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Summary: No PE re-rating for India; enter Good & Clean 7.0

P/E matters more than EPS over shorter timeframes Whilst over long time periods (say, over a decade or more), Sensex returns mirror earnings growth, over shorter timeframes (like on YoY basis), P/E is a bigger driver of index returns than earnings growth. What has driven the Sensexs P/E? Short-term rates, the slope of the yield curve, US bond yields and Gross Fixed Capital Formation (GFCF) growth seem to affect the Sensexs P/E. GDP growth and earnings growth on the other hand do not seem to materially impact P/E. Whilst most of these factors seem to be at inflection points currently, they have not as yet staged a meaningful turnaround (barring US bond yields). What has driven the Sensexs EPS? Monetary easing, rising US bond yields, higher GFCF growth and higher GDP growth seem to affect the Sensexs EPS favourably. On the other hand, high levels of inflation seem to impact it negatively. Given that our Economy team expects a muted recovery in FY15 with persistent inflation and hawkish monetary policy, we expect our current bottom-up Sensex EPS estimate of 1,530 to be downgraded.

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Summary (contd)
Our prognosis for the Sensex in the year ahead We see no major P/E rerating for the Sensex but earnings growth should lift the index to 24,000 (16% upside from current levels) by March 2015. Portfolio strategy We retain our quality at a reasonable price (QARP) approach to portfolio construction as the reversion in the following polarisations would continue: (1) defensives to cyclicals, (2) large caps to small-caps and mid-caps, and (3) growth stocks to value stocks. This QARP approach was incorporated in the Good & Clean portfolio 6.1 portfolio that we launched on 23 September 2013. This portfolio has generated an alpha of 280bps since inception. On a cumulative basis, our Good & Clean portfolios have outperformed the BSE500 by 17 percentage points since inception 11 quarters ago. We now update our 23 September 2013 Good & Clean portfolio to incorporate the latest valuations and FY13 consolidated accounts (which drive the latest iteration of our greatness model). This new portfolio - G&C 7.0 is shown on page 31 of this note.

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Contents
P/E matters more than EPS over shorter timeframes page 5 What drives P/E? page 9 What drives EPS? page 14 One-year prognosis for Sensex page 19 Portfolio strategy page 22

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Sensex returns are mean reverting

Globally, equities are known to mean revert. Thus, prolonged periods of superior equity returns are followed by periods of mediocre returns and vice versa. The exhibit below emphasises this dynamic in the context of Sensex returns - a rolling five-year return plot for the Sensex suggests that Sensex returns mean revert over long periods. Since over the past six months we have just started rising from the zero line, there seems to be a reasonably high likelihood that the recent period of sub-par returns could be followed by a period of superior returns. But what drives Sensex returns?
Rolling five-year Sensex return CAGR

Source: Bloomberg, Ambit Capital research

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Whilst Sensex returns mirror EPS growth over longer periods

Over any time frame Sensex returns has two parts to it: change in P/E and EPS growth i.e., P = P/E + EPS (approximately, without considering the interaction term) Since 1991 both Sensex returns and EPS CAGR have been nearly same at roughly 14% but an R-square of close to zero suggests there is no correlation between the two on a YoY basis.

Over long periods Sensex returns mirror EPS growth

but on a YoY basis there is no correlation between Sensex returns and EPS growth

Source: Ace Equity, Ambit Capital research ; Note: Both Sensex and Sensex EPS values have been rebased to 100 at the beginning of 1991

Source: Ace Equity, Ambit Capital research

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 P/E is a more important driver over shorter timeframes

The annual change in P/E has a much tighter relation with YoY Sensex returns suggesting P/E is a bigger driver of Sensex returns over shorter timeframes (see chart on the right). Whilst P/E is a bigger factor in driving Sensex returns, it is also the more volatile factor (see table on the right). That said, over time P/E seems to have become less volatile for the Sensex (see chart and table below). Dividing the last 20 three years into two equal phases suggests that the volatility in P/E has come down by over half in the second phase vis--vis the first phase.
Volatility in the Sensex P/E has come down over time Over shorter timeframes P/E seems to be a bigger driver of Sensex returns

Source: Ace Equity, Ambit Capital research

but volatility in P/E is much larger than in EPS growth

Measure P/E EPS Standard deviation of annual percentage change* 0.34 0.19

Source: Ace Equity, Ambit Capital Research; Note: * Annual percentage change in Sensex P/E and Sensex EPS over Dec 1991 to Dec 2013

Volatility in P/E has come down in the second phase vs first

Phase Phase 1 Phase 2
Source: Ace Equity, Ambit Capital research

Period Max P/E Jan-91 to Nov-02 57.4 Nov-02 to Dec-13 28.6

Min P/E 9.8 10.4

(Max-Min)/average for the period 2.1 1.0

Source: Ace Equity, Ambit Capital research

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Contents
P/E matters more than EPS over shorter timeframes page 5 What drives P/E? page 9 What drives EPS? page 14 One-year prognosis for Sensex page 19 Portfolio strategy page 22

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Drivers of P/E: The theory

A simple valuation tool like the Gordon growth model (GGM) measures intrinsic value as the present value of expected dividends discounted at the required return on equity. The formula can be readily modified to give a formula for P/E: Po/Eo=[(Do/Eo*(1+g))/(ke-g)]; where, ke = cost of equity = Rf + ERP

P/E should thus be positively linked to growth and negatively linked to interest rates and the equity risk premium (ERP). In the subsequent slides in this section we use actual historical data to gain insights into the practical drivers of Sensex P/E and consequently what they imply for the Sensex P/E going forward Interest rates: We use one-year government bond yields as a proxy for interest rates. (For years prior to 2001, due to lack of data on one-year government bond yields, we use SBIs one-year deposit rate.) Growth: Whilst g in the formula shown above is the growth rates in dividends, we use both the real GDP growth rate and the trailing earnings growth rate as proxies for expectations on g; further, to measure the expectation of economic growth, we use the slope of the yield curve as a proxy as well. ERP: The ERP may be affected by several non-quantifiable factors like political stability. We however explore US bond yields as one factor here, as we surmise that rising US bond yields should indicate an improving global economy and increased risk appetite, leading to inflows into EMs like India. This should result in easier equity availability, thereby reducing their ERP .

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What has driven Sensex P/E historically?

Monetary easing seems to be a prerequisite for P/E rerating Rising US bond yields usually lead to a P/E rerating

Source: Bloomberg, Ace Equity, Ambit Capital Research; Note: 1-year G-Sec yield has been used to represent interest rates starting 2001 and SBI 1-year deposit rate has been used prior to 2001

Source: Bloomberg, Ace Equity, Ambit Capital Research; Note: US yields used here have been detrended for the structural decline of the last two decades- please see slide 34 for the raw series

A steepening yield curve is positive for a P/E rerating too

No strong link between P/E and trailing 12-mth earnings growth

Source: Bloomberg, Ace Equity, Ambit Capital Research; Note: Yield differential between 10-year bonds and 1-year bonds; the red arrow denotes current level of the explanatory variable

Source: Ace Equity, Ambit Capital Research

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What has driven Sensex P/E historically? (cont.)

No strong link between P/E and previous 3-year EPS CAGR P/E shows little link with real GDP growth

Source: Ace Equity, Ambit Capital Research

Source: Bloomberg, Ace Equity, Ambit Capital Research; Note: We have plotted YoY growth in real GDP on a quarterly basis since 98. In the periods prior to that, we have used the same annual GDP growth for all four quarters of that fiscal due to data limitations.

P/E does not seem linked with trailing 3-year avg GDP growth

The link, however, is much stronger with YoY GFCF growth

Source: Bloomberg, Ace Equity, Ambit Capital Research; Note: 3-year average GDP growth is average GDP growth over trailing 12 quarters

Source: CEIC, Ace Equity, Ambit Capital Research; Note: GFCF growth based on 1999-2000 prices till March 2006; the red arrow denotes current level of the explanatory variable

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In conclusion
What affects P/E? Short-term rates, the slope of the yield curve, US bond yields and GFCF growth seem to affect Sensex P/E. GDP growth and trailing earnings growth on the other hand do not seem to materially impact P/E. What do these variables suggest for PE going forward Whilst most of these indicators (i.e. the yield curve slope, GFCF growth) are at inflection points currently, they have not staged a material turnaround yet (barring US yields). Given that our Economy team expects a muted recovery in FY15 with persistent inflation and hawkish monetary policy, we do not see a rerating for Sensex P/E in the year ahead (more on this on slide 19).
Factor Monetary easing Steepening yield curve Rising US bond yield GDP growth Earnings growth GFCF growth Theoretical relationship Positive Positive Positive Positive Positive Positive Historical relationship Positive Positive Positive None None Positive

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Contents
P/E matters more than EPS over shorter timeframes page 5 What drives P/E? page 9 What drives EPS? page 14 One-year prognosis for Sensex page 19 Portfolio strategy page 22

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Drivers of EPS: The theory

Corporate earnings are linked to corporate revenues which in turn should be linked to the overall level of economic growth. The part of economic growth most directly impacting corporates is capital formation. Easy access to both debt and equity capital should in turn provide a fillip to capital formation. Whilst the cost of debt capital is directly linked to interest rates, equity capital availability can be linked to US bond yields. As we have often highlighted in the past (click here for the G&C 6.0 note dated June 13, 2013), rising US bond yields are indicative of an improving global economy and increasing investor risk appetite, leading to increased capital flows into EMs like India (Appendix 1 on page 34 reinforces this view). Inflation, on the other hand, may eat into corporate profit margins and negatively impact EPS. EPS growth should thus be positively linked to GDP and GFCF growth and rising US bond yields and negatively linked to interest rates and inflation. In the subsequent slides in this section we use actual historical data to gain insights into the practical drivers of Sensex EPS and consequently what they imply going ahead.

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What has driven Sensex EPS historically?

Periods of monetary easing lead to higher EPS growth EPS growth seems to follow US yields with a lag

Source: Bloomberg, Ace Equity, Ambit Capital Research; Note: 1-year G-Sec yield has been used to represent interest rates starting 2001 and SBI 1-year deposit rate has been used prior to 2001

Source: Bloomberg, Ace Equity, Ambit Capital Research; Note: US yields used here have been detrended for the structural decline of the last two decades- please see slide 34 for the raw series

Low inflation rates indicate an improving economy but beyond a point higher inflation leads to lower EPS growth

Source: Bloomberg, Ace Equity, Ambit Capital Research; Note: We have used WPI inflation Jun-05 onwards and due to data limitations we had to use CPI prior to that

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What has driven Sensex EPS historically? (cont.)

Over longer timeframes there is a link between Sensex EPS growth and real GDP growth The link between EPS growth and GFCF (capex) growth is even tighter

Source: Bloomberg, Ace Equity, Ambit Capital Research; Note: We have plotted YoY growth in real GDP on a quarterly basis since 98. In the periods prior to that, we have used the same annual GDP growth for all four quarters of that fiscal due to data limitations.

Source: Bloomberg, Ace Equity, Ambit Capital Research; Note: GFCF growth based on 1999-00 prices till March 2006; the red arrow denotes current level of the explanatory variable

Over longer timeframes Sensex EPS growth shows linkage to nominal GDP growth as well

Source: Bloomberg, Ace Equity, Ambit Capital Research; Note: We have used WPI inflation Jun-05 onwards and due to data limitations we had to use CPI prior to that

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In conclusion
What affects EPS? Monetary easing, rising US bond yields, higher GFCF growth and higher GDP growth seem to affect Sensex EPS favourably. On the other hand, high levels of inflation seem to impact it negatively. What do these variables suggest going forward? Our Economy team estimates only a moderate recovery in GDP growth for FY15 whilst the monetary policy is likely to remain hawkish as high inflation persists. Against these headwinds, rising US bond yields (and hence a likely global recovery) seem to be the key supportive factor for the Sensexs EPS. (For our FY15 macro view, please click here.) Our bottom-up estimate for FY15 EPS stands at 1,530 currently. Given the headwinds highlighted in the preceding point, we expect this estimate to be cut going forward (overestimation of EPS by the consensus has become a trend over the last few years please see page 19 for details). We expect a number closer to 1,400, implying 10% YoY growth vs the last ten-year average of 14% (Dec03 - Dec13) and last five-year average of 8% (Dec08 - Dec13).
Factor real GDP growth nom. GDP growth GFCF growth Monetary easing Rising US bond yields Theoretical relationship Positive Positive Positive Positive Positive Historical relationship Positive Positive Positive Positive Positive, but weak
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Contents
P/E matters more than EPS over shorter timeframes page 5 What drives P/E? page 9 What drives EPS? page 14 One-year prognosis for the Sensex page 19 Portfolio strategy page 22

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Do not expect a P/E rerating for the Sensex

We do not see a major rerating for the Sensex P/E (vs its last ten-year average of 17x on a trailing basis). Amongst the drivers of P/E noted earlier (short-term rates, yield curve, GFCF growth and US bond yields) whilst most are at inflection points currently, they have not staged a material turnaround yet (barring US yields). Moreover, our Economy team expects that GDP growth should only modestly increase to 5.1-5.6% in FY15 with monetary policy remaining hawkish (read the note here). The popular notion seems to be that a P/E rerating comes at the inflection point and hence towards the beginning of a period of improvement. In the 2002-2008 bull phase, however, the P/E rerating happened towards the fag end of that run. This low P/E perhaps reflected scepticism which is usually an important ingredient of bull markets. This scepticism also manifested itself in analysts underestimation of one-year forward EPS growth in that phase (i.e. CY06-07, full year consensus estimates are not available prior to 2006). On the other hand, consensus has overestimated EPS growth over the bear phase of the last few years. A favourable political outcome (which the latest CSDS survey is pointing to click here for our 27 Jan 2014 note on this survey) is the most likely wild card that can bring about a revival in animal spirits leading to a P/E rerating. But weighing this against the host of factors highlighted earlier makes us wary of betting on a rerating on balance. We continue to see FY15 as an in-between year (between a challenging and a more promising phase) for India.
P/E rerating in the 2002-2008 bull phase came at the fag end despite consistently high earnings growth

Source: Bloomberg, Ace Equity, Ambit Capital Research

Analyst scepticism in the bull phase vs hope in the bear phase

Source: Bloomberg, Ambit Capital Research; Note: The exhibit above plots the percentage difference between actual EPS for the year vs its estimate 12 months ahead based on CY end numbers.

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EPS growth to drive Sensex to 24,000

EPS estimate
Our Sensex EPS estimate for FY14 stands at 1,270 (implying 7% YoY growth). Furthermore, our bottom-up estimate for FY15 currently stands at 1,530. We believe there is a downgrade risk to these numbers (as has been the case for the last few years - please see the exhibit on previous slide) especially with monetary policy remaining tight. We believe the FY15 Sensex outturn is likely to be close to 1,400 (implying 10% YoY growth). This compares with the last ten-year EPS CAGR of over 14% (Dec03 - Dec13) and the last five-year EPS CAGR of over 8% (Dec08 - Dec13).

Sensex target
Applying a ten-year average of 17.0x trailing P/E leads us to a March 2015 Sensex target of 24,000.

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Contents
P/E matters more than EPS over shorter timeframes page 5 What drives P/E? page 9 What drives EPS? page 14 One-year prognosis for the Sensex page 19 Portfolio strategy page 22

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Three types of extreme market polarisations are normalising

Valuation premium of defensives to cyclicals is reverting from multi-year highs Smallcaps and mid-caps reverting from excessive valuation discounts to large caps

Value has been out of favour for the last three years; value now seems to be staging a comeback

Source: Bloomberg, Ambit Capital Research

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The economy seems to beginning its normalisation

FY15 is likely to be an in-between year for Indian macros GDP growth normalisation should begin as the country reverses the declining growth trend albeit marginally Inflation likely to remain elevated, motivating rate increases in the first half before the eventual relief in the second half. (click here for the detailed note by our Economist)
Inflation is likely to remain elevated in India in FY15 thereby motivating continued repo rate increases until 1HFY15 Indias growth normalisation process to begin in FY15

What stocks should work in such an environment of downbeat but turning macro? We look back at history for cues!

Note: Indicative trajectory for policy rates reflecting our tightening expectation. Source: Bloomberg, Ambit Capital Research

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Look back - Performance of cyclicals vs defensives

The 1990s were characterised by a rising valuation premium of defensives over cyclicals - this premium eventually peaked around 2000. Cyclicals were then rerated relative to defensives and this continued till the early 2008 Sensex peak. What has ensued since is a period of defensives outperforming cyclicals again. Periods of relative rerating of defensives were periods of bear markets for the Sensex (as seen in the plot of inflation-adjusted Sensex below) whilst the phase of cyclical outperformance was a period of strong Sensex returns. The interesting point to note, however, is that cyclicals had started outperforming defensives from around mid-2000, about two years ahead of the beginning of the Sensex rerating itself. With indications of this ratio having peaked again, could a Sensex upmove be around the corner?
Cyclicals to defensives in these periods

Source: Capitaline, Ambit Capital Research; Note: In the exhibit above we define cyclicals as Nifty stocks from Banks & Financial Services, Construction, Capital Goods, Automobiles and Realty sectors. Defensives are defined as Nifty stocks from Pharma and Consumer Staples sectors.

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Look back - Performance of small/mid caps vs large caps

Small-caps to large-caps in these periods

Small-caps relative to large caps: Three distinct phases Valuation derating for small-caps largecaps from 1994 to 1999-2000. relative to

This was followed by an upward rerating until 200506, followed by the current phase of derating. Interesting to note that small-caps turned up (down) ahead of the Sensex re(de)-rating itself.
Source: Capitaline, Ambit Capital Research; Note: Large-caps are the top 100 stocks based on market cap each year whilst small-caps are stocks with market cap ranks between 301 and 500

Mid-caps to large-caps in these periods

Mid-caps relative to large-caps: Three distinct phases Valuation derating for mid-caps relative to large-caps from 1994 to 1999-2000. This was followed by rerating upwards until 2005-06, followed by the current phase of derating since then. Again interesting to see that mid-caps turned up (down) ahead of the Sensex re(de)-rating itself.
Source: Capitaline, Ambit Capital Research; Note: Large-caps are the top 100 stocks based on market cap each year whilst mid-caps are the next 200 stocks (i.e. mcap ranks between 101 to 300)

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Look back - Performance of RoCE quintiles

Whilst high RoCE stocks have done well recently as they had done in the 1990s,

they were the worst performers in the 2000-2008 period. Note: Q5 almost never delivers regardless of decade

Source: Bloomberg, Capitaline, Ambit Capital Research; Note: In the exhibits above we look at the median performance of the top 200 companies on mcap each year ex-BFSI (and for BSE200 firms since 2002; this index was launched in 2002); performance assessment is on a forward-looking 1-year basis using trailing RoCEs.

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Look back - Performance of beta quintiles

Whilst low beta stocks have done well recently as they had done in the 1990s,

this wasnt always the case as the 2000-08 period tells a different story Note: Q1 almost never delivers regardless of decade

Source: Bloomberg, Capitaline, Ambit Capital Research; Note: In the exhibits above we look at the average performance of top-200 companies on mcap each year (and for BSE200 firms since 2002; this index was launched in 2002); performance assessment is on a forward-looking 1year basis using adjusted beta as on 31st Mar each year.

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Look back - Performance of valuation quintiles

Valuations have not mattered in recent times with the mostexpensive stocks performing the best and expensive stocks had done well in the 1990s as well

In the 2000-2008 period, however, valuations did matter, with the cheapest stocks delivering the best returns

Source: Bloomberg, Capitaline, Ambit Capital Research; Note: In the exhibits above we look at the median performance of top-200 companies on mcap each year (and for BSE200 firms since 2002; this index was launched in 2002); performance assessment is on a forward-looking 1-year basis using trailing P/Bs.

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What works best in the current context? QARP!

Summarising this section so far In a normal market scenario, cyclicals and small/midcaps outperform defensives and large-caps, with this inflection preceding the inflection in Sensex returns. Neither the markets love with quality nor its blind eye to valuations (as seen over the last few years) continues in a bull phase. More importantly, low quality never delivers, irrespective of the market phase! The current phase is characterised by an economy which whilst it continues to be challenging, is looking to normalise; at the same time, it is also characterised by a polarised stock market which has only just started to revert. Implications for portfolio strategy As we move toward a normal market scenario, combining valuations with quality should work best. Joel Greenblatts magic formula (magic formula combines earnings yield with return on assets to strike a balance between the two) is a demonstration of QARP. Not only did it work in the normal 2000-2008 period, it has delivered over the last 16-year period as well.
Not only has magic formula delivered in the 2000-08 period

it has worked over the entire 16-year period since 1997

Source: Bloomberg; Capitaline, Ambit Capital Research; Note: In the exhibits above we look at the median performance of the top-200 companies on mcap each year ex-BFSI (and for BSE200 firms since 2002; this index was launched in 2002); performance assessment is on a forward-looking 1-year basis using trailing magic scores.

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G&C 7.0
Portfolio construction methodology Our own version of QARP involves identifying stocks that fulfil the following criteria Do well on our greatness and accounting frameworks [click here for our 26 Nov 2013 note explaining our greatness framework and click here for our 22 Nov 2013 note explaining our accounting framework] Are cheap on at least one of P/E, P/E and EV/EBITDA vs their own five-year history

Whilst we weed out the most illiquid names, even from the resulting set of stocks, we assign 2x weightage to more liquid names (above US$2mn ADV) and 1x to illiquid names. This quality at a reasonable price (QARP) approach to portfolio construction in todays environment results essentially in a play on cyclicality, value and small/midcaps whilst not losing sight of quality. Even after clocking 280 bps of outperformance for G&C 6.1 vs the BSE500 (since September 23, 2013), we stay the course on this approach in our new portfolio, G&C 7.0.
G&C 7.0 portfolio vs the popular benchmark Nifty 50

Portfolio Nifty G&C 7.0

Median mcap (US$ mn) 8,220 1,790

6M ADV (US$ mn) 18.0 2.9

Median FY15 P/E (x) 12.1 8.8

Median FY15 P/B (x) 1.9 1.4

Median FY13 RoE (%) 17.2 18.2

Beta 1.00 0.96

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G&C 7.0- The composition

Company Name Bajaj Auto Tata Motors Exide MRF ICICI Bank Federal Bank IDFC ING Vysya Bank LIC Housing Fin. Larsen & Toubro Engineers India Coal India NMDC Oil India Petronet LNG Cummins India Power Grid Torrent Power Grasim Shree Cement HCL Technologies Cadila Healthcare Torrent Pharma Bharti Airtel Oberoi Realty Sobha Developers McLeod Russel Bharat Electronics Sadbhav Engg. DB Corp Bloomberg Sector BJAUT IN TTMT IN EXID IN MRF IN ICICIBC IN FB IN IDFC IN VYSB IN LICHF IN LT IN ENGR IN COAL IN NMDC IN OINL IN PLNG IN KKC IN PWGR IN TPW IN GRASIM IN SRCM IN HCLT IN CDH IN TRP IN BHARTI IN OBER IN SOBHA IN MCLR IN BHE IN SADE IN DBCL IN Auto Auto Auto Anc Auto Anc BFSI BFSI BFSI BFSI BFSI Engg & Const Engg & Const Metals/ Mining Metals/ Mining Oil & Gas Oil & Gas Cap Goods Utilities Utilities Cement Cement IT Pharma Pharma Telecom Realty Realty Agro Industrials Infrastructure Media Weight Mcap (%) (US$ mn) 4.3 4.3 4.3 4.3 4.3 4.3 4.3 2.1 2.1 4.3 2.1 4.3 4.3 4.3 4.3 4.3 4.3 2.1 4.3 2.1 4.3 2.1 2.1 4.3 2.1 2.1 2.1 2.1 2.1 2.1 9,064 18,213 1,432 1,330 20,134 1,157 2,475 1,733 1,728 15,452 853 26,436 9,293 4,670 1,362 2,043 8,286 843 3,843 2,501 15,942 2,819 1,492 20,318 1,093 468 484 1,298 217 945 6-mnth ADV (US$ mn) 12.8 45.3 3.1 4.4 71.0 3.8 20.0 1.2 12.5 41.8 0.6 14.7 6.6 2.7 2.1 2.2 16.6 1.5 3.4 1.3 24.5 1.5 1.2 26.8 0.6 0.8 1.4 0.5 0.2 0.3 Latest Debt Equity (0.7) 0.6 (2.3) 0.4 NA NA NA NA NA 1.6 (1.1) (1.3) (0.8) (0.6) 0.4 (0.4) 2.5 1.1 0.1 (0.3) (0.0) 0.8 0.0 1.3 (0.3) 0.6 0.1 (0.8) 3.7 (0.0) 3-yr 3-yr 3-yr earnings avg RoE avg PBITM CAGR (%) (%) (%) 23% 89% 4% 32% 28% 25% 20% 40% 15% 6% 12% 22% 23% 11% 42% 15% 27% -24% -6% 11% 47% 8% 27% -38% 3% 18% 6% 5% -45% 6% 58% 50% 21% 22% 13% 13% 14% 13% 20% 16% 35% 38% 32% 20% 29% 31% 15% 18% 15% 20% 29% 30% 31% 9% 15% 10% 17% 16% 9% 27% 18% 10% 14% 8% NA NA NA NA NA 14% 22% 19% 74% 35% 7% 17% 70% 20% 17% 13% 16% 17% 16% 14% 55% 27% 23% 10% 11% 23% FY15 P/E 14.2 7.5 13.4 7.7 8.6 7.4 7.0 11.7 6.8 16.9 9.1 9.1 8.9 6.7 9.2 18.3 8.2 9.8 8.6 15.2 14.4 18.9 15.4 19.8 9.1 8.2 7.9 9.1 13.3 17.1 FY15 P/B 4.8 1.8 2.2 1.4 1.5 0.9 0.9 1.4 1.2 2.3 1.9 2.8 1.7 1.2 1.5 4.3 1.3 0.8 1.0 2.8 4.1 4.1 4.2 1.9 1.3 1.1 1.2 1.0 1.1 4.3

We update the previous portfolio for the latest iteration of our greatness framework (the quality aspect) and for the latest valuations (the reasonable price aspect). Only four changes to the list of 30 stocks from G&C 6.1: Exits: Bank of Baroda (we turned sellers on bottomup on November 1, 2013), Voltas (fall in greatness score), Jagran Prakashan (better replacement available on greatness model) and Supreme Industries (valuations). Entrants: Federal Bank, Shree Cement, DB Corp and Bharat Electronics.

Source: Bloomberg, Ambit Capital Research

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G&C 7.0 - Implied sector weights

Sector Agro Auto Auto Anc BFSI Capital Goods Cement Chemicals Conglomerate Consumer Durable Engg & Const Fertilizers FMCG Industrials Infrastructure IT Logistics Media Metals/ Mining Miscellaneous Oil & Gas Pharma Realty Retail Shipping Telecom Utilities Source: Bloomberg, Ambit Capital Research G&C 7.0 weight (%) 2.1 8.5 8.5 17.0 4.3 6.4 6.4 2.1 2.1 4.3 2.1 8.5 8.5 4.3 4.3 4.3 6.4 Delta between G&C 7.0 and BSE200 2.1 1.5 7.3 (6.8) 2.9 4.1 (0.2) (0.8) (0.2) 3.3 (0.6) (12.8) 1.9 1.6 (11.4) (0.2) 1.2 3.7 (0.3) (1.7) (2.8) 3.8 (0.7) (0.2) 2.1 3.1

As highlighted earlier, for the construction of G&C 7.0, we look for stocks that do well on the greatness framework, are cheap on at least one of P/E, P/E and EV/EBITDA vs the stocks own five year history and are relatively liquid. Even within this set of stocks, we assign 2x weightage to more liquid names (above US$2mn ADV) and 1x to illiquid names. The sector weights, as displayed in the exhibit on the left hand side, are an outcome of the above process. We do not subscribe to using a market-cap weighted index as a reference point for portfolio construction.

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Audit of G&C 6.1

Price (INR) Stock Ticker Stock 20-Sep-13 28-Jan-14 Performance weight (%) BJAUT IN Bajaj Auto 4.3 1,992 1,938 -3% TTMT IN Tata Motors 4.3 338 355 5% EXID IN Exide 4.3 126 101 -20% MRF IN MRF 4.3 12,991 18,882 45% BOB IN Bank of Baroda 4.3 550 565 3% ICICIBC IN ICICI Bank 4.3 987 1,013 3% IDFC IN IDFC 4.3 99 93 -6% VYSB IN ING Vysya Bank 2.1 501 537 7% LICHF IN LIC Housing Fin. 2.1 208 200 -4% LT IN Larsen & Toubro 4.3 846 983 16% ENGR IN Engineers India 2.1 171 153 -11% VOLT IN Voltas 2.1 75 100 34% COAL IN Coal India 4.3 302 279 -7% NMDC IN NMDC 4.3 124 142 15% OINL IN Oil India 4.3 467 458 -2% PLNG IN Petronet LNG 4.3 125 105 -16% KKC IN Cummins India 4.3 409 436 7% PWGR IN Power Grid 4.3 102 97 -5% TPW IN Torrent Power 2.1 72 100 38% GRASIM IN Grasim 4.3 2,821 2,589 -8% HCLT IN HCL Technologies 4.3 1,062 1,400 32% CDH IN Cadila Healthcare 2.1 685 812 19% TRP IN Torrent Pharma 2.1 445 546 23% BHARTI IN Bharti Airtel 4.3 344 305 -11% OBER IN Oberoi Realty 2.1 171 192 12% SOBHA IN Sobha Developers 2.1 282 286 1% MCLR IN McLeod Russel 2.1 259 257 -1% SI IN Supreme Inds. 2.1 326 423 30% SADE IN Sadbhav Engg. 2.1 60 86 43% JAGP IN Jagran Prakashan 2.1 83 89 7% G&C 6.1 weighted returns (%) 6.2 BSE500 index (%) 7,281 7,528 3.4 G&C 6.1 alpha (%, since Sep 13) 2.8 Cumulative Alpha (%, since Mar 11) 16.8

G&C series- cumulative performance

Source: Ambit Capital Research

Note: Performance for Coal India includes special dividend

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Appendix 1- Rising US bond yields positive for EM equities

Uptick in US bond yields have been positive for Indian equities historically

Average quarterly returns during periods of high yields (shaded grey in the previous chart)
Period (and US 10 yr bond yield change) Period 1 (from 5.4% to 7.9%) Period 2 (from 4.3% to 6.6%) Period 3 (from 3.1% to 5.1%) Period 4 (from 2.1% to 3.4%) Period 5 (from 1.6% to 2.8%) Particulars start date: 31/10/1993 start date: 04/10/1998 start date: 15/06/2003 start date: 28/12/2008 start date: 08/07/2012 end date: 08/01/1995 end date: 06/02/2000 end date: 15/07/2007 end date: 17/04/2011 till date S&P 500 returns 0% 8% 3% 5% 5% 4% 2% MSCI EM returns 5% 15% 8% 9% 0% 8% 2% Sensex returns 8% 10% 10% 9% 3% 9% 3%

Avg for these 5 subperiods (i.e. periods of rising yields) Overall avg for the period (Sep-92 till date)

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Appendix 2 - Median stock performance vs Sensex returns

Bear markets for the Sensex are even more brutal for the broader markets, with average and median stock performances significantly inferior to Sensex returns. Overall, across timeframes, the median firms stock performance is significantly inferior to both the average stocks performance or the indexs performance pointing to the centrality of appropriate stock selection!
Median and average stock returns much worse than the Sensex in bear phases - as in the 92-02 period as well as since the 07-08 peak

In the 02-07 bull phase, average stocks did better than the Sensex but the median remained marginally lower

Over the full period, median returns significantly lower than the average as well as the Sensex

Source: Bloomberg, Capitaline, Ambit Capital Research; Note: In the exhibits above we look at the average and median performance of the top-200 companies on mcap each year (and for BSE200 firms since 2002; this index was launched in 2002); frequency of performance assessment is quarterly.

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Disclaimer
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