Sensex a Buy?

Back in mid October, I had cautioned on Sensex being expensive, opining a range of 17.5k for greedy investors and 18.6k for most. It's taken over three months and we are there.

In my view the markets are very near a bottom now. The markets are unlikely to fall below 17.6k – at this level there is very strong value support because the market will then be valued at historic decade median market multiples of prior year median 6 year earnings (PE6). In fact I believe the markets should bottom closer to 18.3k; but the risk of a dip below this level can come with deterioration on sentiment following any minor technical correction in the US markets.

If FY earnings come in at Rs 1,065, we are looking at a market which is valued at close to decade median PE multiples of prior year earnings of 17.15. If FY12 earnings come in at Rs 1,210, the market is valued at near median decade current year PE multiples of 15.12. Looking ahead to FY13, if we look for a 14% nominal earnings expansion (roughly 7% real and 7% inflation), we are at Rs 1,375 on earnings. Decade forward median multiples on forward year earnings of 14.6 implies a value of 20,048; this is a level not unreasonable to expect.

Median 6 year earnings have evolved with a nice pattern; historic median market multiples of median 6 year earnings (PE6) give an implied value of 19,616 for Sensex during 2011. If confidence in earnings growth resumes, the market is likely to head for levels of near 23k, where it would be valued at the 75^th percentile of PE6.

So, in my view it is now a good time to eliminate under-weights which have come about due to the market fall. It's also time to start over weighting equity, with a view to returning to market weight at 20k levels and underweight if the markets rise to over 22.5k. And now is looking like a good time to run with mid cap value stocks; especially in steel, aluminum, agri-commodities & related, energy (especially service providers) and utilities. For staples buying makes sense but perhaps after valuations are beaten down after downward revision of earnings estimates. See recent post on sector musings.

Random Musings on Sectors

Industrials are firing on all cylinders; look at GE, CAT, DE and SI; look at global auto sales for that matter. Backlogs have built up nicely. Margins remain strong too. What does this mean? Industrials tend to be basic materials resource and energy intense. Basic materials resource is also an energy intense sector. The rising backlogs in industrials together with strong margins will lead to incremental basic materials resource and energy demand. For industrials, much of the good news is priced, falling forward margins with resource and energy price sectors price pressure means the sector needs to come back to equal weight and on watch for under weight. For basic materials resources, especially steel/aluminum, look for rising earnings, margins and building backlogs; expect strong performance over six months. For energy, further gains likely; but perhaps over a nine month horizon – confidence in incremental demand for energy coming from rising basic materials resources production will take at least a quarter. Basic materials resources gains could be further enhanced by weather patterns causing havoc in Australia; agricultural commodities remain strong with shortages coming from low production expected from US/Brazil. So stay long and over weight on both energy and basic material resource (including agricultural commodities).

Strength in demand for basic material resource will likely lead to margin pressure in utilities, healthcare and staples; expect utilities and staples sectors to underperform setting up good entry points for building defensive characteristics in the portfolio; stay underweight but look for attractive entry points over next two quarters – expect to need the defensive characteristics and yield later this year!

Healthcare may remain stable because margin is less dependent on basic resource and energy and much of the concern on falling revenues in the absence of new drugs is priced – long term this is a cheap defensive sector with good yields and sound balance sheets; with the FDA getting increasingly concerned on lack of new drug development, I believe the sector is ready to emerge from a secular down trend; remain over weight. Financing growth should be a non issue with oodles of cash sitting on balance sheets; finding the IP ideas may remain a challenge, but encouragement and support from regulators can go a long way.

IT and telecom I like here for the value and yield; specially large cap software, hardware, chip and communication equipment. The sector has emerged from its secular downtrend which started in 2000; balance sheets are strong, yields are solid, valuations are attractive – and growth from all that useless fiber optic cable will now be put to good use (specially with rising energy costs pushing cost of business travel higher). Financing growth should be a non issue with loadsa cash sitting on balance sheets; finding the IP ideas may remain a challenge. It services look priced for perfection; it has already played its role in productivity enhancement during and post recession while employment remained weak; it is an area to avoid.

Financials and discretionary remain in secular down trends. I remain underweight with a view to buy on extreme declines not expected in the coming quarter or two.

It's time for sector rotation!