Ambit - Strategy: The cold logic behind our 16,000 target for the Sensex [1 Attachment]

Strategy: The cold logic behind our 16,000 target for the Sensex 

Over the past few months we have highlighted that the Sensex is likely to head towards 16,000 by the end of June. Given the events of the last few days, clients have sought clarity on the numbers behind our 16,000 estimate for the Sensex. The table below sets out the logic for the same. A glance at the table will show that there are TWO key assumptions behind our 16,000 target: 

Assumption 1: The Sensex's forward P/E, which currently stands at, 14,7x should derate to 13.8x. Why are we saying this? The Sensex currently trades at a 36% premium to MSCI EM (on a forward P/E basis). Over the past 10 years this premium has averaged around 28%. Given the outlook for the Indian economy (rising finance, fuel, labour and input costs in a environment where economic reform is stalled by policy gridlock), we believe that it makes sense for the Sensex's forward P/E premium to derate by around 10% (14.7 going to 13.8) so that our premium to MSCI EM becomes 28% (in-line with India's CY01-10 premium). 

Assumption 2 : The Sensex's FY12 EPS estimate, which currently stands at 1,257, should fall by 7% over the next couple of months as consensus factors in higher input costs. Whilst consensus expects a 13% yoy growth in FY12 Sensex EPS, we believe EPS growth will be pulled down to 6% yoy growth on account of the following 
1) a 2% impact on account of higher interest costs (interest cost account for ~27% of PAT and interest costs are likely to be higher by 75 bps ) 
2) a 2% impact on account of higher fuel costs ( fuel costs account for ~44% of PAT and 50% of fuel price increases are likely to be unhedged) 
3) a 3% impact on account of higher raw material costs (raw material costs account of ~276% of PAT and assuming average WPI inflation of 7.9% in FY12) 

We see this ongoing pullback as a return to sanity for valuations in the Indian market and we continue to believe that investors should use this opportunity to build positions in our 48 stock "good & clean" portfolio (see attached). Over the past two months this equal weighted portfolio has outperformed the BSE200 by 585bps (on a market cap weighted basis the outperformance is still a very respectable 302bps). This portfolio was created 2 months ago keeping in mind the dislocated environment we find ourselves in. We would be happy to sit down with clients and discuss the three step process (outlined below) we used to build this portfolio: 

Step 1: Screening sectors for inflation immunity 
The rationale: High inflation withholds the translation of high sales growth by imposing cost pressures (see exhibit 2 for details). This dynamic explains the historic phenomenon whereby equity returns are lower in a high inflation environment - both across the market as well as across sectors (see exhibit 3 for details). 

The model: Based on consolidated financial data for BSE500 sectors we estimate each sector's exposure to each of the three types of input costs i.e. raw material cost and fuel cost, employee cost and interest cost. Please refer to the attached note titled '5 forces driving India Inc's P&L' for details. 

Step 2: Weeding out stocks with poor quality earnings 

The rationale: Whilst at the level of the overall market between share price performance and accounting quality is not visible, the fact that accounting quality matters for equity returns leaps out at the sectoral level (particularly if we slice the sectors into different market cap buckets). 

The model: Use our forensic accounting model of BSE 500 companies to identify the best one third of stocks within each of these sectors Please refer to our attached note tiled 'Accounting quality matters' to understand how our forensic accounting framework works. 

Step 3: Applying the valuations screen
We then apply three valuation screens - forward P/E, forward EV/EBITDA and forward P/B - to whittle down the long list of 90 stocks emerging from steps 1 & 2 to shorter list of 48 stocks. Each of the three valuation screens compared a stock's current mutliple with its historic 5 year average multiple with the intent being to buy stocks which are trading below their historic P/E, EV/EBITDA and P/E.

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