Good & Clean Portfolio

THEMATIC September 23, 2013

STRATEGY G&C 6.1
Company name Bajaj Auto Tata Motors Exide MRF Bank of Baroda ICICI Bank IDFC ING Vysya Bank
th

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 RBIs 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 20 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. 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).

Sector Auto Auto Auto Anc Auto Anc BFSI BFSI BFSI BFSI BFSI Engg & Const Engg & Const Engg & Const Metals/ Mining Metals/ Mining Oil & Gas Oil & Gas Capital Goods Utilities Utilities Cement

Weight (%) 4.3 4.3 4.3 4.3 4.3 4.3 4.3 2.1 2.1 4.3 2.1 2.1 4.3 4.3 4.3 4.3 4.3 4.3 2.1 4.3 4.3 2.1 2.1 4.3 2.1 2.1 2.1 2.1 2.1 2.1

LIC Housing Fin. Larsen & Toubro Engineers India Voltas Coal India NMDC Oil India Petronet LNG Cummins India Power Grid Torrent Power Grasim

HCL Technologies IT Cadila Healthcare Pharma Torrent Pharma Bharti Airtel Oberoi Realty McLeod Russel Supreme Inds. Sadbhav Engg. Pharma Telecom Realty Agro Industrials Infrastructure

Sobha Developers Realty

Jagran Prakashan Media

Analyst Details
Gaurav Mehta +91 22 3043 3255 gauravmehta@ambitcapital.com Karan Khanna +91 22 3043 3251 karankhanna@ambitcapital.com Saurabh Mukherjea, CFA +91 99877 85848 saurabhmukherjea@ambitcapital.com

G&C 6.1 portfolio versus Nifty 50

Portfolio Nifty G&C 6.1 Median mcap (US$ mn) 7,668 1,761 6M ADV (US$ mn) 15.9 2.8 Median Median FY14 P/E (x) FY14 P/B (x) 14.6 10.5 2.1 1.6 Median FY13 RoE (%) 17.1 17.0 Beta 1.00 0.96

Source: Bloomberg, Ambit Capital research

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 6.1

CONTENTS
Macroeconomic view for FY143

We remain constructive on Indian equities.5

Implications for portfolio strategy....7

The current polarisation of Indian markets. 10

Audit of G&C 6.012

Appendix 1: Overlap with Magic formula..14

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

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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: RBIs latest survey points to the continued hardening of inflationary expectations (from already elevated levels)
13.0%

Inflation Expctations (YoY, in %)

12.5% 12.0% 11.5% 11.0% 10.5% 10.0% 9.5% Jun-13 Dec-12 Mar-13 Jun-13 Sep-13 (Qtr ahead) June-14 (Yr ahead)

Source: RBI, Ambit Capital research

Finally, the RBI highlighted the need to reduce the INRs 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 Feds 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 RBIs 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. The RBI has flattened the inverted yield curve while pushing it upwards by 25bps.

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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 RBIs early-November policy review and ahead of the Feds 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 RBIs 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) Indias enhanced ability to borrow from the World Bank, and (3) the RBIs US$250bn of FX reserves, to defend this level. The new governor is likely to draw a red line at Rs65/USD. We expect GDP growth in 2Q FY14 to be 3.8% YOY (vs 4.4% in 1Q FY14).

There is a high probability that the next round of RBI intervention is administered in mid-October 2013 i.e. ahead of RBIs earlyNovember policy review and ahead of the Feds end-October policy review.

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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 Feds 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 Feds 19th June announcement on QE being throttled off completely by summer 2014. Thankfully, the Feds 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

Feds 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

Source: Bloomberg, Ambit Capital research

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.

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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) Period 1 (from 5.4% to 7.9%) Particulars start date: 31/10/1993 Q1 Q2 Q3 Q4 Q5 sub-period average start date: 04/10/1998 Q1 Q2 Q3 Q4 Q5 sub-period average start date: 15/06/2003 Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12 Q13 Q14 Q15 Q16 sub-period average start date: 28/12/2008 Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 sub-period average start date: 08/07/2012 Q1 Q2 Q3 Q4 sub-period average end date: 08/01/1995 Oct-Dec Jan-Mar Apr-Jun Jul-Sep Oct-Dec US ten-year bond yield change (in %) S&P 500 returns MSCI EM returns Sensex returns US GDP growth (%YoY) India GDP growth (%YoY)

0.4 0.9 0.6 0.3 0.2 0.5

2% -4% 0% 4% -1% 0%

32% -9% -2% 20% -15% 5%

23% 13% 8% 5% -8% 8%

2.6 3.4 4.2 4.3 4.1 3.7

5.7* 5.7* 6.4* 6.4* 6.4* 6.1*

Period 2 (from 4.3% to 6.6%)

end date: 06/02/2000 Oct-Dec Jan-Mar Apr-Jun Jul-Sep Oct-Dec

0.2 0.6 0.5 0.1 0.6 0.4

21% 5% 7% -7% 15% 8%

17% 12% 24% -5% 25% 15%

-2% 22% 11% 15% 5% 10%

5.0 4.9 4.8 4.8 4.9 4.9

5.9 5.9 6.9 6.0 5.7 6.1

Period 3 (from 3.1% to 5.1%)

end date: 15/07/2007 Jul-Sep Oct-Dec Jan-Mar Apr-Jun Jul-Sep Oct-Dec Jan-Mar Apr-Jun Jul-Sep Oct-Dec Jan-Mar Apr-Jun Jul-Sep Oct-Dec Jan-Mar Apr-Jun

0.4 0.3 -0.4 0.7 -0.5 0.1 0.3 -0.6 0.4 0.1 0.5 0.3 -0.5 0.1 -0.1 0.4 0.1

2% 12% 1% 1% -2% 9% -3% 1% 3% 2% 4% -2% 5% 6% 0% 6% 3%

14% 17% 9% -10% 7% 17% 1% 3% 17% 7% 12% -5% 4% 17% 2% 14% 8%

23% 31% -4% -14% 16% 18% -2% 11% 20% 9% 20% -6% 17% 11% -5% 12% 10%

3.2 4.3 4.4 4.2 3.4 3.1 3.6 3.4 3.3 3.0 3.2 2.9 2.2 2.4 1.2 1.7 3.1

8.9 11.0 8.4 8.3 7.1 5.5 9.0 9.4 8.9 9.6 9.9 9.3 9.8 9.4 9.8 9.7 9.0

Period 4 (from 2.1% to 3.4%)

end date: 17/04/2011 Jan-Mar Apr-Jun Jul-Sep Oct-Dec Jan-Mar Apr-Jun Jul-Sep Oct-Dec Jan-Mar

0.5 0.9 -0.2 0.5 0.0 -0.9 -0.4 0.8 0.2 0.1

-12% 15% 15% 5% 5% -12% 11% 10% 5% 5%

1% 34% 20% 8% 2% -9% 17% 7% 2% 9%

1% 49% 18% 2% 0% 1% 13% 2% -5% 9%

-3.5 -4.1 -3.3 -0.2 1.6 2.7 3.0 2.8 2.0 0.1

3.5 5.9 9.3 7.7 11.4 9.5 8.6 9.2 9.9 8.3

Period 5 (from 1.6% to 2.8%)

till date Oct-Dec Jan-Mar Apr-Jun Jul-till date 0.1 0.1 0.6 0.3 0.3 -1% 10% 2% 7% 5% 5% -2% -9% 9% 1% 4% -3% 3% 6% 3% 2.0 1.3 1.4 NA 1.6 4.7 4.8 4.4 NA 4.6

Avg for these 5subperiods Overall avg for the period (Sep-92 till date)

0.2 -0.1

4% 2%

8% 2%

9% 3%

2.6 2.6

8.0 7.0

Source: Bloomberg, Ambit Capital research

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

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. With quality being ultraexpensive, we follow the quality at a reasonable price approach to portfolio construction

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.

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Good & Clean 6.1

Exhibit 4: G&C 6.1
Company name Bloomberg Bajaj Auto Tata Motors Exide MRF Bank of Baroda ICICI Bank IDFC ING Vysya Bank LIC Housing Fin. Larsen & Toubro Engineers India Voltas Coal India NMDC Oil India Petronet LNG Cummins India Power Grid Torrent Power Grasim BJAUT IN TTMT IN EXID IN MRF IN BOB IN ICICIBC IN IDFC IN VYSB IN LICHF IN LT IN ENGR IN VOLT IN COAL IN NMDC IN OINL IN PLNG IN KKC IN PWGR IN TPW IN GRASIM IN Sector Auto Auto Auto Anc Auto Anc BFSI BFSI BFSI BFSI BFSI Engg & Const Engg & Const Engg & Const Metals/ Mining Metals/ Mining Oil & Gas Oil & Gas Capital Goods Utilities Utilities Cement IT Pharma Pharma Telecom Realty Realty Agro Industrials Infrastructure Media Stock weight (%) 4.3 4.3 4.3 4.3 4.3 4.3 4.3 2.1 2.1 4.3 2.1 2.1 4.3 4.3 4.3 4.3 4.3 4.3 2.1 4.3 4.3 2.1 2.1 4.3 2.1 2.1 2.1 2.1 2.1 2.1 Mcap 6-mnth (US$ ADV (US$ mn) mn) 9,202 15,841 1,713 879 3,699 18,189 2,396 1,497 1,672 12,499 921 396 30,408 7,829 4,472 1,497 1,809 7,507 543 4,132 11,825 2,237 1,200 21,960 896 442 452 660 144 442 13.1 43.3 2.4 3.5 13.7 73.9 19.2 1.6 12.9 41.6 0.5 1.8 12.8 6.2 4.6 2.1 2.0 6.2 0.4 3.3 20.2 1.5 0.8 25.8 0.4 0.9 1.4 0.3 0.3 0.2 Latest 3-yr avg 3-yr EPS 3-yr avg Debt: PBITM CAGR (%) RoE (%) Equity (%) 0.0 1.4 0.0 0.6 NA NA NA NA NA 1.7 0.2 0.0 0.0 0.8 2.5 1.1 0.3 0.3 0.9 0.5 1.3 0.6 0.2 0.5 3.2 0.5 24.9 53.3 3.2 32.4 9.3 26.1 13.8 25.0 11.2 (2.6) 20.9 (18.7) 21.9 20.9 10.0 43.0 20.3 24.3 (23.2) (4.5) 21.3 (6.4) 21.5 (37.7) (1.2) 16.5 5.3 22.7 (47.6) 6.4 58.4 49.9 21.3 20.0 20.1 13.1 13.8 13.5 20.3 16.2 35.1 19.4 38.6 32.2 19.9 29.4 31.1 15.4 18.0 14.6 25.6 29.5 31.0 8.6 15.1 10.5 16.6 38.5 8.6 26.4 21.7 10.0 15.0 7.9 NA NA NA NA NA 15.6 28.9 7.4 28.7 90.0 47.4 7.3 19.9 63.8 21.3 19.0 15.3 17.9 17.8 14.7 66.2 27.2 25.8 13.1 12.8 20.5 FY14 FY14 P/E P/B 16.3 8.8 16.7 7.3 5.1 11.6 7.5 11.8 8.4 15.5 10.2 12.1 10.9 8.0 7.4 10.1 15.6 10.0 9.2 9.8 15.0 18.5 14.7 31.4 8.3 9.4 8.2 13.1 11.3 12.5 5.1 2.2 3.1 1.7 0.7 1.6 1.0 1.4 1.4 2.1 2.3 1.4 3.4 1.6 1.3 1.8 4.3 1.5 0.5 1.2 4.3 3.9 4.2 2.3 1.2 1.2 1.3 3.8 0.7 2.6

HCL Technologies HCLT IN Cadila Healthcare CDH IN Torrent Pharma Bharti Airtel Oberoi Realty TRP IN BHARTI IN OBER IN

Sobha Developers SOBHA IN McLeod Russel Supreme Inds. Sadbhav Engg. MCLR IN SI IN SADE IN

Jagran Prakashan JAGP IN

Source: Bloomberg, Ambit Capital research

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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 Agro Auto Auto Anc BFSI Capital Goods Cement Chemicals Conglomerate Consumer Durable Engineering & Construction Fertilizers FMCG Industrials Infrastructure IT Logistics Media Metals/ Mining Miscellaneous Oil & Gas Pharma Realty Retail Shipping Telecom Utilities G&C 6.1 2.1 8.5 8.5 17.0 4.3 4.3 8.5 2.1 2.1 4.3 2.1 8.5 8.5 4.3 4.3 4.3 6.4 Delta between G&C 6.1 and BSE200 2.1 1.9 7.4 (7.0) 3.1 2.3 (0.2) (4.1) (0.2) 8.4 (0.4) (15.0) 2.0 1.5 (9.3) (0.2) 1.4 3.9 (0.4) (2.2) (2.7) 3.8 (0.6) (0.2) 1.7 3.1 Delta between G&C 6.1 and G&C 6.0 2.1 (1.7) 3.4 (0.9) (6.0) (0.9) 4.3 (0.4) (0.4) 4.3 (0.4) 3.4 3.4 4.3 (3.4) (0.9) (1.3)

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

Source: Capitaline, Bloomberg, Ambit Capital research

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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
18,000 15,000 12,000 9,000 6,000 3,000 6.0 5.0 4.0 3.0 2.0 1.0 0.0

Jun-04

Jun-05

Jun-06

Jun-07

Jun-08

Jun-09

Jun-10

Jun-11

Jun-12

Oct-04

Oct-05

Oct-06

Oct-07

Oct-08

Oct-09

Oct-10

Oct-11

Oct-12

Feb-04

Feb-05

Feb-06

Feb-07

Sensex (LHS)
Source: Bloomberg, Ambit Capital research

Feb-08

PB ratio (defensives to cyclicals, RHS)

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

Source: Bloomberg, Ambit Capital research

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

0.70 0.60 0.50 0.40 0.30 0.20 BSE Small Cap Index P/B to BSE Sensex P/B

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

0.90 0.80 0.70 0.60 0.50 0.40 0.30 BSE Mid Cap Index P/B to BSE Sensex P/B

Feb-09

Jan-06

Feb-10

Jan-07

Jan-08

Feb-11

Jan-09

Jan-10

Feb-12

Jan-11

Jan-12

Feb-13

Jun-13
Jan-13 Jul-12

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jul-05

Jul-06

Jul-07

Jul-08

Jul-09

Jul-10

Jul-11

Source: Bloomberg, Ambit Capital research

Source: Bloomberg, Ambit Capital research

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Jul-13

Jul-05

Jul-06

Jul-07

Jul-08

Jul-09

Jul-10

Jul-11

Jul-12

Jul-13

Good & Clean 6.1

The RBI policy and the polarisation

How does the recent RBI policy change the shape of this polarisation? The markets 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 of an inversion in the yield curve

6.0 4.0 2.0 0.0

Jun-07

Jan-07

Oct-05

Oct-10

Aug-06

Nov-07

May-05

-2.0 -4.0

PB ratio, defensives to cyclicals

Source: Bloomberg, Ambit Capital research

Yield differential, 1yr minus 10yr

May-10

Aug-11

Dec-04

Dec-09

Mar-06

Mar-11

Sep-08

Apr-08

Feb-04

Feb-09

Jun-12

Jul-04

Jul-09

Jan-12

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

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.

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

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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.
Price (INR) Ticker TTMT IN BJAUT IN BOB IN ICICIBC IN IDFC IN VYSB IN OINL IN NMDC IN TPW IN PWGR IN BHARTI IN EXID IN ENGR IN LT IN VOLT IN OBER IN PEPL IN SOBHA IN JAGP IN GRASIM IN KKC IN SIEM IN BHE IN SADE IN Stock Tata Motors Bajaj Auto Bank of Baroda ICICI Bank IDFC ING Vysya Bank Oil India NMDC Torrent Power Power Grid Bharti Airtel Exide Engineers India Larsen & Toubro Voltas Oberoi Realty Prestige Estates Sobha Developers Jagran Prakashan Grasim Cummins India Siemens Bharat Electron Sadbhav Engg. Stock weight (%) 5.1 5.1 5.1 5.1 5.1 2.6 5.1 5.1 2.6 5.1 5.1 5.1 2.6 5.1 5.1 2.6 2.6 2.6 2.6 5.1 5.1 5.1 2.6 2.6 12-Jun-13 294 1,743 652 1,081 143 633 557 112 125 108 278 129 151 931 84 198 153 357 91 2,780 452 561 1,349 104 7164.91 20-Sep-13 338 1,992 550 987 99 501 467 124 72 102 344 126 171 846 75 171 137 282 83 2,821 409 480 1,084 60 7280.9 Performance 15.3% 14.3% -15.6% -8.7% -30.5% -20.9% -16.2% 10.1% -42.3% -5.9% 23.9% -1.9% 13.7% -9.1% -10.1% -13.8% -10.6% -20.9% -8.6% 1.5% -9.4% -14.5% -19.6% -42.5% (7.2) 1.6 (8.8) 14.2

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

Exhibit 11: Audit of G&C 6.0

G&C 6.0 weighted returns (%) BSE500 index (%) G&C 6.0 alpha (%, since Jun 13) Cumulative Alpha (%, since Mar 11) Source: Bloomberg

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

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Exhibit 12: G&C series - cumulative performance

25 20 15 10 5 0 -5 -10 -15

Alpha (%)

G&C 1

G&C 2

G&C 3

G&C 4

G&C 5.0

G&C 5.1

G&C 6.0

G&C iteration
G&C iteration alpha (vs BSE500)
Source: Ambit Capital research

cumulative alpha (vs BSE 500)

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Ambit Capital Pvt. Ltd.

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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 Greenblatts Magic Formula (in his book The Little Book that Beats the Market) ranks firms on a combination of the following two ratios: (1) a firms EBIT as a proportion of its net fixed assets plus net working capital - this ratio is akin to an adjusted RoCE; and (2) the firms EBIT as a proportion to its enterprise value - this ratio is akin to a firms 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). The magic formula strikes a balance between high quality and reasonable valuations

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
Growth of INR 100 invested in '97

3,000 2,500 2,000 1,500 1,000 500 1997 1999

Performance of 'magic' quintiles

CAGR
Q1 21% Q2 18% Q3 13% Q4 13% Q5 6%

2001

2003

2005

2007

2009

2011

Year
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.

September 23, 2013

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2013

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Good & Clean 6.1

Exhibit 14: The current first quintile on magic formula from the BSE200 universe
Ticker WPL IN GMDC IN* COAL IN NMDC IN ENGR IN BHEL IN OINL IN CAIR IN KKC IN HEXW IN BJAUT IN AMRJ IN HZ IN MRF IN* APTY IN ONGC IN TRP IN MPHL IN GRASIM IN TTMT IN INFO IN VOLT IN UNTP IN HCLT IN BHE IN MCLR IN ACC IN EXID IN Name Wockhardt GMDC Coal India NMDC Engineers India BHEL Oil India Cairn India Cummins India Hexaware Tech. Bajaj Auto Amara Raja Hindustan Zinc MRF Apollo Tyres ONGC Torrent Pharma Mphasis Grasim Tata Motors Infosys Voltas United Phosphorus HCL Technologies Bharat Electronics McLeod Russell ACC Exide Bottom-up stance Not rated Not rated Not rated Not rated Buy Sell Not rated Sell Buy Not rated Buy Not rated Not rated Not rated Sell Buy Not rated Not rated Not rated Buy Sell Buy Not rated Buy Not rated Not rated Sell Buy Mcap (US$ mn) 1,056 420 28,434 7,438 895 5,465 4,325 9,797 1,685 590 8,953 779 8,580 866 505 39,116 1,154 1,401 3,513 15,968 28,334 345 940 11,570 1,501 452 2,999 1,680 FY13 RoCE* 43% 38% 55% 37% 41% 33% 28% 25% 43% 36% 59% 42% 25% 24% 20% 23% 33% 23% 16% 20% 37% 17% 16% 38% 18% 18% 23% 27% Current Earnings Yield* 23% 27% 14% 20% 15% 26% 18% 19% 9% 11% 7% 9% 14% 14% 20% 14% 8% 11% 16% 11% 7% 12% 13% 7% 12% 12% 9% 7% FY14 EV/EBITDA 4.7 3.2 6.3 3.8 6.1 4.7 3 3.8 13.1 6.8 12.3 8.4 4.9 4.2 3.5 4.2 10.1 7.1 5.5 4.4 12.7 6.6 4.6 10.1 6.1 6.4 8.4 10.2 FY14 P/E 5.2 4.8 10.5 7.8 10.1 7.7 7.4 5.7 14.8 10.4 16 14.7 8.7 7.4 4.9 9.2 14.5 11.7 8.6 9.2 17.9 10.5 6.7 15.2 10.6 8.2 15.2 16.7 FY14 P/B 1.8 0.9 3.2 1.5 2.3 1.1 1.3 1.1 4.1 2.7 5.8 3.8 1.5 1.7 0.8 1.5 4.1 1.9 1 2.3 4 1.2 1.1 4.3 1.3 1.4 2.4 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 pretax 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)

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

September 23, 2013

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Good & Clean 6.1

Institutional Equities Team

Saurabh Mukherjea, CFA Research Analysts Aadesh Mehta Achint Bhagat Ankur Rudra, CFA Ashvin Shetty Bhargav Buddhadev Dayanand Mittal Gaurav Mehta Karan Khanna Krishnan ASV Nitin Bhasin Nitin Jain Pankaj Agarwal, CFA Pratik Singhania Parita Ashar Rakshit Ranjan, CFA Ravi Singh Ritika Mankar Mukherjee, CFA Ritu Modi Shariq Merchant Tanuj Mukhija, CFA Utsav Mehta Sales Name Deepak Sawhney Dharmen Shah Dipti Mehta Nityam Shah, CFA Parees Purohit, CFA Praveena Pattabiraman Sarojini Ramachandran Production Sajid Merchant Joel Pereira
E&C = Engineering & Construction

CEO, Institutional Equities

(022) 30433174

saurabhmukherjea@ambitcapital.com

Industry Sectors Banking / NBFCs Cement / Infrastructure Technology / Telecom / Media Automobile Power / Capital Goods Oil & Gas Strategy / Derivatives Research Strategy Banking E&C / Infrastructure / Cement Technology NBFCs Real Estate / Retail Metals & Mining Consumer / Real Estate Banking / NBFCs Economy / Strategy Healthcare Consumer E&C / Infrastructure Telecom / Media

Desk-Phone E-mail (022) 30433239 (022) 30433178 (022) 30433211 (022) 30433285 (022) 30433252 (022) 30433202 (022) 30433255 (022) 30433251 (022) 30433205 (022) 30433241 (022) 30433291 (022) 30433206 (022) 30433264 (022) 30433223 (022) 30433201 (022) 30433181 (022) 30433175 (022) 30433292 (022) 30433246 (022) 30433203 (022) 30433209 aadeshmehta@ambitcapital.com achintbhagat@ambitcapital.com ankurrudra@ambitcapital.com ashvinshetty@ambitcapital.com bhargavbuddhadev@ambitcapital.com dayanandmittal@ambitcapital.com gauravmehta@ambitcapital.com karankhanna@ambitcapital.com vkrishnan@ambitcapital.com nitinbhasin@ambitcapital.com nitinjain@ambitcapital.com pankajagarwal@ambitcapital.com pratiksinghania@ambitcapital.com paritaashar@ambitcapital.com rakshitranjan@ambitcapital.com ravisingh@ambitcapital.com ritikamankar@ambitcapital.com ritumodi@ambitcapital.com shariqmerchant@ambitcapital.com tanujmukhija@ambitcapital.com utsavmehta@ambitcapital.com

Regions India / Asia India / Asia India / USA USA / Europe USA India / Asia UK

Desk-Phone E-mail (022) 30433295 (022) 30433289 (022) 30433053 (022) 30433259 (022) 30433169 (022) 30433268 +44 (0) 20 7614 8374 deepaksawhney@ambitcapital.com dharmenshah@ambitcapital.com diptimehta@ambitcapital.com nityamshah@ambitcapital.com pareespurohit@ambitcapital.com praveenapattabiraman@ambitcapital.com sarojini@panmure.com

Production Editor

(022) 30433247 (022) 30433284

sajidmerchant@ambitcapital.com joelpereira@ambitcapital.com

September 23, 2013

Ambit Capital Pvt. Ltd.

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Good & Clean 6.1

Explanation of Investment Rating

Investment Rating Expected return (over 12-month period from date of initial rating) >5% <5%

Buy Sell

Disclaimer
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Additional information on recommended securities is available on request.

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