The last of stock taking

We list out the final two stocks that we want to pick up for the Safe Wealth model portfolio before going on a buying spree in the next fortnight.

Dipen Sheth | Print Edition: March 5, 2009

In the past few issues, I have outlined some large companies, such as the Reliance Industries , State Bank of India , Infosys , Bharti Airtel and Nestle . These will walk into our Safe Wealth portfolio almost by default, given their lead positions in the overall context of the Indian economy. We also discussed why other such India proxies like NTPC and Hindustan Unilever were the right-business-at-wrong price stocks. Now, it's time to walk you through two more 'country proxies' so that we can start nibbling on our fresh portfolio positions from the next issue onwards. These are Larsen & Toubro and Rural Electrification Corporation (REC).

What the research Reports say
BNP Paribas: Market Outlook
The report dated 6 Februay 2009 mentions frontline largecap stocks such as the ICICI Bank and Bharti Airtel that are likely to benefit from the structural growth drivers of the Indian economy in the long term. These include:
1. Increase in infrastructure investments driven by the need to improve infrastructure (power, roads, ports and airports, irrigation, etc.) and supported by rising domestic savings rates (up from 22% in mid-1990s to 35% in 2008).
2. Sustainable increase in domestic consumption, especially in durables (driven by low product penetration, coupled with increasing affluence, improving emographics and increasing urbanisation).
3. Rising energy security, driven by new oil and gas discoveries and acquisition of overseas oil fields.

4. Cost arbitrage in services and manufacturing, leading to continuation of outsourcing by developed economies from India and other emerging economies.

Even though some of these structural drivers have
come under cyclical pressures, the long-term positive
impact of these drivers on the economy (and hence, on corporate earnings and share prices) is undeniable.

Of these, REC is the most likely to raise eyebrows. After all, who wants to invest in a PSU specialising in lending to the power sector? I do. This is why: such lending has been rendered almost risk-free by legal and policy actions over the past few years. The loan books of specialised and low operating cost lenders like REC and Power Finance Corporation (PFC) are poised to grow at 20-25% CAGR, even as overall credit growth levels off in banks and falls for vehicle finance companies. Besides, REC is available at a significant discount to its larger and more visible sibling, PFC.

Even on an absolute basis, REC has turned in an excellent quarterly result for December 2008. The net interest income (difference between interest earned and paid) rose 48% year-on-year (YoY) to Rs 446 crore, while the profit after tax (PAT) was up a whopping 41.4% to Rs 319 crore. How many lenders, banks included, have reported this kind of growth recently? The reason is not difficult to fathom: REC's loan book has swelled to Rs 48,300 crore and is already up 22.8% since March 2008.

These are absolutely solid loans to national or state-level power generation as well as transmission and distribution (T&D) entities in both private and public sectors. Its non-performing assets (NPAs) have actually reduced to a negligible 0.04%. Further, I expect REC to deliver a PAT of Rs 1,200-1,250 crore (implying a 23% return on equity for 2008-9), which should take its book value to over Rs 77 a share. My target for 2009-10: Rs 95, which makes the highly profitable and safe REC (CMP: Rs 83) available at a 12-13% discount to one-year forwardadjusted book value (dividends included).

HSBC: India insights
The sector recommendations by the HSBC Global Research as on 12 January 2009.
Consumer discretionaryAutosUnderweight
IndustrialsEngineering Underweight
Consumer staples (FMCG)-Neutral
Real estate-Underweight
FinancialsPSU Banks Overweight
Information technology-Neutral
Recommendations are based on a time frame of 6 to 12 months

What can go wrong? REC's loan growth can slow down if power sector investments do not come through, as has been envisaged in the eleventh Five Year Plan. The interest spreads earned by it (currently at about 3.4%) can shrink as lending rates cool off. But slippage in asset quality, the one big fear about all lenders in these times of economic slowdown, is unlikely to bug REC. So, even if its currently high RoE reverts to the 16-19% band, REC's loan growth prospects, coupled with its asset quality, is reason enough to buy it for a premium to book value.

Meanwhile, choosing L&T (at a CMP of Rs 680) for our Safe Wealth portfolio can qualify as a contrarian move, given the bad media coverage that the company has received recently for its Satyam exposure! What started off as an aggressive treasury decision has snowballed into a messy acquisition adventure that is probably making Henning-Holck Larsen and Soren Kristian Toubro turn in their graves. Given a choice, I'd merge L&T Infotech with Satyam at a ratio that will give L&T a stake of over 75% in the merged entity. This will help it achieve a hassle-free control as well as the benefits of listing the infotech business.

ICICI securities: Market strategy
A look at the changes in the model portfolio of ICICI Securities as on 10 February 2009.
Sector% Weight in index—Sector weights—15 Apr '08 9 Feb '09
Financials20.823 20
IT services & technology9.912 6
Oil & Gas19.314 14
Capital goods & Infra12.515 10
Consumer goods8.18 15
Metals6.23 3
Auto43 8
Telecom78 8
Reality1.24 4
Sector weights do not add up to 100 as only some have been listed

Satyam apart, let us not forget that L&T (at a market cap of Rs 39,000 crore) is India's largest and most capable construction company. The concern here is whether we should award it a premium valuation, given the economic slowdown and the resultant slippage in cash flows visible across the construction sector. L&T will remain superior to the sector but may still post lower cash flows. Pro-forma financial performance will still look good as net profits are on target to grow about 25% for 2008-9. Order books will climb a little higher at 2.2 times the revenues by year-end. But a slowdown in order inflows has set in and the private sector capex is stalling, which is affecting L&T's hydrocarbon equipment and industrial construction business.

As if on cue, the company has announced a foray in power equipment manufacturing (this might work) and ship building (this definitely won't!). It must be said that L&T is a well-diversified national proxy with a top class management. The question is how to value its over Rs 2,700-crore expected net profit (from engineering and construction operations, plus treasury) for 2008-9, and its various subsidiaries in all kinds of businesses, including infotech, infra-asset ownership and finance. Most brokerages have constructed an elaborate sum-of-the-parts (SOTP) valuation for L&T at around Rs 800-1,000 a share. Our portfolio strategy on this complicated giant should be to slowly average to a 10-15% position and buy big chunks on bad days.

The response/feedback section has fallen strangely silent of late, and I will attribute this to the 100% cash position in both our portfolios, rather than a lack of interest in our exercise. Stand by for the first few trades in our portfolios by next fortnight, and keep your ideas flowing in.

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