Higher earnings potential of cos and improving business environment make seemingly expensive stocks a red-hot proposition for funds

ET Intelligence Group: Shares of large companies that seem expensive to retail investors may not be so for big investors such as sovereign and pension funds. Infrastructure conglomerate Larsen & Toubro is a case in point. The company is trading at 27 times one-year forward earnings, compared to its average 5-year price-to-earnings multiple of 16.While the stock may seem expensive on this score, the company’s robust order book of Rs 1.95 lakh crore and revenue visibility for the next 3-4 years that will enhance its earnings per share (EPS), makes it more attractive. That explains why sovereign wealth and pension funds take longer term view and have continued to remain invested in large Nifty 50 companies such as BHEL, UltraTech Cement and GAIL, along with L&T.

According to Pankaj Pandey, head of research at ICICI Securities, sovereign and pension funds consider factors such as demographics, political stability and macroeconomic factors. “When these factors are positive, these funds take a long-term view,“ he said. At present, sovereign and pension funds account for about 17% of the total investments made by foreign institutional investors in India. This leaves them enough room to make more long-term strategic investments on the basis of earnings potential of companies in 2016-17 and 2017-18.

There are compelling reasons for these investors to put in First, these funds have invested mainly in developed markets where interest rates are abysmally low. So, these funds are on the lookout for companies that can deliver higher earnings growth than 6-8% in the long term. Large Nifty companies offer such potential. UltraTech Cement, for instance, is currently trading at 25 times next year’s earnings. This may make it appear expensive, but these long-only funds consider earnings over the entire cement cycle which typically stretches to 7-8 years. Besides, these funds usually invest in the business of the company rather than its stock.

This is the key reason why foreign institutional investors (FIIs) have been increasing their holdings in BHEL over the past two years. BHEL’s earnings are likely to remain depressed for the next two years since its order book has not been growing due to stiff competition. But once policy hurdles are cleared in the power sector, the company will be the key beneficiary. These funds value BHEL on discounted cash flow (DCF) method, which captures the earnings for the next 10 years. This is in contrast to the approach of the buy-side analysts, who arrive at a fair value, considering earnings over the next year. With Indian stocks appearing attractive from a long-term perspective, sovereign and pension funds increased their share of investments among FIIs in the country to 16.5% in August 2014 compared with 10.86% in September 2013.

“Fund managers of long-only funds give more weightage to earnings visibility because in the long term, the valuation difference between the value and growth narrows down. So, they invest only if they are convinced about the earnings visibility of companies.They are, however, faced with the challenge of selecting judicious investments,“ said a fund manager of a domestic fund house on the condition of anonymity .