Modest upside for the index, but strong returns likely from our top picks
We are setting a 12M BSE Sensex target of 14,500 (+9%). This may not appear
exciting, but we aren’t bearish like most on the Street. More importantly, our top
picks – BHEL, Grasim, ICICI Bank, Infosys and Reliance – offer significant upside
(20%+ in most cases) on a 12M view. Our non-consensus view is based on:

#1: Interest rates are nearing their peak
We believe the RBI’s interest rate up-cycle is near its top with another rate hike
priced in – inflation is headed down in next few weeks, the stock market froth has
been taken out, real estate is beginning to cool off and credit growth is slowing
down. With millions being added to the workforce annually, the RBI can’t ignore
growth completely (and political priorities could switch quickly); Instead, it is now
likely to shift focus to FX inflows which should limit further Rupee appreciation.

#2: Infrastructure worries overdone
India’s infrastructure remains woefully inadequate, but it is not likely to slow down
growth dramatically just yet. The Street seems to be focusing on headline capacity
addition – in power, roads, ports, railways, airports, etc – that has been behind
targets. However, there are ongoing significant efficiency improvements (e.g.
higher PLFs at power plants, faster turnaround time for ships and railway wagons)
which are increasing effective capacity and may enable a growth surprise.

#3: Growth and RoE still very good – upside from earnings upgrades
The Street appears overly concerned about Sensex earnings growth slowing down
(DB estimate: from ~35% in FY07 (Mar) to ~17% in FY08e). Even ignoring
possible estimate upgrades as the year progresses, ex-oil growth is 22% and RoE
flat yoy at 25.3% despite higher capex as margins are still robust – 12M forward
P/E of 17x and P/BV of 3.8x for such growth/RoE is attractive in our view. Reliance
and ONGC drag down index growth/RoE, but they are attractive value plays with
many catalysts. Note India still offers highest RoE in Asia and has actually lagged
most of the region since the March sell-off (10% from the peak).
Don’t follow the herd into defensives; stay away from small/mid-caps
Our non-defensive model portfolio has outperformed since end-Jan despite the
recent correction. We suggest overweighting banks, capital goods and cement,
and an underweight in FMCG, utilities and pharma. Small/mid-caps may appear
cheap, but they are most likely to get hurt in a high-interest rate environment, and
we think it is too early to call for a return in risk-appetite. Stick with large caps. Key
risks: (1) RBI over-tightening (2) sharp US slowdown (3) carry trade unwind.


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