Will 2007 be another dream year?

Though the outlook for 2007 remains positive, market experts advice investors to tone down their returns expectations.

As far as the broad market was concerned, 2006 was a dream run. After opening slightly above the 9000-point level, the Sensex crossed 14,000 points in early December 2006 and closed near that level. If investors didn't gain as much as the Sensex (46.7 per cent), they still earned good returns on an absolute basis.

At the current stratospheric levels, there are many questions in the minds of retail investors--Where are the markets headed in 2007? Will the equity party continue this year? What should retail investors do this year?

The Smart Investor asked these questions to some of the market experts. They believe that the year 2007 will be good for the markets in general as India will continue to attract good foreign flows but investors will have to tone down their returns expectations.

The stretched valuations and the risk of sustainability of consistent performance for Indian corporates will keep the market on the edge and hence volatile.

However, they think that opportunities are available if investors take up a stock-specific or bottom-up approach, which would include mid-cap stocks.

Market players unanimously feel that the growth story of India Inc is intact, but current prices in many cases are above acceptable levels. Read on to find out what they say.

Ridham Desai
MD & Research Head, JM Morgan Stanley Securities

India brings to the table four advantages that are long-term value drivers for equities. The macro story lends itself to strong dividend growth, with falling volatility in growth in dividends.

The demographic story could translate into a favourable structural liquidity story, while robust capital market infrastructure allows investors to leverage India's ROE-obsessed entrepreneurs.

However, the price that is being paid for these critical success factors appears to be above acceptable levels, especially in the context of the risks of investing in India. Consequently, our base case is for a 16 per cent decline in the BSE Sensex by the end of 2007 on our residual income.

Global factors are likely to remain the key influence on India's equity returns over the next 12 months. The most critical factors include US growth/inflation, crude oil prices and emerging market valuations. India-centric factors seem less critical, but include FDI, capex, equity supply, policy, politics, central bank action and domestic risk appetite.

We tend to believe that the "November Effect", which historically runs from November to February, may end earlier this time and the market may start 2007 on shaky ground.

How long such a correction lasts will eventually test market participants though we would not be surprised if this is a quick sharp correction reminiscent of the May 2006 dip in market values.

Debt-funded consumption growth will be hit by the rise in the cost of capital and the soft landing of the credit growth cycle.

Additionally, macro stability indicators are at worrying levels: the inflation rate, the current account deficit, property prices and credit quality have already reached worrying levels, and policymakers' ability to allow the strong growth trend to continue is limited.

This slowdown in growth will be accompanied by a moderation in top line growth for India's corporate sector. Moreover, capital costs (interest and depreciation expense) are set to rise.

We believe that growth could disappoint and we would not be surprised if profit growth slips into single digits for a quarter or two in the coming months.

The silver lining for fundamentals is that corporate balance sheets are in very good shape with relatively low level of debt and high level of cash. Thus, the rise in corporate activity that has happened in 2006 is likely to pick up pace in 2007.

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Naresh Kothari
Head Institutional Equities, Edelweiss Securities

We expect 2007 to be another good year for the markets, but also a year of high volatility. Investor expectations are currently factoring in hyper-growth with the markets having another runaway year.

We, however, expect corporate India to maintain a reasonable earnings growth rate of 16-18 per cent. Our view on intra year volatility stems from this possible mismatch of expectations and actual quarterly numbers.

Overall, we expect market returns in the range of 15-20 per cent and we do not expect any significant P/E re-rating of the markets. While this number may be low as compared to the last couple of years, we believe there are bottom-up opportunities for stock selection which will provide additional upsides to investors this year.

Though the current quarter will continue to be strong, short-term trends like firm interest rates and cost push, both on physical and human resources, could lead to margin shrinkage in the second and third quarters of the calendar year.

We continue to like the infrastructure space, particularly infrastructure creators, for their strong secular growth profile. We also like the IT industry and banks having access to low-cost funds, as we expect interest rates to remain firm. 
 

INFRA PLAY
Company name	CMP (Rs)	P/E (FY07E)	P/E (FY08E)
Larsen and Toubro	1442.00	28.55	21.85
B.L .Kashap_sons	1436.00	23.16	17.51
HCL Technologies	648.00	20.57	17.05
PNB*	507.00	1.51	1.29
* Price to book value

Larsen and Toubro (L&T): L&T's strong order accretion and significant exports will maintain the pace of growth. Adjusted for subsidiaries, valuations look attractive (at 1.4x FY07E revenues of the parent).

B L Kashyap: The company, focused on urban infrastructure development, has an order book of Rs 1,250 crore spread over 22 million sq ft. It is also present in the real estate sector and is developing approximately 10 million sq ft of residential space.

HCL Technologies: We expect the company to post revenues and net profit CAGR of about 30 per cent and 28 per cent respectively, over FY06-08E given the high long-term revenue visibility and improved outlook for margins.

Punjab National Bank (PNB): PNB has a 49 per cent CASA ratio (low cost deposits) and is the biggest beneficiary of tight liquidity when short-term interest rates are going up. The company has very little pressure on its investment book.

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Sandeep Nanda
Head of Research, Sharekhan

We expect markets to reach 15,500-16,000 within next twelve months, which is a reasonable target. Earnings growth of companies, benign Union Budget, stable global macro factors and low crude oil prices relieving inflationary pressures will be the key factors responsible for the positive sentiment in the market.

While the global growth rate will slow down, India would continue to grow at robust rate and thus attract good FII flows in line with other emerging markets. 
 

FOCUS ON LARGE CAPS
Company name	CMP (Rs)	P/E (FY07E)	P/E (FY08E)
Aditya Birla Nuvo	1247.00	49.88	31.97
ICICI Bank*	890.00	3.27	2.91
M&M	906.00	14.61	12.16
Thermax	387.00	26.00	20.00
Grasim	2789.00	185.93	146.79
* Price to book value

This would lead to strong liquidity conditions and money supply will continue growing at 19-20 per cent. Given strong FII flows, large-caps will continue to remain in focus though mid-caps and small-caps are attractively valued.

TOP PICKS
Aditya Birla Nuvo: Aditya Birla Nuvo's strategy of minting money from the cash-rich businesses of rayon, carbon black and fertilisers, and focussing on the high-growth businesses namely of garments, telecom, insurance and IT/ITES.

ICICI Bank: ICICI Bank, India's second-largest bank, has the dual advantages of a healthy growth in both loans and fee income given its strong positioning in the retail advances segment. Various subsidiaries (life insurance, general insurance and securities) add Rs 300 to the overall valuation.

Mahindra & Mahindra (M&M): The government's increasing thrust on agriculture and the easy availability of credit would benefit M&M's tractor sales added by enhanced product mix with a number of new launches, new utility vehicle platform, mid-sized car Logan, and other products in collaboration with International Trucks. Subsidiaries like Tech Mahindra, Mahindra Gesco, and M&M Financial are doing very well.

Thermax: India Inc's increasing capital expenditure will benefit Thermax' energy and environment businesses. It has a strong order book of Rs 2,973 crore which is equivalent to 1.8x FY06 revenues.

Grasim: Grasim, one of the largest cement producers in the country and also the largest domestic player in the VSF industry is expanding its capacities further. Its 51 per cent cement subsidiary, UltraTech, will up its consolidated earnings.

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Amitabh Chakraborty,
Head of Research, BRICS PCG

In our opinion, 2007 will be a year of consolidation, where one can expect a potential 10-12 per cent index return. However, mid-caps will out-perform, partly because many of them have relatively under-performed the Sensex in 2006 and most of them will continue to surprise the market with superior earnings.

The UP elections and the movement of crude price on account of the UN sanctions imposed on Iran will be critical factors to look at.

Moreover, wage inflation is also becoming a worry which could hurt margins of companies as well as put inflationary pressures on the economy. Structurally the Indian economy is on a stronger wicket. A slowing US economy and weakness in dollar will keep FII money flowing in India and other emerging markets. 
 

FOCUS ON MID CAPS
Company name	CMP (Rs)	P/E (FY07E)	P/E (FY08E)
Venus Remedies	385.00	14.81	9.87
Garware Offshore	246.00	16.40	10.25
Lloyd Electric	155.00	9.00	8.00

TOP MID-CAP PICKS
Venus Remedies: Venus, which is into injections and anti-cancer drugs has strong earnings visibility. The company expects its sales and profit to grow at 50 per cent y-o-y till 2010. It has reported sequential growth in sales and net profit in the last eight quarters.

Garware Offshore: Gareware Offshore,which services the offshore drilling support function for exploration companies, including ONGC and Transocean, is well poised to deliver strong earnings going forward as high oil prices makes deep water offshore drilling for gas and oil a viable business.

The company has two PSVs and four anchor handling tug supply vessels, which will be added by seven vessels in CY09.

Lloyd Electric: Lloyd Electric, the largest heat exchanging coil manufacturer in India, is a supplier to most air conditioner OEMs, including Samsung, LG, Bluestar and Hitachi.

The company has entered into manufacturing of refrigeration coil in technical collaboration with a Korean company. Recently, the company has bagged the air conditioning of Delhi metro coaches and we expect repeat orders to flow in for Bangalore and Mumbai metro as well.With $30 million cash in the balance sheet, growth through the inorganic route cannot be ruled out.

The air conditioning business is witnessing a boom due to huge consumption demand driven by rising purchasing power of Indian people and setting up of retail malls.

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Ajay Parmar,
Head-Ideas Research, Emkay Share & Stock Brokers Ltd.

During 2007, corporate India will have to perform as it has promised and stocks will be treated accordingly. At current level, the valuations are over-stretched for FY07 earnings and even on FY08 earnings for many of them.

Thus, investors need to adopt medium to long term investment horizon. Any buying call based on FY08 numbers should be taken only after looking at the earnings visibility and the past track record of the company. We believe that in 2007, investors may not earn as much as they did in 2006 generally.

The mid-cap segment is likely to out-perform mainstream stocks. On a global map, India will be an attractive destination among the emerging markets due to strong macro story, robust GDP growth and increased purchasing power creating a very positive investment environment
 

OUTPERFORMING MID CAPS
Company name	CMP (Rs)	P/E (FY07E)	P/E (FY08E)
Ratnamani Metals	440.00	8.46	6.98
Sterlite Optical	233.00	17.92	10.59
Nucleus Software	686.00	19.06	15.95

TOP PICKS
Ratnamani Metals and Tubes: We see good growth prospects in the company's precision stainless steel tubes and spiral arc welded (SAW) carbon steel pipes business due to its diversified customer base, multi-locational plants, long standing relationships with large customers, excellent quality credentials and adequate management bandwidth.

Sterlite Optical Technologies: The company is on the verge of a strong turnaround in its optic fibre business with an upsurge in realisations after 15 quarters of flat prices.

Global demand for optic fibre is on the rise and will see CAGR of 18 per cent plus for the next three years. Its backward integration and expansion will help post robust performance for the next two-three years.

Acquisition of power transmission conductors business brings strong visibility and stability in earnings.

Nucleus Software Exports: We believe that the commercial success of the company's flagship products FinnOne and its quality clientele (both domestic and international) articulates Nucleus' technical and domain capabilities.

Products revenues have grown at an enviable CAGR of 24 per cent over the last nine quarters and we believe the momentum has just begun, since the company is yet to explore EMEA (Europe, Middle East and Africa) and US markets. Roll-out of FinnOne for GMAC's US operations could be a big opportunity for the company.

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Kalpesh Parekh,
Head of Institutional Sales, ASK Raymond James

After experiencing volatility at higher levels in 2006, the year 2007 should continue to remain volatile due to rising interest rates and valuations for large cap companies remain challenging.

We believe stock specific opportunities still exist aplenty and patient investors will be better off investing in quality stocks bearing valuations in mind. 
 

BE STOCK SPECIFIC
Company name	CMP (Rs)	P/E (FY07E)	P/E (FY08E)
Infosys	2240.00	32.70	25.90
Gammon India	419.00	29.93	19.95

TOP PICKS
Infosys: The company has a strong brand name with well-known execution capabilities and a transparent management. Its banking product 'Finacle' will aid in non-linear growth going forward. It leads the industry in return ratios (around 40 per cent ROE).

Gammon India: The strong growth prospects mainly on the back of a heavy order book and execution skills with a limited possibility of equity dilution makes the stock attractive.

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Kunj Bansal
Chief Invesment Officer, Religare

In 2007, the market is likely to continue to offer attractive opportunities and is expected to have positive direction on the back of continued growth in the economy and good visibility of corporate performance.

However, one will have to be cautious of the factors like oil price, interest rate movement and negative surprises in corporate performance.

The continued interest in the market by domestic as well as foreign investors will also keep the inflow into equity market strong and buying interest live. 
 

SECTOR KINGS
Company name	CMP (Rs)	P/E (FY07E)	P/E (FY08E)
Areva T&D	1046.00	43.58	NA
NIIT	525.00	25.00	20.19

TOP PICKS
Areva T&D: Areva T&D, one of the few large players in the transmission and distribution of electricity, will be a big beneficiary of the capital spending on power and also civil nuclear power plants becoming a reality.

The massive upgradation of the T&D network which has seen little investments in the last 30 years is a multi-billion dollar opportunity for the company in the coming years.

NIIT Ltd: NIIT is a pure play on the education industry in India with the individual learning business and corporate business growing at a robust pace. A recent acquisition of "Element K" has further strengthened NIIT's content development business.