Mkt looks fairly valued; don't see much upside: Kotak Sec

Q: Do you see the room for earnings surprises in 2008 calendar because as we end 2008 financial , you are probably going to see earnings slightly higher than what you started the year of with in terms of expectations?

A: That’s been the big story. If one looks at last 3-4 years, whenever we started the year, we were looking at 10-15% in stored for the next year and then one had series of credits over for the last year unfolded. If one looks at FY07 fiscal year, I think we had about 36% earnings, eventually. FY08 - if I remember correctly, we started about 14% on its work projection; now we are going to end up at about 30%. Keep in mind the fact that it is because of the DLF cut included in the Index. If you exclude that it is about 24%; but is still quite high compared to from where we started the year.

As for now, FY09 assets - we are looking at about 18%-18.5% earnings growth and unfortunately if one does a micro study of sectors, there is very little scope for earnings upgrade at this point of time. If one looks at commodities, most of the commodities are trading well near their historical highs. One is starting to see some sort of pricing pressure emerging in some sectors like cements as well as telecom because of the regulatory changes that have happened in the last few months. So across sectors, I don’t think there is any scope for significant earnings upgrades at this point of time and let’s see how the performance pans out during the course of the years.

Q: But if once again like in 2007, the force of liquidity rather than rationale fundamental valuations will set stock prices, is it prudent to chase some of the contrarian sectors, which have not performed like auto and IT as you are suggesting? Or do you think that is the money which will chase the performing sectors again?

A: If you look at our portfolios of stocks that we were recommending clearly, we are overweight on auto as well as technology. I would assume there would be some re-rating as far as those sectors are concerned.

Coming to the stocks, which have already done very well; again this is all turned by liquidity - so it is a very difficult call to take on a stock on a fundamental basis, if more money comes, then you could see some of the stocks going up even further.

But I keep saying, at some point in time, the disconnect between where the stock prices are and where they should be  - the space on which the fundamentals are based - that is going to look stark. So at some point of time, those stocks will start correcting.

Q: You seem to like a whole clutch of those public sector banks - Andhra Bank, Union Bank, Corporation Bank - what makes you bullish on that lot?

A: Coming back to the original point you have raised about re-rating; the stocks have hardly performed. Plus we are also seeing interest rates cycle probably starting to soften from maybe in the early part of 2008. So that should be positive for the public sector banks.     

Q: You don’t see some of those commodity stocks reaching far higher valuation levels both in ferrous and non-ferrous?

A: Valuations are quite high. If you look at commodity stocks, there is no fundamental justification for stocks to be trading at 8-10 EV/EBITDA at the peak of the cycle; assuming that they are the peak of the cycle. And honestly, the stock would be trading at about 4-6 EV/EBITDA, not more than that to take a proper cost of capital etc.

But here you have at the peak of those cycles you have the stocks trading at about 8 EV/EBITDA - that does not make any sense. If prices go up further, then we are looking at maybe some scope for higher earnings in that case. But multiples just look too high for me. So we are not comfortable about metal stocks. Also, as far as fundamentals are concerned at least in case of both aluminium as well as zinc, we are looking at a surplus scenario in a way compared to the deficit which you saw in 2005-2006 - our calendar years.     

Q: Just a quick word on some of the energy plays upstream oil like Cairn; gas plays like GAIL, which have had significant rallies in the last couple of weeks. How are you positioned on those two stocks and what’s your recommendations?

A: Again valuations of the stocks are making sense honestly in some of the energy sector names. Cairn’s stock price is probably discounting USD 90/bbl price in perpetuity. Some sections of the markets feel that this is a take out candidate. But honestly, I’m not too sure why any company would be buying a stock, which is looking at USD 90/bbl crude price  in perpetuity. Yes, crude prices are USD 90/bbl now. But no company - be it a BPCL or a Shell will take out or any other company which is discounting something like more than USD 90/bbl price perpetuity. What does it say to the acquiring companies? It basically shows that the company is not in the position to discover oil and gas at a reasonable price – the finding cost for any company would not be more than USD 8 to 10/bbl even now. And the long-term normalized price for internal budgets or companies, I don’t think is more than USD 55/bbl. So it doesn’t give a very good signal if the company is acquiring some other company, I think on USD 90/bbl crude price kind of a range.

GAIL again, the expectation is that if one is a big beneficiary of increased gas volumes, whenever Reliance Gas starts production sometime in the second half of current year. But I think one should be careful about what’s happening with the regulatory fund. As of now, GAIL’s returns on capital employed are quite high as far as the regulatory business is concerned and would see some pressure or downward revision tariffs once framework is in place as far as gas transportation business is concerned. Also, keep in mind that GAIL earns lot of money on the LPG business as well as on its petrochemical space on the arbitrage between crude oil price and gas price in the country. And again, I don’t think one should be giving very high multiple for that kind of onstream.