is my value conviction; even though the cycle timing might not be perfect.

Telecom is in a transition phase. In the years gone past, it traded like a utility. People had their landlines; everyone had a land line. They paid the cost. There was no great growth. Investors had stable earnings and high dividends. Then came the communications revolution! Everything changed. Mobiles and wireless became a huge growth market. Once everyone in the world has a mobile perhaps the industry will return to normality with stable earnings and high dividends. The problem is that I do not see this happening.

I believe we are at the beginning of the communications revolution and that mobiles will play a starring role. Telecom companies own and operate the platform; this is the stage on which the communication revolution will be acted. Telecom companies which stay with the back stage support will do quite well from increased usage. The real smart telecom players will go beyond the stage; instead of playing the role of back stage support, they will be a part of plot. The telecom players who participate in communication services and commerce will be winners.

So far we have seen Apple and I-phone; the beauty lies in I-tunes. We have seen Blackberry and its email platform. We have seen Nokia and Ovi. The telecom operators are benefiting from rising usage but so far profiting from applications has passed by them. Cheap and falling telecom costs are essential for developing e-commerce, e-mobile and similar applications; without participating in this business, the telecom sector will find that they march in place even while those leveraged on the telecommunications platform prosper. There are millions of applications which will come to the market over the years; mobiles are well suited to communications in the cloud - be sure that we will live in the cloud in the years to come. The really successful telecom players are those who will be able to deliver cloud innovation; they will benefit from both usage as well as from applications. Internet search is a much sought after area – accesses to a huge audience consumers in a non intrusive manner is the appeal. Telecom players have similar degree of consumer access; they need to find non intrusive ways of monetizing it. We have to wait and watch to see if the telecom sector has the ability to innovate and enter the cloud.

As it happens, I believe there are plenty of opportunities outside of the cloud; for instance mobile penetration is better than internet in rural India. Rural India has needs which have been long ignored. Needs which can be well supported on a mobile communication platform; for instance commodity prices, seed procurement, weather forecast, planting schedules, fertilizer utilization knowledge can all be provided via a mobile platform. Mobiles can also play an important role in supply chain management. For example procuring agricultural commodities where it is needed can eliminate transport costs; a hand-phone can quickly identify where the goods are and match them to where they are needed – what is required is a high quality platform and marketing to popularize it. Mobiles could be credit cards, they could be passports; high penetration and an ability to access consumers is a massive opportunity – the successful players will build services which can monetize this access.

In my view, quality shines through - in this sector we in India are fortunate to have Bharti Airtel. If I had to pick the top global telecom opportunity, it would be Bharti Airtel. They have recognized that the telecom model has to be integrated with services and have made great progress. But we still have to see whether they are able to innovate to win both in and outside the cloud.

Sector Watch: Utilities

Moving on to Utilities; this sector has a record of underperformance following market bottoms through the recession end, 6 months following the recession end and 12 months following the recession end. The expectation is for continued underperformance. Keep in mind that underperformance does not mean valuations will get cheaper; it just means that if the broad market goes up 20%, this sector will go up less than 20%.

The big plus for electricity producers is a massive shortfall in supply. While capacity is short, utilities have absolutely zero marketing risk. Of course as a result of regulation, prices are controlled which could lead to margin pressure as a result of rising cost of inputs. But even in a controlled price environment, it is likely that long term margins will be maintained; the nation has a need for electricity and reasonable profitable margins is what will attract investment to the sector. Utilities are a defensive sector; the demand for what they produce is consistent with only seasonal variations. In India, the sector has strong growth prospects as a result of supply shortfall; it also has powerful growth prospects as a result of rising demand. Consumers, industrials and material sectors are all wanting more; we have new consumers as poverty recedes, we have ever-growing needs from a growing industrial sector (particularly infrastructure development), and we have rising demand from a rapidly expanding material supplier group. Thus long term prospects for the sector are very strong.

Utilities as a sector has a high dividend yield characteristic; in India while growth remains a necessity, dividend growth might take a backseat because capital created through excess cash flow can be allocated to growth instead of dividends. Yet, in the very long term, once demand and supply are in balance, the dividend growth is likely to be quite amazing. Buyers in perpetuity could end up having an absolutely amazing yield to cost to bring joy and prosperity to the retirement years.

The negative on the sector is high debt levels used to finance long term projects; stable cash flows make high degrees of leverage advantageous. And while leverage can create shareholder value it does come with risk. You see it adds earnings volatility to a sector which has defensive characteristics as a result of stable earnings. Thus, as interest rates rise, the sector valuations tend to deteriorate. Yet earnings stability and long project gestation do mean that the sector successfully sustain higher than normal debt levels.

As with everything, the best buying time is always ahead of recession ends; when utilities outperform during bear markets, they lose less and so while the sector might be expensive on relative valuation; the absolute values are best at this time. The next best time to buy the sector is when the yield curve is normal and expected to start flattening. At present the yield curve is steep, with expectations tending to normalization. Perhaps late next year will provide a nice entry opportunity for relative value investors.

On a secular basis, I would buy the sector on valuation, whenever it becomes available and hold for the very long term. As with other defensives, I will not reduce positions; i.e. let the changes in relative sector market valuation take care of portfolio over and under-weights with no active management. India's secular trend emanates from staples, healthcare, utilities and telecom. All these sectors are long term dividend growth sectors. In India they enjoy growth prospects for several years. The young aggressive trader crowd will likely find the group boring; but there is nothing boring about dividend payers later in an investing career; it provides hard investable cash in difficult markets, it provides portfolio stability because of its low beta characteristics and it creates discretionary income in the later years.

Sector Watch: Healthcare

In terms of growth, much of it stems from emerging markets and this shall continue. On a long term basis, the case for investment in health care, energy and staples (basic necessities food) is compelling; we in the emerging markets are in a secular bull which will run to at least 2030. Where we stood in 2007, was at pause point; emerging markets had grown at a furious pace. There was a need to pause and build capacity before the next phase of growth commenced; thus a period of earnings regression while industry invests in increasing capacity while sustaining present business should have been expected.

In my view the source of the powerful secular trend in India emerges from staples and this is followed by healthcare, utilities and telecom; these satisfy basic necessities. Other sectors will be major beneficiaries; but always remember from whence the secular power emanates. Because India is so very over populated, all sectors can create huge opportunity. For instance on financials, a bank account per individual in the potential labor pool is massive beyond contemplation. Internet access penetration is also a humongous opportunity. If economic prosperity touches 10% of our population, it creates a market for consumer discretionary items in excess of 100 million people; that is huge in a global context. The infrastructure required to support growing needs makes an amazing opportunity for industrials; roads, bridges, dams, transportation; you name it and the opportunity exists. And this creates massive demand for materials and energy.

On a near term basis I expect the healthcare sector to underperform the broad markets. This is normal for the present phase in the economic cycle. Medium term I remain very optimistic for the sector. There are several sector positives. US healthcare reform is a positive trigger. Rising demand from generics is a positive. FDA drug approval rates are rising. Lifestyles have changed dramatically; lifestyle related disease is a big healthcare opportunity – diabetes, blood pressure, obesity, heart disease are all on the rise. Change in the demographic profile with escalating aging in developed economies is a positive. Several blockbuster drugs coming off patents in the coming two to three years opens up a big market for generics; at the same time development of new drugs have been exceptionally slow for several years – it is time for investment in R&D to start delivering new drugs. The sector (specially IP creators in big pharma) is very undervalued on a cycle and secular basis. But the biggest sector positive is growing need for healthcare in emerging markets. Generics, IP, Hospitals, Health Insurance; you name it and the secular trend is powerful. No doubt there are negatives too; political wrangling in US could lead to sector uncertainty, rising input costs (including chemicals) can squeeze margins; but on balance this sector is poised to deliver very powerful secular returns (15 years to 20 years).

My comments from my sector watch notes on staples apply to healthcare too; I have repeated them below:

"Buy your staples when the sector is undervalued and then let the market take care of staple sector over and under-weights for you; there is no compelling reason to add or reduce positions/share-count to build sector over and under-weights. At present staples as a sector looks cheap on a relative PE, yet I believe these stocks will be cheaper on an absolute basis once money flow shifts to energy and energy outperforms for over a year.

I am not convinced that reducing holdings in defensives following a market bottom is a good idea; the funding for rising positions in cyclical stocks should come mainly from shifting in portfolio allocation between debt and equity. The defensive sectors are not really true market hedges – when there is a recession they will fall too, perhaps to a lesser degree than other sectors, but they will fall nonetheless. The market hedge during bear markets should really come from over-weights to debt because debt will fall as interest rates are cut in response to the recession."

Long Term Fundamentals

Will Malthus be denied --- yet again?

"I think I may fairly make two postulata. First, That food is necessary to the existence of man. Secondly, That the passion between the sexes is necessary and will remain nearly in its present state. These two laws, ever since we have had any knowledge of mankind, appear to have been fixed laws of our nature, and, as we have not hitherto seen any alteration in them, we have no right to conclude that they will ever cease to be what they now are, without an immediate act of power in that Being who first arranged the system of the universe, and for the advantage of his creatures, still executes, according to fixed laws, all its various operations.

...

Assuming then my postulata as granted, I say, that the power of population is indefinitely greater than the power in the earth to produce subsistence for man. Population, when unchecked, increases in a geometrical ratio."

Because population grows at geometric progression while production grows at arithmetic progression; as population outstrips food production, natural disasters, famines, wars shall occur to restore the balance between mankind and nature.

What went right for the world? For one, productivity grew exponentially. On the other part, population growth, while exponential, is showing clear signs of defying the laws of nature - as economies mature, there is increasing evidence of falling fertility which arrests population growth. This together with forced and education based birth control, has somewhat slowed population growth from what it could have been. While population growth is restrained from a peak growth rate, increasing longevity does mean a larger standing army and thus a permanent increase in demand.

On the demand side, while resources are finite, the voracious capacity to consume is not; both manual intervention and a Darwinian response by humanity may help delay the Malthusian correction; in the mean time science shall answer the challenge of increasing productivity to sustain the masses. On the supply side, energy is the fuel which fires the engine of industrial growth. Food is the fuel which fires people; without food there are no people; no demand. On health care, I personally find the Biotech industry utterly fascinating; of course I know nothing about the technical side of things, but I do follow the industry and its pipeline drugs closely from an investor perspective. Humans have such a desire to live in perpetuity, be it through life extensions or reincarnations; an industry which tries to satisfy the human quest for immortality must succeed. That aside, I have always wondered whether an answer to the age old Indian epics lies in Biotech; as in is immortality or reincarnation simply a genetic legacy explained; did Rama truly live for an epoch through advanced medicine or is it simply living through passage of a genetic legacy (with death being the consequence of the maternal line being ultimately extinguished); or hybrid beings (mythological beings like Garuda) a genetic possibility. Ultimately science will provide energy alternatives; science will also provide new technology which shall usher in the next green revolution; so too it shall provide drugs which shall continue to increase longevity.

In terms of global demographics, India's population shall not plateau until 2050. In China, population growth remains on an uptrend through 2030, at which stage it is expected to plateau. In terms of comparison, the opportunities for growth now are unrivalled, perhaps the closest comparable being the rebuilding of Germany, Japan and much of Europe after World War II. This time round, the growth drivers shall be the building of the under-developed world generally and China and India in particular.

Fundamentally, the era of low inflation is over. China as the factory of the world served as a catalyst to usher in an era of low multi decade inflation levels. While the story of China remains untold, the inflation impact has been played out. This does not mean we now usher in an era of hyper inflation; but it does mean that the world needs to adjust to a higher long term inflation rate of 4% (which is really a simple mean reversion rate in a historic context) compared with targeted rates of 2%. In addition to sound business and demographic fundamentals, this expectation is in itself supportive to energy, commodities, health care and staples (agricultural commodities), which are historic beneficiaries during times of rising inflation. Of the four, energy & commodities carry the highest degree of cyclical risk - my view is that we are approaching a cyclical peak within a strong secular bull. Health care carries new drug development risk coupled with patent expiry & generic competition and for this reason while long term fundamentals remain sound, health care has not displayed the typical defensive characteristics as financial markets run past a cyclical peak; yet health care services remains a source of growth and opportunity. Staples remain my favorite; a traditionally defensive sector, with immense growth potential and a natural tendency to profit during periods of higher inflation. Within Staples, food as the fuel of humanity deserves most attention. While there is a degree of cyclical risk associated with fertilizers (agricultural chemicals such as nitrogen and potassium); alternative areas such as seeds, warehousing, food storage and distribution etc. remain solid; seeds remain my favorite - it is my belief that the marriage of biotechnology & agriculture shall produce the next denier of Malthus.

Health care in India has been neglected for many a year. India can expect the health care sector to grow by over $45 billion by 2012. During 2005, India health care was sized at $22.8 billion; the table below illustrates where India was in 2006 and where she strives to be in 2012.

 

The sector has grown at an annualized rate of over 16% over the recent past years and employs over 4 million people; by 2012, it is expected to grow from 5.2% of GDP to 7%. During this period public spending is expected to double from 0.9% of GDP to 2% of GDP. The public commitment to health care is apparent through policy actions which include; tax and service tax incentives, reduced import duties to 5% and significant increases in public spending; including a commitment to increase spending on health and family welfare by 22% to $3.7 billion. The government contribution to health care is 21% of the total; while this spend can be expected to grow it is the private health care space which can be expected to grow exponentially. Growing population, changing demographics, rising disposable income, urbanization and changed lifestyles together with insurance are the key growth drivers; the health care delivery systems is where the nation needs to build capacity; for without the capacity there can be no growth.

The demographics are indicative of an exploding Indian population through 2050. Today, we cannot meet the needs of the populace; despite an increase in facilities, it is expected that by 2012 India will need at least an additional 750,000 in-patient beds. The WHO recommends 3 beds per 1,000 people as a sensible ratio of in-patient beds; in India today we can provide at best 1.5 beds per 1,000. Today India has 229 medical colleges producing 25,000 Doctors per year, 136 medical schools enroll 6,000 post graduate trainees annually. There are an estimated 660,801 Doctors and 1,371,121 Nurses in India; but with an exploding population, India's needs for qualified medical professionals are immense; we need over a million additional nurses and an additional 500,000 doctors by 2012. Investment in nursing and medical schools is required; 106 of the 229 medical schools in India are private; integration of such educational institutions with major hospitals groups is one way to success. With the demographics expected, this area shall remain one of growth for many years to come.

Statistics tell a story; one of growth; consider this illustration of where India is and whence they must get to. Hospital infrastructure needs to almost triple for India to have facilities consistent with other mid income Countries.

	India	Low Income (e.g. Sub Sahara)	Mid Income (China, Brazil)	High Income (US, Western Europe)
Beds/000	1.5	1.5	4.3	7.4
Doctors/000	1.2	1.0	1.8	1.8
Nurses/000	0.9	1.6	1.9	7.5

 

Nationally, for hospitals, over the years 2005 to 2007, the government bodies and investment agencies shall invest $7 billion in the hospitals infrastructure; this is not enough; the requirement is for at least $25-30 billion and this leaves an $18-23 billion $ demand led opportunity in the hands of the private sector. In terms of consumer led demand, the private spend on health care delivery was at $20 billion in 2001; it is expected to growth to $50.2 billion by 2011 and to $78.6 billion by 2012. In terms of physical medical infrastructure development, the investment required goes from $7.8 billion in 2006, to $38.8 billion in 2009 and $78 billion in 2012.

In terms of vision of the un-contemplated consider this; China has a health care market size of $137 billion compared with India at $34 billion; this is illustrative of medium term growth potential as the population size is similar and in an economic context, we are in a similar time and place as China was a decade ago. Longer term, consider Germany; their health care market stands at $250 billion for a population which is a fraction of India's own population. Now open the horizons of your mind and consider the potential growth viewing the US market size as a guide; the health care market size in US is mind boggling at $2,100 billion; adjusted for population, in not so bizarre circumstances we could have a health care market size of $6,300 billion in India. A CAGR of 12% annually would bring India to this level by 2050; but of course facilities then available; would lie far short of those required, because the population will have lifted towards peak levels by 2050 (population growth of 2% annually would take us to 2.3 billion by 2050).

In addition to the capacity shortfall; new growth drivers are emerging. Population growth is an important driver of demand, but it is one of several factors coming into play. With increased prosperity, health care awareness is on the increase; this creates demand for preventative health care services; the percentage of working class people is expected to grow from 32% in 2006 to 36% in 2016. Urbanization and changing lifestyles are leading to lifestyle disease; heart disease and diabetes are on the up; this too creates opportunity. In 2006, cardiac, oncology and diabetes collectively accounted for 13% of the hospitalization cases. In terms of value, these three ailments accounted for 36% of the inpatient revenues. These ailments are estimated to account for 16.8% and 20.0% of the hospitalization cases in years 2011 and 2016, respectively. Increased longevity creates a larger standing army to care for and this creates specific demand in geriatrics; at the same time a growing populations grows the need for pediatric services. Rapid changes in technology are creating growth through changes bringing in new previously untreatable diseases into the market; this provides a wide variety of growth opportunities, particularly in oncology, neurology and pain management.

We have market size and margin drivers too. Over 90% of the private health care market ($14.8 billion, rising to $33.6 billion by 2012) is serviced by the unorganized service providers; organized players able to offer affordable quality health care have a major opportunity to increase market share at the expense of the unorganized provider. Healthcare in Urban India is cheap in a global context; the obvious jumps to mind "medical tourism"; what jumps to my mind is different – over time the price gap will close, which means the potential for margin growth in India over and above inflation is high. This table below illustrates the big price gap which provides a medical tourism opportunity today; and as the price gap narrows it paints a pretty picture for domestic India hospital margin growth potential.

$'s	US	UK	India
Heart Surgery	40,000	23,000	6,000
Bone Marrow Transplant	250,000	150,000	26,000
Liver Transplant	300,000	200,000	69,000
Knee Replacement	20,000	12,000	6,000
Cosmetic Surgery	20,000	10,000	2,000

 

Medical tourism is one of the most lucrative segments of the healthcare sector without doubt. Medical tourism is an area with major potential and this is expected to increase India's share of the global hospital services market quite radically; this market is expected to grow from $350 million per annum now to $1.6 billion in 2012; as must be expected, much of this revenue will be generated by up-market tertiary hospitals. The process has begun; in 2006-07, India was able to attract approximately 150,000 patients to the country, up from 10,000 patients about five years ago. With an annual growth rate of 30 percent, India is already inching closer to Singapore and Thailand, which are established medical care hubs that attract millions of medical tourists each year. Even the Ministry of Tourism recognizes the potential; the Medical Visa term has been extended to three years from 6 months.

Growth in medical insurance is increasing market size; revenue attributable to insurance or third party administrators has grown from 2% in 2001-02 to 16% in 2005-06; it is expected to increase a further 50% by 2011/2012; premium income is expected to be $3.8 billion by 2012. The insurance market size is expected to grow from $680 million in 2006 to near $4 billion by 2012; a growth rate nearing 35% per annum.

Additionally, we have growth from new detective innovations (CAT, MRI PET), new novel treatments (particularly ten therapeutic areas) and medical service delivery systems (polyclinics, super specialty hospitals). These are creating growth and major margin improvement opportunities.

Finally, we have growth from the next R&D cycle. The R&D cycle is typically eighteen years long; from discovery to patent expiry. While the cycle flows, important discoveries tend to cluster around certain dates. For the immediately prior R&D cycle, since 2005 we have seen patent expiry ratcheting up and accelerating and we expect it to continue through 2011; yet we expect the new stars from the next R&D cycle start emerging during 2010 to 2014. Human ingenuity will provide new novel treatments in several fields, be it via progress in biotech, stem cell or other areas of research. There are ten therapeutic areas into which much R&D capital has been deployed; developments will as always need a delivery mechanism; that is a hospital. These therapeutic areas are (a) Allergy & Respiratory, (b) Cardiovascular, Metabolic and Endocrine Diseases, (c) Gastrointestinal & Hepatology, (d) Genitourinary/Sexual Health, (e) Infectious Diseases, (f) Inflammation, (g) Neuroscience, (h) Oncology (i) Ophthalmology, and (j) Pain management - developments in these therapeutic areas will result in future growth opportunities; new treatments drive growth in the market size.

Sector Watch: Consumer Staples

The consumer staples sector is a defensive one. During bear market declines, this sector outperforms. Following market bottoms through to the end of a recession the sector performs in line with broader markets. Once the recession is over, consumer staples tends to underperform; it is not a time to invest in the sector when the leading economic indicators flash improvements. Valuations in this sector tend to get most interesting when energy as a sector is in a late stage of its cycle outperformance.

Keep in mind that consumer staples earnings are relatively stable during the course of an economic cycle. As a result, valuations tend to follow earnings and earnings growth as they occur; prices are less volatile. This sector gives reasonable long term returns with lower levels of volatility; it has low beta characteristic; stocks in this sector are unlikely to give you the mind boggling returns that can be earned in cyclical stocks; at the same time the debilitating losses on cyclical which occur during bear markets are equally unlikely. The investor aim should be to buy quality and hold for a long, long period of time. The sector will automatically get underweighted when cyclical stocks rise and over-weighted as cyclical stocks collapse.

The best time to buy the sector is when it's PE's are reasonable. PE's in the sector start to look very reasonable relative to the broad markets as cyclical stocks rise following a recession; that is not a time to buy; buy when the sector is cheap on an absolute not relative basis. Buy your staples when the sector is undervalued and then let the market take care of staple sector over and under-weights for you; there is no compelling reason to add or reduce positions/share-count to build sector over and under-weights. At present staples as a sector looks cheap on a relative PE, yet I believe these stocks will be cheaper on an absolute basis once money flow shifts to energy and energy outperforms for over a year.

I am not convinced that reducing holdings in defensives following a market bottom is a good idea; the funding for rising positions in cyclical stocks should come mainly from shifting in portfolio allocation between debt and equity. The defensive sectors are not really true market hedges – when there is a recession they will fall too, perhaps to a lesser degree than other sectors, but they will fall nonetheless. The market hedge during bear markets should really come from over-weights to debt because debt will fall as interest rates are cut in response to the recession.

Keep in mind that the normally staid and staples sector is actually in a growth phase at present. In India the growth opportunity is greater in staples than in several other sectors. There is no doubt in my mind that as poverty is alleviated, people will first buy their dal & subzi (lentils & vegetables) according to nutritional need instead of buying based on affordability. After nutritional need based buying is satisfied, religion permitting, a shift to high protein meat might occur. The sequence after the need for basic necessities (staples) is met should be health (healthcare), followed by utilities (water, electricity, gas) and followed by communication (telecom). It is only later that we will see matching potential from cyclical sectors; the time for people to go buy that Merc is a long way off. Keep this phenomenal growth potential in mind when you come to your decision of what a reasonable valuation is; I would be absolutely delighted to buy staples at a multiple of 14 and would be willing to start buying at 20X.

And in the meantime recognize that cyclical stocks will provide great returns, but with high volatility over an economic cycle. Several cyclical industries are big beneficiaries of growth driven by defensives; for example roads are required for transporting goods, hospitals are required to provide healthcare, power companies & water management are required to provide the populace with electricity and water. The infrastructure (industrial sector) needs require money, which is good for financials. They also need productivity which is helped along by IT. These needs also require materials like cement, chemicals, seed, steel, iron ore, which is good for basic materials. And since it is not an equal world, discretionary income will rise as will discretionary spending even as poverty is in the process of reducing. So cyclical flash opportunity from; but always keep in mind that the driving source is from defensives - this is where the secular trend emerges from.

Sector Watch: Energy

Following my post on materials earlier today, I thought I'd go ahead and post on Energy too. That leaves me with four days to cover the four remaining sectors, which will conclude my sector watch series. Next week I hope to start a portfolio review of Blackstone's India Fund; I am planning on doing a general overview and then adding a daily quant review for each of the top 24 stock holdings over the next several days.

As it happens I wrote my thoughts on energy not so long ago; you can read that here. And I will ramble on a while longer below. Energy is a late cyclical sector. As the market bottoms, energy continues to underperform through to the end of the recession. During six months following the end of a recession, the sector outperforms. But then it returns to underperformance in the subsequent six months. At the end of the day, the sector underperforms starting with the market bottom through twelve months after a recession. Thus, the next six months is unlikely to bring a period of outperformance for the sector; it might because the secular trend provides a strong tailwind, but using history as a guide, sector outperformance is not expected. Nevertheless, any sector falls would be excellent buying opportunities. Energy is a late cyclical, it takes the baton from materials and sprints to the finish line at the cycle peak; there it hands the baton to staples and the defensives to bring the economic cycle to a close. Buying energy during a phase of underperformance provides magnificent returns; the best time is of course the bottom of the market but after that phase, we are rapidly approaching the next best time to buy energy. It is a good idea to book profits on early cyclical stocks (financial and IT) and use it to build up positions in energy.  I would go as far as saying it is worth shifting defensives to underweight to provide funding for energy overweights.  But remember, some defensives (India Telecom) is trading a good valuations; I would not go underweight here because while there will likely be continued underperformance in the sector, the longer term gain potential is very promising.

There are a lot of sector positives on energy, which might cause very moderate or even no underperformance in the coming months. The first is the Baltic dry; it has flashed past 2009 highs set in June; this indicator is closely co-related to energy. The reflation trade and the secular trend of commodities is alive and well; perhaps even escalating in power; yet sentiment on oil remains subdued; the shortage of oil bulls is a powerful positive. With an improvement in global GDP growth rates, commodities are back in leadership. More importantly, resource rich nations are outperforming at both economy and currency level. And perhaps most importantly, using historic valuations as a guide, the sector is still undervalued on prior year, current year and forward year basis; the undervaluation is even more apparent when six year median earnings is used. I find using six year median earnings as a very useful valuation measure for large cap cyclical stocks because it does reflect a very reasonable level of core earnings potential. In my view, oilfield services and drillers are undervalued as is exploration and production. I expect the latter to lead with even stronger outperformance to follow from the former.

The sector negatives include low refining margins, which I expect to recover as energy demand from basic material joins growing demand from consumers, transportation and industrial sectors. Inventories remain high and with no meaningful declines expected until later in the cycle. Even as inventory declines, there is much comfort from knowing that the market is very well supplied; even considerable growth in demand can be more than met from current OPEC production cuts. With inventories remaining high, the oil tanker rates remain subdued. Once oil tanker rates rise, it will probably be too late for the sector will outperform ahead of that event.

In India energy, in the small and mid cap space, I am very comfortable with Selan & Cairn. In the large cap area, I am very happy with Reliance, but I am getting increasingly concerned about (a) the fact the company may over play its hand on the potential Lyondell Basell acquisition (b) acute discomfort with potential weak governance with respect to the family agreement in general & the RNRL litigation in particular and (c) more indigestion from a recent SEBI request asking the government to consider action against RIL for allegedly routing funds to dummy companies for buying large quantity of its shares in 2000. News, however is news, I will give Reliance the benefit of doubt unless governance issues are proven; after all Mukesh Ambani has also been judged amongst the top five global CEO's. I like ONGC very much, it is possibly my favorite India energy pick, but I will invest in the company only if valuations are dirt cheap, or after the government stops its practice of routinely abusing minority shareholders by forcing ONGC to share in losses associated with fuel subsidies. Lest I forget, in my view, the best balance of value and quality in large cap energy lie in the global markets; Schlumberger, Halliburton, National Oilwell Varco, Baker Hughes, Transocean, Diamond Offshore and Pride are my favorites amongst oilfield services and drillers. Chevron, BP, Occidental, Hess and Conoco are strong E&P prospects.

Good governance is critical for investors, data and transparency are important; even more important is clear evidence that a person in a position of influence is not using the position to separate other shareholders from their economic right. I mentioned discomfort with Jindal Drilling on data transparency in a recent post. I was disappointed with L&T disregarding the fact that its investors were interested in infrastructure development when it went after Satyam earlier this year. I am deeply concerned with the lack of transparency on the recent DLF merger with DAL. I also mentioned concerns of governmental abuse of its position of influence in a recent post. And I am also concerned about management competence in managing viable capital structures; an area I have visited on several occasions when looking at the extreme degree of corporate leverage used by several major Indian corporate houses. Without doubt not all of the highly leveraged entities are habitual debt offenders (entities with high leverage embedded in the long term capital structure), but several are. Governance is very important for long term investors and it is an area where laws and reporting in India need to be strengthened considerably. On reporting, I cannot imagine why balance sheets are not reported quarterly when the degree of leverage is a very significant investor consideration. Cash flow and the balance sheet are an integral part of financial reporting; earnings on their own tell only a small part of the story. But now I drift; I will conclude before I bore you to tears.

My call on energy is to maintain overweight positions and look to increase positions if the sector underperforms during the coming six months. Keep in mind, that energy is a sector in which I have worked for over twenty years; my relationship with the economics is intuitive. My positions have been built up very close to the bottom. And I am long term bullish. Had I not entered the sector as early as I did, at this stage I would be market-weight on the sector and looking to go overweight during any period of moderate underperformance.

Sector Watch: Basic Materials

After Industrials, we look to basic materials. History tells us that the material sector outperforms following a market bottom through to the end of a recession. It also tells us that the sector continues to outperform both six and twelve months following the recession end. What was different in the present cycle was the cataclysmic crash in the sector, followed by the dramatic reversal since the market bottom. The extent of the sectors rise prior to its fall and subsequent recovery remains important in the sectors forward outlook.

In my view the secular theme for materials remains very strong. In fact possibly even stronger; in addition to emerging market demand which is growing rapidly, I also anticipate a rise in developed economies demand as a consequence of a need to upgrade infrastructure in US, backed by governmental commitment to act. An increase in developed economy demand from mainly sustenance levels to incremental demand is indeed a powerful force. This is a demand driven fundamental secular trend. And to add to the sector potential is potential for further strength caused by financial investment (the reflation trade) in commodities in an era when inflation is expected to be moderately higher than long term levels coupled with a declining $.

The Baltic dry index is up and away of this; this traditionally points to healthy and growing demand for metals. Pricing power is once again in the hands of producers – steel scrap prices have been rising and that is a very clear indication on where to expect prices to head in the coming months. The sector valuations are no longer cheap on current or forward year earnings potential. If however, we recognize that the sector is deeply cyclical, current and forward earnings viewed in the context of six year median earnings (core earnings) are low. Multiple expansion is unlikely, however, considerable earnings expansion ahead in the economic cycle leave me with a very positive view on the sector.

I have noted below my view of the basic material sector on an industry level:

Chemicals as an industry within the basic materials sector has very strong potential; investment in infrastructure, housing and automobiles is a net positive for the chemical industry; growing demand from agriculture is another positive industry driver – both enjoy a powerful tailwind from a strong secular trend in emerging economies. Today, chemicals as an industry, is strongly supported by agriculture; the growing population of the world needs to be fed – both seed technology & chemicals have support from this ever growing need. Chemicals also enjoy supported from an improved outlook for the auto's and construction segment.

Construction materials also remains a high reward potential industry; investment in home building and infrastructure needs construction materials; cement as an industry has strong upside potential. In cement, with further consolidation in the industry, we could even look forward to more long term stability. Until we see further consolidation, the cement industry which is stretched by over capacity can continue with high levels of volatility – we are now at a point in time when the upside volatility is likely to get more evident.

Within the basic material sector, steel producers remain my favorite followed closely by miners. For the miners; natural resources by nature are finite. The cost of discovering and developing new mines is increasing, and the depletion rate of aging resources is accelerating. As new mines are developed to satisfy rising demand, the marginal cost of production increases; in such a situation, prices must rise. Natural resource owners typically have backward sloping short term supply curves during periods when marginal cost of new fields is causing a shift in the supply curve. Producer assets are safe underground and when prices are low relative to future expectations, the incentive to monetize commodities is also low. Thus supply falls despite rising prices and this drives prices up further; in fact the spread between spot and future prices creates an arbitrage opportunity which puts an upward trend on spot rates. As prices rise, profitability of the entire sector rises; the old low marginal cost fields are highly profitable offset in part by the increased cost of developing new fields.

This brings me to steel, my top industry in the basic materials sector. In steel, there are concerns about over-capacity. There are also concerns over, China having transitioned to a net exporter status from an importer. But I remain convinced that the market is not recognizing two things. The first is that over-capacity in steel has to be viewed in the context of time; the scale of growth in demand from emerging economies requires capacity expansion and it will not be long before further capacity is required. The second and perhaps more important is the complete change in the structure of the steel industry. For decades, steel producers have been fragmented. They have had a high degree of input resource dependence and little to no negotiating power versus miners and energy providers. The fragmentation has also meant that the pricing power versus customers has been weak; the intensity of competition kept a firm lid on prices even as economic expansions occurred. The consolidation in the steel industry led by Mr. Lakshmi Mittal has completely changed the face of the industry forever. Consolidation in the industry has resulted in better negotiating power versus both material users and raw material providers. In addition, steel producer investment in power and mining has reduced levels of resource dependency. But perhaps the most important aspect of consolidation has been the ability of low marginal cost producers to cut production and force inventory levels down in order to prevent a collapse in steel prices. There is no doubt that the recession we went through caused steel prices to collapse. But equally, it is clear that producer action has resulted in a situation where prices have recovered – this is quite unlike the yesteryears when steel price collapse caused a massive inventory build-up and subdued prices for an extended duration. Low marginal cost producers could and did cut inventory to and into the bone. The result, surplus inventory was rapidly depleted. The consequence; high marginal cost capacity was required post the inventory drawdown; the collapse in prices is no longer a phenomenon over an extended period of time. A consolidated steel industry acts for steel in a manner very similar to how OPEC acts for energy – welcome to the new world of steel; ignore the new era at your peril!

Sector Watch: Industrials

The next sector to evaluate is industrials. Like consumer discretionary, IT and financials, industrials outperform between a market bottom and the recession end. Of course the degree of outperformance is to a lesser degree, just as the underperformance during the period preceding the market bottom is less severe. During the 3 months following recession ends, industrials continue to outperform even as consumer discretionary, IT and financials slip in relative performance.

But during the second 3 month period following recession end, industrials suffer indignities and slip to underperform. This is a period during which interest rate rises are being contemplated; fear and caution cause a slip in performance. But once people understand that rising rates also mean that a meaningful recovery has taken hold, the negative catalyst is removed; industrials outperform in the second six month period following a recession end. Thus industrials can be expected to underperform for another month or so; and during this time we find the best entry opportunities after the very appealing valuations which are seen near market bottoms. After this period of underperformance, industrials can be expected to outperform for well over a year; this period is a buying opportunity.

Marine, Construction & Farm Machinery, Electrical Components & Equipment are likely to be outperformers in the months ahead and these industries are likely to be joined by capital goods with a slight lag. This sector has strong fundamentals; in India we have infrastructure as a great need for an emerging market. At the same time there is strong continuing commitment to the sector in China. But what I like best is that even US has reasonable expectations for the sector. Infrastructure in the US has been poorly rated in a recent survey the government is committed to shift stimulus spending to infrastructure. Roads, rail, bridges, internet highway are some areas where there will be significant investment. This is a big positive because the incremental spend on infrastructure is going to rise from sustenance investment to incremental investment. And of course business spending is likely to remain stronger than consumer spending; this gives strength to the sector on cycle relative performance.

The big negatives for industrials are (a) over owned (b) over bought (c) valuation is challenging (d) balance sheets are over leveraged and credit is tight. In addition, margins could face very considerable pressure from rising materials and energy cost. For this reason industrials as a sector are not expected to grow at the amazing pace as the recently concluded economic cycle; nonetheless growth can be expected to remain healthy and in excess of GDP growth rates.

Industrials have maintained valuation better than most sectors through the recession; strong backlogs and earnings visibility saved the sector. In addition, the theme of the India domestic driven economy has resulted in aggressive investment in the sector; while materials and energy were punished as a result of negative global secular trends, industrials were not. In my view the sector is over owned, over bought and over-valued. I do remain at market perform on the sector; however I would overweight the sector only on significant declines – it is possible that we will see this occur over the coming months.

Sector Watch: Consumer Discretionary

First financials, then IT and then Consumer Discretionary! Consumer discretionary as a sector is perhaps the most cyclical of the ten sectors. Historically consumer discretionary performs with the greatest vigor following a market bottom and through the end of the recession. For the six months following the end of a recession the sector performs broadly in line with markets. It then returns to a period of outperformance in the subsequent six months.

I am expecting a repeat performance this time round; in fact if anything I expect a period of extended outperformance. Consumer discretionary as a sector has a tendency to outperform for a period of six months after unemployment peaks. In the US, I remain of the view that unemployment has not yet peaked; job creation has likely troughed, but for unemployment to peak, I would need to see rising unemployment as people who left the labor force in US return. In India, in my view the peak in unemployment is behind us.

Consumer durables and retail in India have outperformed in line with expectation. They can be expected to continue outperformance for a period of six months. However, there is risk in new buying in these industries; the aim during periods of robust outperformance is to book profits to return to sector equal weight ahead of a downgrade to market perform. Media as a sub industry is already at a level where I rate the sub-industry at market-perform; I expect no outperformance going ahead as the juice is milked by this sub industry ahead of durables and retail. Additionally, several Indian media entities have fairly disgraceful balance sheets.

The hotels, restaurants and leisure industry within the consumer discretionary sector can be expected to outperform other consumer discretionary sub-industries over the next six months; in this sub industry, valuations are still inexpensive on a forward basis; new money can enter the segment with a higher degree of comfort compared with media, retail and durables. This sector is the main reason why discretionary tends to outperform for a six month period following an unemployment peak.

Consumer discretionary outperformance in the Indian export driven industry also has very strong cyclical outperformance potential. The strength in the Rs is a negative, but expectations for export scale expansion at this point in the cycle are too low; rising demand from developed country markets will offset any negative impact associated with exchange rates. Continuing SOP's from the government will also help. Money flows have avoided this area because of great sector negatively associated with consumer discretionary expectations in developing markets. On a cyclical basis I expect a strong reversal; US consumer discretionary sector is under-owned and oversold. Inventories have been cut into the bone and inventory building plus rising consumer demand can be expected in 2010 as unemployment starts reducing. Lending standards are also loosening and this is essential for outperformance in the sector. Inflation is contained, productivity and efficiency is vastly improved and this results in slowly rising discretionary income. Unemployment is seen as peaking in 2010; job creation and falling unemployment also create discretionary income. Negatives associated with rising savings rates, home loan, card & mortgage delinquencies and the consumer focus on deleveraging remain; but in my view the negatives are priced on a cycle basis.

The secular trend for consumer discretionary is positive in India; but negative headwinds from US exist. In the financial sector, a negative secular global trend can be expected to spread to all markets. The same is not true for consumer discretionary sector. In fact a global adverse secular trend can be a positive for India – global sector allocations can be maintained by underweighting discretionary spending in developed economies while overweighting the sector in emerging market. It is for this reason that I believe this sector will do well in the upcoming cycle; and it is for the very same reason that I would urge investor caution. Much has been said about India's domestic growth driven model with lesser reliance on exports. But remember this; if it has been said, it has been priced. Besides, India's domestic growth story will be driven first by consumer staples; we are several years away from the time that discretionary income will rise to a level where consumer discretionary can be a true secular outperformer. Consumer discretionary as a sector is very interesting for its future growth potential; but it comes with risk – discretionary income has been created for employees' country wide but the biggest creators of discretionary income come from employees in IT and financial services sectors. Both sectors have significant linkage to global secular trend. Consumer discretionary is very interesting because of its very long term growth potential; but because of high money flows into the sector, caution on valuation must be exercised.

Sector Watch: Information Technology

Information Technology follows with outperformance on the heels of financial services. Using history as a guide, IT outperforms the market between a market bottom and the end of recession. In the present cycle, we have witnessed the outperformance. During the six months following the recession end the sector underperforms and returns to market-perform in the subsequent six months. Using history as a guide, the expectation is for IT to underperform during the first half of 2010; perform in line with markets during the second half of 2010 and then return to outperformance for most of 2011.

For India, since IT is driven mainly by IT services, things might be different. The market did bottom before the end of the recession; and the recession is believed to be over. IT normally outperforms following a market bottom in anticipation of companies investing in IT to enhance productivity. It is very possible that IT will continue to prosper, because the recession end we have witnessed is not driven by private investment – it is driven by stimulus. The outperformance we have seen so far can easily be explained by a flight of capital to quality, with the outperformance coming from earnings expansion remaining to be reflected in valuations. IT companies the world over (including India) have very strong balance sheets with little debt; the crisis has resulted in the value of a strong balance sheet being appreciated by investors – and this is now reflected in valuation. Once private investment in IT starts as a private economy led end of recession is anticipated, the market valuations on IT could improve causing an extended period of sector outperformance.

This time round IT will play an even more important role; global companies have cut labor to and into the bone. Investment in IT will likely be intense, because the need for efficiency and productivity gains is critical in a HR constrained environment.

IT also has other positive factors; companies have kept investment in systems and software at low levels for several years. A return to trend levels of IT investment is likely; hardware needs upgrading and much development has occurred in software. Bank lending standards in US are slowly loosening and better access to credit is a positive for investment in IT.

Discretionary spending on IT is also likely to be strong as a private economy driven end of recession takes hold during middle of 2010. There is a lot of pent up demand and new consumer products which could lead to a very powerful replacement cycle once unemployment in US starts to decline. Actually, unemployment will probably continue to rise for a while - as people move back into the labor pool unemployment will rise. What we really have to watch out for is a turn in job creation – this will signal a coming reduction in future unemployment levels and this will be an exceptionally powerful positive. I will definitely want to be in the market ahead of the turn in job creation, which I believe is just around the corner. Bank lending standards in US are slowly loosening and this is an indication of an expectation of improved job creation going ahead. Better access to consumer credit is a positive for discretionary IT spending.

Despite the positives, I remain neutral on the sector. For IT in general and IT services in particular there are three significant negatives. The first is that companies remain reluctant to invest in IT; it is possible that the IT replacement cycle will be deferred until better long term growth is perceived – keep in mind that recent improvements in ISM and anecdotal evidence of improved IT spending are being seen. The second is great intensity of global competition; majors like Dell, IBM & HP will likely be formidable competitors to India IT service providers. The third is that the quality premium is at risk as risk aversion abates; while the sector is not expensive on forward cycle earnings basis, I believe that value expansion which follows rising earnings expectations will be offset in part by multiple contraction once money flows to low quality in anticipation of better gain potential.

IT has been under-owned since the bubble burst early in the century; the fundamentals of IT are now beginning to look long term positive and valuations still have to reflect this.

To conclude, I am positive on IT but remain at market-perform because I believe there are enough negatives ahead to provide better near term entry opportunities.