74 Ambit Strategy Good & Clean Portfolio

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

Good & Clean Portfolio

THEMATIC September 23, 2013

STRATEGY

G&C 6.1

Company name Sector Weight (%)

Bajaj Auto Auto 4.3

Tata Motors Auto 4.3

Exide Auto Anc 4.3

MRF Auto Anc 4.3

Bank of Baroda BFSI 4.3

ICICI Bank BFSI 4.3

IDFC BFSI 4.3

ING Vysya Bank BFSI 2.1

LIC Housing Fin. BFSI 2.1

Larsen & Toubro Engg & Const 4.3

Engineers India Engg & Const 2.1

Voltas Engg & Const 2.1

Coal India Metals/ Mining 4.3

NMDC Metals/ Mining 4.3

Oil India Oil & Gas 4.3

Petronet LNG Oil & Gas 4.3

Cummins India Capital Goods 4.3

Power Grid Utilities 4.3

Torrent Power Utilities 2.1

Grasim Cement 4.3

HCL Technologies IT 4.3

Cadila Healthcare Pharma 2.1

Torrent Pharma Pharma 2.1

Bharti Airtel Telecom 4.3

Oberoi Realty Realty 2.1

Sobha Developers Realty 2.1

McLeod Russel Agro 2.1

Supreme Inds. Industrials 2.1

Sadbhav Engg. Infrastructure 2.1

Jagran Prakashan Media 2.1

Analyst Details

Gaurav Mehta +91 22 3043 3255 [email protected]

Karan Khanna +91 22 3043 3251 [email protected]

Saurabh Mukherjea, CFA +91 99877 85848 [email protected]

G&C 6.1: Quality at a reasonable price We follow a ‘quality at reasonable price’ approach to portfolio construction for the next iteration of our G&C portfolio which essentially leaves us with a pro-cyclical stance. With the RBI’s 20th September policy likely to lower the cost of short-term funds, with GDP growth likely to be at 5.1% in 2HFY14 (vs ~4% in 1H) and given valuations, we are comfortable with this stance. We close G&C 6.0 with a negative alpha of 8.8 percentage points (the first underperformance by a G&C portfolio) and we launch G&C 6.1. Since inception in March 2011, the G&C portfolios have generated alpha of 14 percentage points (vs BSE500).

We expect a modest economic revival in 2HFY14

The net effect of the measures announced by the RBI on 20th September is likely to drive down the cost of short-term money and flatten an inverted yield curve. We expect headline GDP growth to record a mild improvement in 2HFY14 driven by normal monsoons, higher Government expenditure growth and stronger export growth. Our GDP growth estimates are: 4.4% YoY in 1QFY14 (actual), 3.8% YoY in 2QFY14, 5.1% YoY in 3QFY14 and 5.1% YoY in 4QFY14.

Global flows situation remains conducive

The postponement of the QE taper by the US Federal Reserve means that the rise in US bond yields should be more gradual. This should help India, as the benefits of inflows and a Western economic recovery trickle through. Indeed periods of rising US bond yields have been good for the Indian equity markets and economic growth historically.

Stock picking critical in a polarised market

We remain constructive on Indian equities, although the current polarisation of Indian markets makes stock picking especially critical. We are steering clear of expensive defensives, especially the frontline consumer names. We also maintain our underweight on the Banking and Financials stocks and remain wary of high beta, speculative, broken balance sheet plays.

G&C 6.1 portfolio versus Nifty 50

Portfolio Median mcap (US$ mn)

6M ADV (US$ mn)

Median FY14 P/E (x)

Median FY14 P/B (x)

Median FY13 RoE (%) Beta

Nifty 7,668 15.9 14.6 2.1 17.1 1.00

G&C 6.1 1,761 2.8 10.5 1.6 17.0 0.96

Source: Bloomberg, Ambit Capital research

Quality at a reasonable price

Given the excessive quality premium being paid by ‘Mr. Market’, we follow a quality at a reasonable price (QARP) approach to portfolio construction. Using our proprietary greatness and forensic accounting frameworks, we look for sector leaders available at reasonable valuations to construct the Good & Clean 6.1 portfolio. We find only incremental changes versus G&C 6.0, which was an outright cyclical portfolio. We close G&C 6.0 which was launched on 13 June 2013 and has underperformed the BSE500 by 8.8 percentage points. Since inception in March 2011, the G&C portfolios have generated alpha of 14 percentage points (vs BSE500).

Good & Clean 6.1

September 23, 2013 Ambit Capital Pvt. Ltd.

CONTENTS Macroeconomic view for FY14…………………………………………………………3

We remain constructive on Indian equities………………………………………….5

Implications for portfolio strategy…………………………………………………....7

The current polarisation of Indian markets………………………………………. 10

Audit of G&C 6.0………………………………………………………………………12

Appendix 1: Overlap with ‘Magic’ formula………………………………………..14

Appendix 2: Would G&C 5.1 have done better?........................................... 16

Good & Clean 6.1


Our macroeconomic view for FY14 On 20th September, the RBI, as part of its inter-quarter monetary policy review: (1) reduced the MSF rate by 75bps to 9.5%, (2) increased the repo rate by 25bps to 7.5%, and (3) reduced the minimum daily maintenance of the CRR from 99% of the requirement to 95%. Consequently, the MSF rate, the repo rate and the reverse repo rate under the LAF now stand at 9.5%, 7.5% and 6.5% respectively. RBI highlights upside risks to inflation and the need to support the currency The RBI highlighted that whilst the decision by the US Federal Reserve to hold off tapering has buoyed financial markets, tapering is inevitable. Consequently, there is a need to prepare for this eventuality.

Secondly, whilst core inflation is expected to remain contained, two factors, namely the second round impact of diesel price increases and the effect of exchange rate depreciation, are likely to impose upside risks to inflation. Moreover, the RBI highlighted the need to guard against the hardening of inflationary expectations, which once unhinged are near impossible to contain (see Exhibit 1 below).

Exhibit 1: RBI’s latest survey points to the continued hardening of inflationary expectations (from already elevated levels)

Source: RBI, Ambit Capital research

Finally, the RBI highlighted the need to reduce the INR’s vulnerability to macroeconomic shocks by actively improving the internal determinants of the value of the INR, namely the fiscal deficit and domestic inflation.

In view of each of these considerations namely, the need to prepare for the eventual tapering of monetary policy by the Fed as well as the need to check inflation, the RBI administered a repo rate increase of 25bps.

Furthermore, in view of the financial stability generated by the Fed’s postponement to taper, the RBI began the process of normalising the non-traditional monetary policy measures in July 2013 and hence it cut the MSF rate by 75bps. Given that liquidity conditions are in deficit mode, the MSF rate is currently the operational policy rate. Hence, the net effect of the RBI’s measures is likely to drive down the cost of short-term money. Even though the repo rate is not the current operational policy rate, an increase in the same signals to the market a shift to a hawkish stance which is likely to drive up the cost of money across the maturity spectrum. Therefore, the RBI both flattened the inverted yield curve and shifted it upwards by 25bps. This is exactly what we had said the RBI should do in our 2nd September and 11th September notes.

9.5%

10.0%

10.5%

11.0%

11.5%

12.0%

12.5%

13.0%

Jun-13 Dec-12 Mar-13 Jun-13 Sep-13(Qtr ahead)

June-14(Yr ahead)

Infla

tion

Expc

tatio

ns (Y

oY, i

n %

)

The RBI has flattened the inverted yield curve while pushing it upwards by 25bps.

Good & Clean 6.1


Where do we go from here? Given that the governor has clarified that his priorities are likely to be: (1) defending the currency, and (2) capping inflationary expectations for now, we reiterate our view of rate increases of another 25-50bps being administered in the rest of FY14. This is likely to be accompanied by the stabilisation of the MSF corridor (cumulatively by 100bps) which is likely to be concentrated upon from September to October 2013, as the next Fed meeting is scheduled for end-October 2013. It is critical to note that as highlighted by the policy document, these actions may or may not be scheduled on policy dates. In fact, it seems highly likely that the RBI will move before the next policy date. There is a high probability that the next round of intervention is administered in mid-October 2013 i.e. ahead of RBI’s early-November policy review and ahead of the Fed’s end-October policy review. What is likely to be the shape of GDP growth, inflation and exchange rates over the rest of FY14? In anticipation of the coming change in monetary policy stance and recognising that now neither monetary nor fiscal policy can support growth, in our note dated 2 September 2013, we lowered our headline GDP growth forecast for FY14 to 4.7% YoY. As regards the quarterly trajectory of GDP growth in FY14, we expect GDP growth in 2QFY14 to come under significant pressure, as the RBI’s tight monetary policy measures will crimp growth through July-September. From thereon, we expect headline GDP growth to record a mild improvement in 2HFY14 driven by: (1) normal monsoons, (2) higher Government expenditure growth on a YoY basis, and (2) the lagged impact of project clearances pushed by the Government in 1HFY14 as well as export growth supporting manufacturing sector growth. In specific, we expect GDP growth in the rest of FY14 to be as follows: 4.4% YoY in 1QFY14 (actual), 3.8% YoY in 2QFY14, 5.1% YoY in 3QFY14 and 5.1% YoY in 4QFY14. As regards, inflation we expect headline inflation to inch upwards in 2HFY14 mainly driven by the second round impact of diesel price increases and the impact of the currency depreciation driving price rises. Owing to the combined impact of these dynamics, we expect WPI inflation to be recorded at ~6.5% YoY in 4QFY14 (up from the average 5.3% YoY inflation recorded in April-August 2013). Finally, moving on to the vexed issue of the exchange rate, whilst we see the fundamental fair value of the currency at Rs56-58/USD given that currency markets are reeling under the impact of an oncoming macroeconomic shock (i.e. the prospects of the Fed tapering) the actual value seems likely to continue deviating from the fundamental value. Our discussions with policy experts suggest that the new governor is likely to draw a red line at Rs65/USD and is likely to use his improved armoury of: (1) the US$50bn BoJ swap-line, (2) India’s enhanced ability to borrow from the World Bank, and (3) the RBI’s US$250bn of FX reserves, to defend this level.

There is a high probability that the next round of RBI intervention is administered in mid-October 2013 i.e. ahead of RBI’s early-November policy review and ahead of the Fed’s end-October policy review.

We expect GDP growth in 2Q FY14 to be 3.8% YOY (vs 4.4% in 1Q FY14).

The new governor is likely to draw a red line at Rs65/USD.

Good & Clean 6.1


We remain constructive on Indian equities If we leave the domestic macroeconomic situation aside, then the global flows case for India has strengthened. The Fed’s decision on 18th September to postpone the QE ‘taper’ should mean that the rise in US bond yields will not be sharp and spiky as had seemingly been factored in thus far by the markets. A gradual rise in US bond yields should allow sufficient time for the benefits of a gradual recovery in the Western economies to trickle through to the rest of the world. In addition, this should allow capital inflows to remain healthy for India, not just helping equity markets but also alleviating concerns on the balance of payments situation. We thus remain constructive on Indian equities.

Indeed, historically, rising US bond yields have augured well for the Indian market (see Exhibit 2). A simple explanation of this relationship can be traced to the fact that rising US yields correspond to a stronger US economy and rising investor confidence which in turn help markets and economies like India.

Rising yields would naturally push the cost of equity higher (by increasing the risk-free rate). However, an improving recovery should cause the risk premium to move lower. Therefore, rising yields accompanied by an improving economy will thus have two offsetting effects on the cost of equity - the yield rise will pull it higher whilst an improving economy should push it lower. Beyond a point, however, the rise in rates will kill the growth itself too and cause the risk premium to move decisively higher. That was the fear created by the Fed’s 19th June announcement on QE being throttled off completely by summer 2014.

Thankfully, the Fed’s 18th September announcement, which seems to suggest that the QE withdrawal would have no pre-specified calendar, should mean that the pace of the rise in bond yields has been moderated and hence the growth recovery in the US should now be the dominant effect, thus pushing the equity risk premium lower (and hence equity prices higher).

Exhibit 2: Rising US bond yields have historically been positive for Indian equities


For readers not fully convinced with the visual representation of the argument shown above, we present a more quantified version in the table that follows on the next page. The table summarises the returns for the S&P500, MSCI Emerging Markets Index and Sensex alongside GDP growth rates for India and the US, in each of these sub-periods. In all of the five periods in which the US ten-year bond yield rose, the Sensex comprehensively outperformed the S&P500; the exception is the fifth period (beginning 8 July 2012), during which the S&P 500 rose 5% and the Sensex rose 3% on a quarterly average basis.

Fed’s decision to postpone QE ‘taper’ should slow the upward trajectory of US bond yields without altering its direction

This should be positive for Indian capital inflows and equity prices

Good & Clean 6.1


Exhibit 3: Quantification of equity and economic performance in periods of rising US bond yields

Period (and US ten-year bond yield change) Particulars

US ten-year bond yield change (in %)

S&P 500 returns

MSCI EM returns

Sensex returns

US GDP growth (%YoY)

India GDP growth (%YoY)

Period 1 (from 5.4% to 7.9%)

start date: 31/10/1993

end date: 08/01/1995

Q1 Oct-Dec 0.4 2% 32% 23% 2.6 5.7*

Q2 Jan-Mar 0.9 -4% -9% 13% 3.4 5.7*

Q3 Apr-Jun 0.6 0% -2% 8% 4.2 6.4*

Q4 Jul-Sep 0.3 4% 20% 5% 4.3 6.4*

Q5 Oct-Dec 0.2 -1% -15% -8% 4.1 6.4*

sub-period average

0.5 0% 5% 8% 3.7 6.1*



end date: 06/02/2000

Q1 Oct-Dec 0.2 21% 17% -2% 5.0 5.9

Q2 Jan-Mar 0.6 5% 12% 22% 4.9 5.9

Q3 Apr-Jun 0.5 7% 24% 11% 4.8 6.9

Q4 Jul-Sep 0.1 -7% -5% 15% 4.8 6.0

Q5 Oct-Dec 0.6 15% 25% 5% 4.9 5.7

sub-period average 0.4 8% 15% 10% 4.9 6.1



end date: 15/07/2007

Q1 Jul-Sep 0.4 2% 14% 23% 3.2 8.9

Q2 Oct-Dec 0.3 12% 17% 31% 4.3 11.0

Q3 Jan-Mar -0.4 1% 9% -4% 4.4 8.4

Q4 Apr-Jun 0.7 1% -10% -14% 4.2 8.3

Q5 Jul-Sep -0.5 -2% 7% 16% 3.4 7.1

Q6 Oct-Dec 0.1 9% 17% 18% 3.1 5.5

Q7 Jan-Mar 0.3 -3% 1% -2% 3.6 9.0

Q8 Apr-Jun -0.6 1% 3% 11% 3.4 9.4

Q9 Jul-Sep 0.4 3% 17% 20% 3.3 8.9

Q10 Oct-Dec 0.1 2% 7% 9% 3.0 9.6

Q11 Jan-Mar 0.5 4% 12% 20% 3.2 9.9

Q12 Apr-Jun 0.3 -2% -5% -6% 2.9 9.3

Q13 Jul-Sep -0.5 5% 4% 17% 2.2 9.8

Q14 Oct-Dec 0.1 6% 17% 11% 2.4 9.4

Q15 Jan-Mar -0.1 0% 2% -5% 1.2 9.8

Q16 Apr-Jun 0.4 6% 14% 12% 1.7 9.7

sub-period average

0.1 3% 8% 10% 3.1 9.0



end date: 17/04/2011

Q1 Jan-Mar 0.5 -12% 1% 1% -3.5 3.5

Q2 Apr-Jun 0.9 15% 34% 49% -4.1 5.9

Q3 Jul-Sep -0.2 15% 20% 18% -3.3 9.3

Q4 Oct-Dec 0.5 5% 8% 2% -0.2 7.7

Q5 Jan-Mar 0.0 5% 2% 0% 1.6 11.4

Q6 Apr-Jun -0.9 -12% -9% 1% 2.7 9.5

Q7 Jul-Sep -0.4 11% 17% 13% 3.0 8.6

Q8 Oct-Dec 0.8 10% 7% 2% 2.8 9.2

Q9 Jan-Mar 0.2 5% 2% -5% 2.0 9.9

sub-period

average 0.1 5% 9% 9% 0.1 8.3



till date

Q1 Oct-Dec 0.1 -1% 5% 4% 2.0 4.7

Q2 Jan-Mar 0.1 10% -2% -3% 1.3 4.8

Q3 Apr-Jun 0.6 2% -9% 3% 1.4 4.4

Q4 Jul-till date 0.3 7% 9% 6% NA NA

sub-period

average 0.3 5% 1% 3% 1.6 4.6

Avg for these 5subperiods 0.2 4% 8% 9% 2.6 8.0

Overall avg for the period (Sep-92 till date) -0.1 2% 2% 3% 2.6 7.0


Good & Clean 6.1


Implications for portfolio strategy Even with a constructive stance towards Indian equities, choosing the right pockets is important especially in a market as polarised as this (we summarise some key dimensions of this polarisation in Exhibits 6-9 on page 10). Our thoughts on portfolio strategy are summarised below. We begin with the pockets that we look to avoid.

Underweight Banking & Financial Services: As has been the case over the past 14 months, we remain significantly underweight on this sector owing primarily to structural concerns on asset quality, intensifying competitive intensity around the eight new bank licences that look likely to be given in March 2014 and higher cost of deposits for Indian banks (after the RBI’s relaxation in branch opening norms in tier-1 cities).

SELL expensive defensives: The valuation premium of defensives to the rest of the market is at historical highs, as pessimism and weak macroeconomic conditions have led to extreme risk aversion over the last few years (see Exhibit 6 on page 10). We believe valuations are overstretched in most of the key defensive names (eg. ITC, HUL, GSK Consumer, Sun Pharma), leaving little margin for safety. On a bottom-up basis, we see increased risk especially to the high-flying FMCG names (see our Consumer team’s note dated 4 June 2013).

Wary of high beta, speculative plays: Even with a constructive stance on equity markets and with the expectation of an economic revival in 2HFY14, we see limited hope for broken balance sheet, high beta plays at this stage of the cycle and hence we stay clear of these stocks. The cost of capital – debt and equity – will stay high in India for some years to come and hence it will be difficult for the broken balance sheet companies to function normally.

This then leads us to the key question of what should investors BUY then?

Quality at a reasonable price (QARP) Given the extreme premium placed on quality these days, we follow a quality at a reasonable price (QARP) approach, pretty much regardless of the sector.

We thus look to buy stocks which are sector leaders in terms of quality as assessed on a combination of our proprietary ‘greatness’ and ‘forensic’ accounting models (whilst our ‘greatness’ framework tests for demonstrated consistent financial improvements over long periods historically, our ‘forensic’ accounting framework tests for the quality of financial reporting).

Of these quality names, we then look for stocks still trading at reasonable valuations (i.e. they should be cheap on at least P/E, P/B or EV/EBITDA with respect to their own five-year average valuations). This leads to our new Good & Clean portfolio, G&C 6.1, presented in Exhibit 4.

Unsurprisingly, the quality and reasonable valuation approach gives the portfolio a ‘cyclical’ tilt. We find no Consumer names in the portfolio and very few names from the Pharma and Technology sectors.

Changes from G&C 6.0 (launched on 13 September 2013) G&C 6.0 was an outright pro-cyclical portfolio, wherein we had deliberately avoided sectors such as Consumers, Pharma and IT. With a QARP approach whilst we still essentially end up with a pretty much pro-cyclical portfolio, there are a few changes:

Additions: HCL Tech, MRF, LIC Housing Fin, Supreme Inds, Coal India, Petronet LNG, Cadila Healthcare, Torrent Pharma, and McLeod Russel.

Deletions: Prestige Estates, Siemens, Bharat Electronics.

We remain wary of the BFSI space, expensive defensives and high beta, speculative plays

With quality being ultra-expensive, we follow the quality at a reasonable price approach to portfolio construction

http://webambit.ambit.co/reports/Ambit_ConsumerStaples_SectorInitiation_04Jun2013.pdf

Good & Clean 6.1


Exhibit 4: G&C 6.1

Company name Bloomberg Sector Stock

weight (%)

Mcap (US$ mn)

6-mnth ADV (US$

mn)

Latest Debt: Equity

3-yr EPS CAGR (%)

3-yr avg RoE (%)

3-yr avg PBITM

(%)

FY14 P/E

FY14 P/B

Bajaj Auto BJAUT IN Auto 4.3 9,202 13.1 0.0 24.9 58.4 21.7 16.3 5.1

Tata Motors TTMT IN Auto 4.3 15,841 43.3 1.4 53.3 49.9 10.0 8.8 2.2

Exide EXID IN Auto Anc 4.3 1,713 2.4 0.0 3.2 21.3 15.0 16.7 3.1

MRF MRF IN Auto Anc 4.3 879 3.5 0.6 32.4 20.0 7.9 7.3 1.7

Bank of Baroda BOB IN BFSI 4.3 3,699 13.7 NA 9.3 20.1 NA 5.1 0.7

ICICI Bank ICICIBC IN BFSI 4.3 18,189 73.9 NA 26.1 13.1 NA 11.6 1.6

IDFC IDFC IN BFSI 4.3 2,396 19.2 NA 13.8 13.8 NA 7.5 1.0

ING Vysya Bank VYSB IN BFSI 2.1 1,497 1.6 NA 25.0 13.5 NA 11.8 1.4

LIC Housing Fin. LICHF IN BFSI 2.1 1,672 12.9 NA 11.2 20.3 NA 8.4 1.4

Larsen & Toubro LT IN Engg & Const 4.3 12,499 41.6 1.7 (2.6) 16.2 15.6 15.5 2.1

Engineers India ENGR IN Engg & Const 2.1 921 0.5 - 20.9 35.1 28.9 10.2 2.3

Voltas VOLT IN Engg & Const 2.1 396 1.8 0.2 (18.7) 19.4 7.4 12.1 1.4

Coal India COAL IN Metals/ Mining 4.3 30,408 12.8 0.0 21.9 38.6 28.7 10.9 3.4

NMDC NMDC IN Metals/ Mining 4.3 7,829 6.2 - 20.9 32.2 90.0 8.0 1.6

Oil India OINL IN Oil & Gas 4.3 4,472 4.6 0.0 10.0 19.9 47.4 7.4 1.3

Petronet LNG PLNG IN Oil & Gas 4.3 1,497 2.1 0.8 43.0 29.4 7.3 10.1 1.8

Cummins India KKC IN Capital Goods 4.3 1,809 2.0 - 20.3 31.1 19.9 15.6 4.3

Power Grid PWGR IN Utilities 4.3 7,507 6.2 2.5 24.3 15.4 63.8 10.0 1.5

Torrent Power TPW IN Utilities 2.1 543 0.4 1.1 (23.2) 18.0 21.3 9.2 0.5

Grasim GRASIM IN Cement 4.3 4,132 3.3 0.3 (4.5) 14.6 19.0 9.8 1.2

HCL Technologies HCLT IN IT 4.3 11,825 20.2 0.3 21.3 25.6 15.3 15.0 4.3

Cadila Healthcare CDH IN Pharma 2.1 2,237 1.5 0.9 (6.4) 29.5 17.9 18.5 3.9

Torrent Pharma TRP IN Pharma 2.1 1,200 0.8 0.5 21.5 31.0 17.8 14.7 4.2

Bharti Airtel BHARTI IN Telecom 4.3 21,960 25.8 1.3 (37.7) 8.6 14.7 31.4 2.3

Oberoi Realty OBER IN Realty 2.1 896 0.4 - (1.2) 15.1 66.2 8.3 1.2

Sobha Developers SOBHA IN Realty 2.1 442 0.9 0.6 16.5 10.5 27.2 9.4 1.2

McLeod Russel MCLR IN Agro 2.1 452 1.4 0.2 5.3 16.6 25.8 8.2 1.3

Supreme Inds. SI IN Industrials 2.1 660 0.3 0.5 22.7 38.5 13.1 13.1 3.8

Sadbhav Engg. SADE IN Infrastructure 2.1 144 0.3 3.2 (47.6) 8.6 12.8 11.3 0.7

Jagran Prakashan JAGP IN Media 2.1 442 0.2 0.5 6.4 26.4 20.5 12.5 2.6


Good & Clean 6.1


Implied sector weights G&C 6.1 has been built on a bottom-up basis i.e. we have searched for the best companies which are available at reasonable valuations. However, the portfolio has implicit sector weights and these are shown in the table below.

The three sectors where we are most overweight in G&C 6.1 are: Auto Ancillaries, Engineering & Construction and Metals/Mining.

The three sectors where we are most underweight in G&C 6.1 are: Banking & Financial Services, FMCG and IT.

Exhibit 5: Implied sector weights for G&C 6.1

Implied sector weight (%)

Sector G&C 6.1 Delta between G&C 6.1 and BSE200

Delta between G&C 6.1 and G&C 6.0

Agro 2.1 2.1 2.1

Auto 8.5 1.9 (1.7)

Auto Anc 8.5 7.4 3.4

BFSI 17.0 (7.0) (0.9)

Capital Goods 4.3 3.1 (6.0)

Cement 4.3 2.3 (0.9)

Chemicals - (0.2) -

Conglomerate - (4.1) -

Consumer Durable - (0.2) -

Engineering & Construction 8.5 8.4 4.3

Fertilizers - (0.4) -

FMCG - (15.0) -

Industrials 2.1 2.0 (0.4)

Infrastructure 2.1 1.5 (0.4)

IT 4.3 (9.3) 4.3

Logistics - (0.2) -

Media 2.1 1.4 (0.4)

Metals/ Mining 8.5 3.9 3.4

Miscellaneous - (0.4) -

Oil & Gas 8.5 (2.2) 3.4

Pharma 4.3 (2.7) 4.3

Realty 4.3 3.8 (3.4)

Retail - (0.6) -

Shipping - (0.2) -

Telecom 4.3 1.7 (0.9)

Utilities 6.4 3.1 (1.3)

Source: Capitaline, Bloomberg, Ambit Capital research

QARP essentially leads to a pro-cyclical portfolio as reasonably priced quality stocks in defensive sectors are a rarity these days

Good & Clean 6.1


The current polarisation of Indian markets Exhibit 6: The valuation premium of defensives to cyclicals is at a multi-year high


Exhibit 7: ‘Value’ has been completely out of favour of late


Exhibit 8: Small-cap to large-cap valuation discount at an extreme…


Exhibit 9: … as is the valuation discount of mid-cap to large-cap


0.0

1.0

2.0

3.0

4.0

5.0

6.0

-

3,000

6,000

9,000

12,000

15,000

18,000

Feb-

04

Jun-

04

Oct

-04

Feb-

05

Jun-

05

Oct

-05

Feb-

06

Jun-

06

Oct

-06

Feb-

07

Jun-

07

Oct

-07

Feb-

08

Jun-

08

Oct

-08

Feb-

09

Jun-

09

Oct

-09

Feb-

10

Jun-

10

Oct

-10

Feb-

11

Jun-

11

Oct

-11

Feb-

12

Jun-

12

Oct

-12

Feb-

13

Jun-

13

Sensex (LHS) PB ratio (defensives to cyclicals, RHS)

0.20 0.30 0.40 0.50 0.60 0.70

Jul-

05

Jan-

06

Jul-

06

Jan-

07

Jul-

07

Jan-

08

Jul-

08

Jan-

09

Jul-

09

Jan-

10

Jul-

10

Jan-

11

Jul-

11

Jan-

12

Jul-

12

Jan-

13

Jul-

13

BSE Small Cap Index P/B to BSE Sensex P/B

0.30 0.40 0.50 0.60 0.70 0.80 0.90

Jul-

05

Jan-

06

Jul-

06

Jan-

07

Jul-

07

Jan-

08

Jul-

08

Jan-

09

Jul-

09

Jan-

10

Jul-

10

Jan-

11

Jul-

11

Jan-

12

Jul-

12

Jan-

13

Jul-

13

BSE Mid Cap Index P/B to BSE Sensex P/B

Good & Clean 6.1


The RBI policy and the polarisation How does the recent RBI policy change the shape of this polarisation? The market’s reaction post the RBI policy review on 20 September 2013 suggests that the market has been perturbed by the repo rate increase. Whilst clearly this has obvious implications for the economy, one should not overlook the fact that the inverted yield curve is being flattened too, i.e. rates at the shorter end are indeed coming down. Whilst the effect of the repo rate increase is obviously negative, the effect of the inverted yield curve being flattened will be positive for the economy, as it lowers the cost of funds for financial intermediaries.

Indeed a significant part of the underperformance of our pro-cyclical G&C 6.0 portfolio has been accompanied by the inversion of the yield curve. Historically, an inverted yield curve has been good for defensives on a relative basis, whilst a normal/steep yield curve favours cyclicals (see the exhibit below).

Exhibit 10: The recent bout of underperformance by cyclicals has been on the back ofan inversion in the yield curve


Usually, rising repo rates lead to a yield curve inversion, which is hence obviously negative for the economy. However, since the current repo rate increase is accompanied by the flattening of an inverted yield curve, it is not obvious that it carries particularly potent negative implications.

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PB ratio, defensives to cyclicals Yield differential, 1yr minus 10yr

An inverted yield curve has favoured defensives over the last few months

This time the repo rate increase is not being accompanied by an inverting yield curve but in fact by the flattening of an inverted yield curve

Good & Clean 6.1


Audit of G&C 6.0 The last iteration of our Good & Clean portfolio has underperformed the BSE500 by 880bps since June 2013, thus dragging the overall outperformance of the G&C family of portfolios down to 14 percentage points (vs the BSE500) since inception in March 2011. Here are a few thoughts from a deeper dive into this underperformance:

This recent underperformance has been due to factors predominantly centered on a combination of weaker-than-expected GDP growth alongside the yield curve inversion (kicked off by the RBI in mid-July).

At a sector level, our overweights in the Industrials (E&C, Infra, Capital Goods and Industrials) and Realty sectors have contributed to the underperformance as has our underweight in Information Technology.

Stock selection in the Utilities and Energy also contributed to underperformance.

On the other hand, overweights in Telecom and stock selection in Consumer discretionary (Auto) worked in our favour.

Exhibit 11: Audit of G&C 6.0

Price (INR)

Ticker Stock Stock weight (%) 12-Jun-13 20-Sep-13 Performance

TTMT IN Tata Motors 5.1 294 338 15.3%

BJAUT IN Bajaj Auto 5.1 1,743 1,992 14.3%

BOB IN Bank of Baroda 5.1 652 550 -15.6%

ICICIBC IN ICICI Bank 5.1 1,081 987 -8.7%

IDFC IN IDFC 5.1 143 99 -30.5%

VYSB IN ING Vysya Bank 2.6 633 501 -20.9%

OINL IN Oil India 5.1 557 467 -16.2%

NMDC IN NMDC 5.1 112 124 10.1%

TPW IN Torrent Power 2.6 125 72 -42.3%

PWGR IN Power Grid 5.1 108 102 -5.9%

BHARTI IN Bharti Airtel 5.1 278 344 23.9%

EXID IN Exide 5.1 129 126 -1.9%

ENGR IN Engineers India 2.6 151 171 13.7%

LT IN Larsen & Toubro 5.1 931 846 -9.1%

VOLT IN Voltas 5.1 84 75 -10.1%

OBER IN Oberoi Realty 2.6 198 171 -13.8%

PEPL IN Prestige Estates 2.6 153 137 -10.6%

SOBHA IN Sobha Developers 2.6 357 282 -20.9%

JAGP IN Jagran Prakashan 2.6 91 83 -8.6%

GRASIM IN Grasim 5.1 2,780 2,821 1.5%

KKC IN Cummins India 5.1 452 409 -9.4%

SIEM IN Siemens 5.1 561 480 -14.5%

BHE IN Bharat Electron 2.6 1,349 1,084 -19.6%

SADE IN Sadbhav Engg. 2.6 104 60 -42.5%

G&C 6.0 weighted returns (%) (7.2)

BSE500 index (%) 7164.91 7280.9 1.6

G&C 6.0 alpha (%, since Jun ’13) (8.8)

Cumulative Alpha (%, since Mar ’11) 14.2

Source: Bloomberg

The pro-cyclical G&C 6.0 portfolio has underperformed by 880bps since June 2013

The cumulative alpha for the G&C series is now down to 14% points since inception in March 2011

Good & Clean 6.1


Exhibit 12: G&C series - cumulative performance

Source: Ambit Capital research

-15-10-505

10152025

G&C 1 G&C 2 G&C 3 G&C 4 G&C 5.0 G&C 5.1 G&C 6.0

Alp

ha (%

)

G&C iteration

G&C iteration alpha (vs BSE500) cumulative alpha (vs BSE 500)

Good & Clean 6.1


Appendix 1: Overlap with ‘Magic’ formula Our 13 September 2013 note had discussed another approach of identifying candidates that offer quality at a reasonable price (QARP), viz, the ‘Magic’ formula approach. Joel Greenblatt’s Magic Formula (in his book ‘The Little Book that Beats the Market’) ranks firms on a combination of the following two ratios: (1) a firm’s EBIT as a proportion of its net fixed assets plus net working capital - this ratio is akin to an adjusted RoCE; and (2) the firm’s EBIT as a proportion to its enterprise value - this ratio is akin to a firm’s earnings yield adjusted for capital structure.

We modify these measures slightly to arrive at the following two measures for return ratio and earnings yield respectively:

Our ‘return ratio’ is pre-tax RoCE which includes interest and dividend income along with EBIT in the numerator and total capital including cash in the denominator.

Our ‘earnings yield’ has the same numerator as pre-tax RoCE and the denominator is market value of capital (debt as well as equity without excluding cash).

We rank the BSE200 firms on both these parameters individually. We then add the two ranks to arrive at cumulative ranks for each firm; thus, the firms which receive high scores have both good return ratios and inexpensive valuations. Based on these scores, we then rank the firms into quintiles. The performance of quintiles is presented in Exhibit 11 and suggests that the ‘magic’ does work.

Exhibit 13: Magic formula over the last 16 years on average return basis

Source: Capitaline, Bloomberg, Ambit Capital research

In the following exhibit, we highlight the first quintile of firms that currently rank the best on the ‘magic formula’ amongst the BSE200 firms. These firms should thus provide the best mix of RoCEs and valuations.

It is interesting to note the overlap between this list and the current G&C 6.1 portfolio - 14 of these 28 stocks find a place in G&C 6.1. These names include Tata Motors, HCL Tech, Bajaj Auto, Cummins, Exide, Engineers India, Voltas, Coal India, NMDC, Oil India, Grasim, Torrent Pharma, MRF and McLeod Russel.

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1997

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2001

2003

2005

2007

2009

2011

2013Gro

wth

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NR

100

inve

sted

in '9

7

Year

Performance of 'magic' quintiles

Q1 21%

Q2 18%

Q3 13%

Q4 13%

Q5 6%

CAGR

The ‘magic’ formula strikes a balance between high quality and reasonable valuations

http://webambit.ambit.co/reports/Ambit_Strategy_Thematic_13Sept2013.pdf

Good & Clean 6.1


Exhibit 14: The current first quintile on ‘magic formula’ from the BSE200 universe

Ticker Name Bottom-up stance

Mcap (US$ mn)

FY13 RoCE*

Current Earnings Yield*

FY14 EV/EBITDA FY14 P/E FY14 P/B

WPL IN Wockhardt Not rated 1,056 43% 23% 4.7 5.2 1.8

GMDC IN* GMDC Not rated 420 38% 27% 3.2 4.8 0.9

COAL IN Coal India Not rated 28,434 55% 14% 6.3 10.5 3.2

NMDC IN NMDC Not rated 7,438 37% 20% 3.8 7.8 1.5

ENGR IN Engineers India Buy 895 41% 15% 6.1 10.1 2.3

BHEL IN BHEL Sell 5,465 33% 26% 4.7 7.7 1.1

OINL IN Oil India Not rated 4,325 28% 18% 3 7.4 1.3

CAIR IN Cairn India Sell 9,797 25% 19% 3.8 5.7 1.1

KKC IN Cummins India Buy 1,685 43% 9% 13.1 14.8 4.1

HEXW IN Hexaware Tech. Not rated 590 36% 11% 6.8 10.4 2.7

BJAUT IN Bajaj Auto Buy 8,953 59% 7% 12.3 16 5.8

AMRJ IN Amara Raja Not rated 779 42% 9% 8.4 14.7 3.8

HZ IN Hindustan Zinc Not rated 8,580 25% 14% 4.9 8.7 1.5

MRF IN* MRF Not rated 866 24% 14% 4.2 7.4 1.7

APTY IN Apollo Tyres Sell 505 20% 20% 3.5 4.9 0.8

ONGC IN ONGC Buy 39,116 23% 14% 4.2 9.2 1.5

TRP IN Torrent Pharma Not rated 1,154 33% 8% 10.1 14.5 4.1

MPHL IN Mphasis Not rated 1,401 23% 11% 7.1 11.7 1.9

GRASIM IN Grasim Not rated 3,513 16% 16% 5.5 8.6 1

TTMT IN Tata Motors Buy 15,968 20% 11% 4.4 9.2 2.3

INFO IN Infosys Sell 28,334 37% 7% 12.7 17.9 4

VOLT IN Voltas Buy 345 17% 12% 6.6 10.5 1.2

UNTP IN United Phosphorus Not rated 940 16% 13% 4.6 6.7 1.1

HCLT IN HCL Technologies Buy 11,570 38% 7% 10.1 15.2 4.3

BHE IN Bharat Electronics Not rated 1,501 18% 12% 6.1 10.6 1.3

MCLR IN McLeod Russell Not rated 452 18% 12% 6.4 8.2 1.4

ACC IN ACC Sell 2,999 23% 9% 8.4 15.2 2.4

EXID IN Exide Buy 1,680 27% 7% 10.2 16.7 3.1

Source: Capitaline, Bloomberg, Ambit Capital research. Note: We have removed Indraprastha Gas, MCX, Petronet LNG, Gujarat State Petronet and GAIL owing to the specific nature of their sectors. * RoCEs and earnings yields based on FY12 financial statements for GMDC and MRF; arranged by ‘magic’ score; RoCE is pre-tax RoCE which includes interest and dividend income along with EBIT in the numerator and total capital including cash in the denominator; earnings yield has the same numerator as pre-tax RoCE and the denominator is market value of capital (debt as well as equity without excluding cash)

Good & Clean 6.1


Appendix 2: Would G&C 5.1 have done better? Since our decisive shift into cyclicals with G&C 6.0, some clients have suggested that we should stop acting as portfolio managers and give clients the best stocks in India from our models irrespective of sectoral considerations. We highlight the G&C 5.1 portfolio here (which was launched on 1 March 2013 and closed on 13 June 2013) which captures the best stocks from all major sectors on our proprietary Greatness and forensic accounting frameworks. Had we not closed G&C 5.1 on 13 June 2013, between 1 March 2013 and 20 September 2013, the portfolio would have outperformed the BSE500 by 1.5%.

Exhibit 15: Audit of G&C 5.1 launched on 1 March 2013 (and assuming we had closed it on 20 September).

Ticker Stock Sector Performance EIM IN Eicher Motors Auto 25% TTMT IN Tata Motors Auto 18% BJAUT IN Bajaj Auto Auto 1% KMB IN Kotak Mahindra Bank BFSI 13% CUBK IN City Union Bank BFSI -20% BOB IN Bank of Baroda BFSI -21% IIB IN IndusInd Bank BFSI 0% MMFS IN MM&FS BFSI 34% TCS IN TCS IT 29% OFSS IN Oracle Fin. Serv. IT 6% HCLT IN HCL Technologies IT 47% PLNG IN Petronet LNG Oil & Gas -11% IOCL IN IOCL Oil & Gas -24% GAIL IN GAIL (India) Oil & Gas 2% OINL IN Oil India Oil & Gas -12% COAL IN Coal India Metals/ Mining -3% NMDC IN NMDC Metals/ Mining -10% HZ IN Hind. Zinc Metals/ Mining 17% TPW IN Torrent Power Utilities -56% PWGR IN Power Grid Utilities -3% APNT IN Asian Paints FMCG 14% SKB IN GlaxoSmith C H L FMCG 9% NEST IN Nestle India FMCG 6% ITC IN ITC FMCG 21% CDH IN Cadila Healthcare Pharma -10% LPC IN Lupin Pharma 48% GLXO IN Glaxosmith Pharma Pharma 17% IDEA IN Idea Cellular Telecom 38% BHARTI IN Bharti Airtel Telecom 7% TTAN IN Titan Retail -11% BATA IN Bata India Retail 11% EXID IN Exide Auto Anc 1% APTY IN Apollo Tyres Auto Anc -12% ENGR IN Engineers India Engineering & Construction -10% LT IN Larsen & Toubro Engineering & Construction -7% VOLT IN Voltas Engineering & Construction -5% OBER IN Oberoi Realty Realty -38% PEPL IN Prestige Estates Realty -20% SOBHA IN Sobha Developers Realty -28% JAGP IN Jagran Prakashan Media -14% Z IN Zee Entertainment Media 3% TTKPT IN TTK Prestige Consumer Durable 13% GRASIM IN Grasim Cement -5% MC IN Madras Cement Cement -24% KKC IN Cummins India Capital Goods -14% SIEM IN Siemens Capital Goods -5% CRISIL IN CRISIL Miscellaneous 29% SI IN Supreme Industrials 3% BHE IN Bharat Electronics Industrials -4% SADE IN Sadbhav Engg. Infrastructure -45% G&C 5.1 weighted returns (%) 3.1 BSE500 index (%) 1.6 G&C 5.1 alpha (%, since Mar ’13) 1.5 Source: Bloomberg

Good & Clean 6.1


Institutional Equities Team

Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 [email protected]

Research

Analysts Industry Sectors Desk-Phone E-mail

Aadesh Mehta Banking / NBFCs (022) 30433239 [email protected]

Achint Bhagat Cement / Infrastructure (022) 30433178 [email protected]

Ankur Rudra, CFA Technology / Telecom / Media (022) 30433211 [email protected]

Ashvin Shetty Automobile (022) 30433285 [email protected]

Bhargav Buddhadev Power / Capital Goods (022) 30433252 [email protected]

Dayanand Mittal Oil & Gas (022) 30433202 [email protected]

Gaurav Mehta Strategy / Derivatives Research (022) 30433255 [email protected]

Karan Khanna Strategy (022) 30433251 [email protected]

Krishnan ASV Banking (022) 30433205 [email protected]

Nitin Bhasin E&C / Infrastructure / Cement (022) 30433241 [email protected]

Nitin Jain Technology (022) 30433291 [email protected]

Pankaj Agarwal, CFA NBFCs (022) 30433206 [email protected]

Pratik Singhania Real Estate / Retail (022) 30433264 [email protected]

Parita Ashar Metals & Mining (022) 30433223 [email protected]

Rakshit Ranjan, CFA Consumer / Real Estate (022) 30433201 [email protected]

Ravi Singh Banking / NBFCs (022) 30433181 [email protected]

Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 [email protected]

Ritu Modi Healthcare (022) 30433292 [email protected]

Shariq Merchant Consumer (022) 30433246 [email protected]

Tanuj Mukhija, CFA E&C / Infrastructure (022) 30433203 [email protected]

Utsav Mehta Telecom / Media (022) 30433209 [email protected]

Sales

Name Regions Desk-Phone E-mail

Deepak Sawhney India / Asia (022) 30433295 [email protected]

Dharmen Shah India / Asia (022) 30433289 [email protected]

Dipti Mehta India / USA (022) 30433053 [email protected]

Nityam Shah, CFA USA / Europe (022) 30433259 [email protected]

Parees Purohit, CFA USA (022) 30433169 [email protected]

Praveena Pattabiraman India / Asia (022) 30433268 [email protected]

Sarojini Ramachandran UK +44 (0) 20 7614 8374 [email protected]

Production

Sajid Merchant Production (022) 30433247 [email protected]

Joel Pereira Editor (022) 30433284 [email protected]

E&C = Engineering & Construction

Good & Clean 6.1


Explanation of Investment Rating Investment Rating Expected return

(over 12-month period from date of initial rating)

Buy >5%

Sell <5%

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74 Ambit Strategy Good & Clean Portfolio

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