UBS - India Strategy - 18th July 2008.

N ear term pressures have intensified Economic headwinds continue; reducing Sensex target to 15500. The Indian market continues to face severe economic headwinds in the form of global commodity (especially oil) price spurt, high inflation that’s unlikely to decline in the near term, and a growing current account deficit exerting downward pressure on the Rupee. Political uncertainty poses additional risk. We downgrade our end-08 Sensex target to 15500 from 19600. At our target, Sensex would trade at 1-year forward PE 13.2x (current PE 12.6x, earlier target 16.1x, long term average 15x).

India underweight in Asia, further currency depreciation predicated UBS Strategist Niall Macleod (“Asia Equity Strategy: Beyond a bounce”) underweights India due the risks arising from its external deficits and low real rates. UBS economist Philip Wyatt has recently forecast further depreciation in Rupee (45.4 by end-2008 and 50 by end-2009)

Our top underperformers UBS analysts are bearish on several stocks in the near term. Reasons are a combination of slowdown in revenue growth, uncertainty in earnings due to Government policy, and potential earnings disappointments leading to earnings estimate downgrades. We highlight the most significant: TCS, Suzlon, the oil marketing companies (HPCL and IOC), GAIL and Cipla. For a list of high conviction Buy ideas we direct the reader to our recent report “Our highest conviction stock ideas” dated July 3.

Near term headwinds continue The most significant headwinds to the Indian economy arise from rising global commodity prices (especially oil) which are feeding into higher inflation, and hence higher interest rates. Higher financing costs are leading to declining consumption, and hence declining growth in industrial production (IIP). It is pertinent to note that the recent spurt in bank credit growth (since early April) appears misleading as far as the growth outlook is concerned. We believe the increase in credit growth is largely driven by increased bank credit to oil companies (oil companies’ credit requirement driven by rising oil prices). Better
indicators of growth are the real variables (IIP growth, auto sales, diesel demand) and probably real interest rates.

Moreover, we believe FII inflows are unlikely to pick up in the near term as rising crude oil prices could continue to expand India’s current account deficit and therefore, continue to exert downward pressure on the Rupee. UBS economist Philip Wyatt (“India: Rupee, where next?” dated July 16) has recently forecast the Rupee/S by end of 2008 to be at 45.4 (currently 42.9), and by end of 2009 to be at 50. In a scenario of depreciating INR, we believe foreign capital flows are unlikely to resume.

A combination of concerns on economic slowdown (leading, eventually to decline in earnings forecasts) and concerns on slowdown in portfolio inflows lead us to reduce our Sensex target by end-2008. Year-end Sensex target reduced When we calculated our previous Sensex target (“Structural growth under cyclical pressure” dated April 21), interest rates (represented by 10-year bond yields) were c1.5% lower than they are today, crude oil price was at c$110/bbl
(vs c$140 today) and WPI inflation was at c7.5% (almost 12% today). Such spike in inflation and liquidity drivers were unanticipated. We change our Sensex forecast as we believe interest rates, inflation and current account deficit are likely to stay high over next 2-3 quarters.

Among our Sensex determining variables two have changed – Sensex EPS
estimates have declined (by 1.4% in FY09 and 3.1% in FY10) and risk-free rate
forecast has increased (from 8.8% to 10% by end-2008). Consequently, our target 1-year forward PE for Sensex falls from 16.1x to 13.2x and our end-08 Sensex target declines from 19600 to 15500.

Our current target implies that the Indian market is likely to underperform Asia
marginally over next 6 months. The main risk to our forecast seems to arise from the fact that India tends to outperform its Asian peers when all markets move up, and tends to underperform on the way down (UBS Asian Regional Strategist Niall Macleod expects a bounce-back in Asian equities as Asia appears oversold. In that scenario India may outperform in the near term.
Risk to earnings estimates significant Our current estimated EPS CAGR of 23.5% for Sensex over FY08-10E clearly appears on the higher side. We believe there’s significant earnings risk in banks, real estate, engineering and metals. These sectors contribute 38-39% of market’s
earnings.

Some significant potential underperformers. On a bottom-up basis UBS analysts are bearish on several stocks in the near term. Reasons are a combination of slowdown in revenue growth, uncertainty in earnings due to Government policy, and potential earnings disappointments
leading to earnings estimate downgrades. We highlight the most significant among these: TCS, Suzlon, the oil marketing companies (HPCL and IOC), GAIL and Cipla.

Statement of Risk.
The biggest risk to Indian market arises from increasing oil prices and increasing commodity prices which are leading to rising inflation and rising interest rates. Growing current account deficit is leading to depreciation in the Rupee and decline in foreign portfolio inflows. Near term political uncertainty is likely to add to the volatility in the market.