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Speaking to CNBC-TV18, Manishi Raychaudhuri, ED, UBS Securities said that they have a Sensex target of 22,600 by 2008-end and added that they expect 21-22% Sensex earning CAGR over three years. He said that the markets, at 21 times, are fully valued and that there isn’t much re-rating potential for markets at these levels. According to him, the cost of capital is coming down and higher a P/E is sustainable.

Raychaudhuri said that many sectors are appearing fully valued but no collapse is likely. He is positive on the markets for 2008. According to him, midcaps are playing catch up with largecaps due to huge valuation gaps. He added that IT, some engineering and construction largecaps have bidding advantage for large, high margin projects.

“The is plenty of money from both, international and domestic investors, waiting on the sideline,” Raychaudhuri said.

Excerpts of CNBC-TV18’s exclusive interview with Manishi Raychaudhuri:

Q: How are you feeling about India in the next year and what kind of targets has UBS setout?

A: We have a target 22,600 by the end of 2008. We have actually increased it from 19,000, which was our previous target. That entire increase is predicated on re-rating as we believe that the cost of capital in India is coming down, so it possibly deserves higher PE sustainably.

Currently, the market is trading at about 21 times, that would obviously mean that the market is possibly fully valued even though the valuation is supported by the earnings growth in different sectors. In fact, for the Sensex, we anticipate about 21-22% earnings CAGR over the next three years. But, it is fair to say that there is hardly any re-rating potential for this market because many of the sectors are appearing fully valued right now.

But all in all, we feel that earnings growth is likely to remain stable. Valuations, even if they correct a little from these levels, they won’t collapse. Net-net we are quite positive on the Indian market for 2008.

Q: How are you feeling about the way this entire midcap space has come out and got counted. Do you think that part of the market as well is going to show this much momentum over the next few months?

A: If one looks at the first nine-ten months of the year 2007, the entire rally in the market was driven by the largecaps, that too a very small concentrated group of largecap stocks. So obviously the midcap space is now playing catch-up because the valuation gap between the largecaps and the midcap names had become just too divergent and too large. So several of the midcap names were appearing attractive on the relative valuations, that’s exactly what’s happening now. So they are, at least partly, catching up with their largecap peers in terms of growth adjusted valuations.

Ultimately I think the investor would be interested in those companies where the earnings growth is sustainable, where the valuations are supported by sustainable earnings growth going forward and the companies which can differentiate themselves from the rest of the pack. In fact, in some areas, let say in IT services, maybe in some cases in engineering and construction, possibly the largecap companies have an advantage because they can bid for the bigger projects which typically tend to have slightly higher margins.

So, I don’t think one can paint the picture with a broad brush that midcaps are better or largecaps are better. I think it will differ across sectors and even across different company groups.

Q: However in the near-term it is valuation that is a matter of concern for the market the way stocks have been running up. You also talked about 21 times PE on the index. Is that a big concern right now and what kind of earnings potential you think this market will do or the companies would deliver to justify the PE?

A: If one looks at the Sensex, which is typically easier to comment because of the relatively small number of companies there, the EPS growth forecast that we have for next three years is somewhere between 21-22% CAGR. I would stress on the word EPS because the earnings growth forecast is actually a little higher. But we are seeing dilution in some of the metal companies and some of the banks, so the EPS growth numbers tends to come down little.

Having said that, this 21-22% CAGR is actually forecast to come down from a level of 30-35% that we have seen for the last three years. So there is a bit of main reversion that we are seeing. But on an absolute basis, this 21-22% is not a bad number. The current one year forward PE at 21 times is possibly supported by 21-22% earnings growth because that essentially implies a PEG of about one time. But at the same time, I would also mention that this level of PEG, which is just about one time or slightly higher than that, is possibly the historical peak that the market has traded at. If one leaves out one or two instances in 1994-95 and again in 1999-2000, which would mean that the market is fully valued right now.

I don’t think there is any further re-rating potential from these levels. We may see some correction from these levels though I don’t think that the correction would be severe, it will possibly not be more than 8-10% because ultimately there is still a lot of money waiting in the sidelines to be invested in the Indian market both, from the foreign investor side and from the domestic investor side.

Q: In terms of sectoral performances we have been seeing lot of action in the real estate pack again purely in terms of valuation argument. How are you viewing the way these stocks have gained over the last few months?

A: If I take a broad view on the sector itself, I think real estate, construction and the bridging of the demand supply gap essentially; the kind of housing stocks that’s available and the housing stocks that would be needed going forward, that gap has to be bridged over maybe next three-five years. Therefore, over a long-term one has to remain positive in this sector.

In our model portfolio, we have a neutral weight on real estate right now. One of the reasons for that is we have seen some slowdown in sales this year which could a impact on the topline of the large companies going forward, maybe about six months to one year down the line. That’s why, even though we have overweights on other interest rate sensitive sectors like banks and automobiles, we have a neutral weight on real estate.

Q: Your report indicates that some of the under valued spaces include the steel stocks. What is the story there you see over the next 6-12 months?

A: Metals in general is a sector that we are overweight on. I’ll give a brief outlook on the themes that we are playing on. We think that this whole investment cycle both in infrastructure, industrial capex and real estate is likely to continue over at least the next three-five years. So one has to keep playing that investment cycle or the capex cycle.

Secondly, we also think that the lending and interest rates, from the bank’s perspective, have possibly peaked out at these levels. Anecdotally we know that mortgage rates have come down a little, auto loans have come down to 100-125 bps and even though the RBI may not signal a peak in the interest rate cycle in the very near-term, we think that the actual lending and deposit rates may have peaked out at the current levels.

So from that perspective, we are obviously positive on the sectors which are geared to this investment and capex cycle. So we have overweights on engineering, construction, cement and on metals as well.

On metals, particularly on both, steel and non-ferrous, there is another angle which is the global metal prices. On global metal price we are positive on aluminium and we have a neutral to positive view on steel as well because we think that the large capacity additions that we had seen recently, they are possibly tapering off in 2008 and 2009. So if one looks at the valuations of steel companies, in that context, then there is reason to be bullish on the large frontline names.

Q: What’s the sense you get when you speak to some of your institutional clients because the expectation here is that come January, there is going to be a large dollop of liquidity for this market and that more than anything will probably propel us higher. Are you getting the sense that money is been banked on the side waiting to get in?

A: As far as the interest on India is concerned, that remains considerably high, not just from the traditional long only investors in India, but also from the alternative investors and the relatively new investors. We have seen this repeatedly in the successive conferences that we have had or for that matter even some of the events organized by the competitors - that the interest in India from the new investors is considerably high.

Add to this the fact that there is injection of liquidity into the emerging markets by the easing by the Fed and the European Central Bank. One also has a situation where this combination of investor interest and liquidity in the emerging markets is propelling the important emerging markets higher. So that certainly is a possibility, I don’t know whether that will happen in January itself, it’s almost impossible to take that kind of a short-term call.

But, if one looks at the fundamental factors influencing the continued investments into India, which are a combination of currency strength in the emerging markets and a continuation of easing by the Fed and the other Central Banks, I think these two fundamental factors are likely to remain and they would continue to influence investor preferences over 2008 as well.

Q: In terms of sectoral calls, IT and autos, two ranked under performers, are you taking a contrarian call on IT right now and particularly autos since there is so much M&A activity happening in that space. What’s the view?

A: We are overweight on automotives. Right now we have an overweight on the model portfolio primarily because we think that in different segments of automotives, demand revival in 2008 is a distinct possibility. This is a combination of our view that the interest rate cycle is possibly peaking out and some of the new model launches both in two-wheelers and four-wheelers. These we think, would review consumer interest in this space.

On IT on the other hand, we have a neutral stance. We don’t yet have an underweight because the concerns on IT are two fold. Firstly, the rupee would continue to appreciate and therefore, the dollar based growth would be higher then the rupee denominated growth. Secondly, the United States’, BFSI space as well call it, they are significant contributors to the topline and margins of the IT companies. But that space in the United States is seeing turmoil. So we don’t know yet, but it could have a cut in the IT Budget. So these are two main concerns.

But at the same time, we think that the valuations of the frontline IT companies are close to the lower end of their historical trading ranges. So it’s possibly not the right time to capitulate on IT and go underweight. So we have a neutral stance and we are playing predominantly the largecap frontline companies there.

Source: Moneycontrol.com