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Thank You, Minister!

Sep 23, 2019

“I think tax reform is the single most important thing we can do in this country to unleash economic energy” – Dennis Muilenberg

Summary

• The Sitharaman Put was born on Friday, and sentiment as well as markets have put in a bottom.

• The tax cut is a triple kicker to the markets, in the form of higher absolute earnings, higher earnings growth for a time and higher profitability and cash flows.

• This has the makings of a sustained move higher, propelled by a reversal of sentiment, and monetary and fiscal policy measures.

• We recommend a gradual tilt back to neutral weight on mid-caps.

• We book profits on our long duration call, and our focus shifts to PSU, corporate bonds, absolute yield, yield compression, low duration and well-managed credit.

The Sitharaman Put is Born

Markets last week had been holding support twice at important long-term technical levels. Third time proved unlucky and the indices broke lower on Thursday. Technical strategists on the media were consensus bearish. The move lower was dramatic and painful and 10,000 on the Nifty appeared to be the next stop.

At the moment of maximum pessimism, Finance Minister Sitharaman stepped forward with the courage of Churchill, the backing of P.M. Modi, delivered an impact greater than a certain President’s tweets, saved the day and handed bears their heads on a platter. Which reinforces for us what we’ve known for a long time – being bearish as an investor is a loser’s game. No rational short will want to take on a F.M. on the war path to rescue the nation from below par growth. The Sitharaman Put is born.

Less Government, Less Taxation, Better Governance

P.M. Modi’s rallying cry during the 2014 elections is coming to pass. We wish that we could have taken a less painful means of getting to where we are this year, but we applaud the government for taking the bold move towards lower tax rates, saving the day for equity markets and monetary pain for lakhs of investors.

Sentiment Has Bottomed, and so Has the Market

Pessimism on Thursday was likely the worst we’ve seen in years, and by Friday afternoon, the mood was changing. The Finance Minister delivered meaningful, big bang reform. We believe we have witnessed a bottom in sentiment. It would also be reasonable to conclude the market has witnessed a bottom as well.

A Triple Kicker to the Markets

The benefits of lower taxes are many-fold.First, absolute earnings move immediately higher, which translates to lower forward P/Es.Second, earnings growth moves immediately higher, for four quarters on year over year comparisons.Third, actual cash flows move permanently higher, and enable companies to invest in productive growth, pass on savings, or spend, or invest.Finally, companies – domestic and international – are also immediately incented to set up new factories in India.

Filtering to the next level, stocks that benefit most are the ones with high effective tax rates, high profitability and high ROEs.Simple back of the envelope math suggests that this move is akin to a steroid shot for such companies.

Capitalization Benefit – Tilt Mid Caps Gradually to Neutral Strategic Weight

Large caps have been paying the highest effective tax rates, and therefore will be the greatest beneficiaries.Mid caps at the index level outperformed marginally on Friday.With the tax cut, and improving fundamentals, the case for deploying to mid caps strengthens.However, the performance of the midcap index on Friday appeared to be skewed by a few names and dispersion of returns was large.We continue to recommend a gradual move back towards strategic, neutral weight on mid and small, while retaining a healthy exposure to large.

Make in India to pick up in 2021

The reduction in tax for new factories creates an incentive for capex investment, and makes India competitive amongst its Asian peers. This will clearly make the Indian economy a desired investment destination in Asia for manufacturers planning to shift operations away from China.

Outlook

Based on the various measures unleashed and the commitment of the government to revive growth, the bottom appears to be in.The government is clearly committed to growth, both from a fiscal and monetary perspective.Sentiment has bottomed.On a relative basis, equities now appear to be immediately attractive relative to bonds and gold.

If You Missed the Rally on Friday

If you’ve missed the rally on Friday, we would still deploy early in the coming week.In our view, this has the makings of a sustained move higher and the risk of much lower prices has receded considerably.The news is big bang, so we do not think this is a one day market wonder.It is a permanently higher plateau for earnings and greater profits.

For certain large cap companies, our target prices revert higher by up to 25% due to the higher plateau of earnings.Should sentiment revive, investment will come forth and a virtuous cycle will unfold.Therein also lies the risk to the forecast, which is that the demand recovery will need to be driven by sentiment, wealth effect, private investment and greater profits to the few making their way to the many.Overseas risks remain a perennial overhang.Still, we’ll take this over Nifty heading lower to 10,000.

Sectoral Breakdown

Banks and consumption benefit, particularly quality banks and high roe consumption plays.With higher cash flows, banks ability to lend immediately improves, particularly for casa constrained banks.Ironically, the greater the profitability, the higher the benefit.The immediate benefit is to companies that have incremental, untargeted demand.

Notably, companies with no profits, low profits or cyclically depressed profits won’t see any immediate benefit.Pharma and IT companies will see limited benefits.Industrials look interesting, but with a lag, as investment will need to come forward.Construction and infra companies will also not benefit meaningfully due to exemptions.Cement stocks look to benefit but we remain wary of the sector due to lumpy investment flows and cyclicality.Autos have a long road ahead, and rationality on pricing must return to the sector.Companies will need to reduce pricing.Demand for commercial vehicles could bounce back quicker.

PMS Strategy

Titans, our multi cap fund, went to full deployment levels on Aug 7th and 26th.The portfolio is quality growth, and well positioned to benefit from the tax cuts.Olympians, our large cap fund, deployed an additional 3% cash early Friday and is now down to under 5% cash levels.Both portfolios are handily outperforming the markets year to date, and we’ll do a detailed quarter end performance review next week.

Fixed Income

We still expect the repo rate to head lower in the second half of the year.The RBI would do well to lower rates to ensure the recovery takes hold.The challenge will be the question asked by the bond markets at the longer end of the curve.The 10 year was clearly questioning the fiscal math, rising 15 bps on Friday.The government’s plan will hinge on some combination of a sovereign bond issue and public entity divestiture to bring forward a below the line budget balancing.Net net, we envision a scenario where the short end of the curve could head lower, while the long end stabilizes, in a classic curve steepening.

Take Profits on Duration, Move to Credit and PSU, Corporate Bonds

The Rupee looks set to appreciate back to steady state levels around 70.With stability in the currency, the government’s overseas borrowing plan makes more sense.Clearly, with an improving economy, higher profits, credit begins to make sense for aggressive portfolios.We would exit duration exposure at the long end of the curve, and lock in profits from our rate call made earlier this year, paying the tax and exiting with a net after tax return of 14-15% annualized.

Separately, PSU bonds and Banking funds look to be in a position to benefit from improving economic fundamentals and profitability.Spread compression between corporates and g-secs now looks more likely to come through.Finally, the short end of the curve looks attractive, but only for the short term.Therefore, our longer term bets would focus on PSU, corporate bonds, absolute yield, yield compression, low duration and well-managed credit.

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