Until end-February, the correction in Larsen and Toubro Ltd (L&T) shares was exactly in line with the broader market—both the Nifty and L&T fell by 15% year-till-date. But while the Nifty has corrected by another 8% this month, L&T shares have fallen by 22.5%.
Having corrected by nearly 40% from its highs in January, L&T shares are looking attractive at Rs2,728, especially given an average price target of more than Rs4,000 put out by five foreign brokers. At current levels, the stock provide an upside of 25% even if it were to achie-ve the lowest of these targets.
Also, the core business is now valued at around 15 times estimated earnings for fiscal year 2009-10, which analysts consider cheap since earnings are expected to grow at an average rate of more than 30% in the medium-term. (This is based on the most conservative estimate of Rs454 per share, among the five brokers, for L&T’s non-core businesses such as IT and finance and the value of its holdings in Ultratech Cement Ltd and its infrastructure subsidiary.) Some analysts have assigned a higher value for L&T’s various subsidiary companies, in which case the core business would appear even cheaper.
Coming to the reason for the bearishness in the L&T scrip lately, it’s important to note that the said losses on account of hedging commodity price risk would almost entirely be compensated by gains in the company’s core business. In the previous two years, it was the other way round, when margins in the core business were hit owing to higher commodity prices, but were partially offset by gains from the hedging activity. The net result remains the same. The problem, however, was that some analysts had estimated similar gains from hedging (as in the preceding year) in their earnings model. The fact that there would be losses instead came as a rude shock in these cases.
But more importantly, the outlook for the core business remains strong—besides a bulging order book, it now has new growth drivers in infrastructure projects, shipbuilding and power equipment. And even while a few brokerages have cut their earnings target, they’re still well above the current share price.
Global markets pricing in a stagflation scenario
Stagflation, the combination of high inflation with a recession, is the new bugbear for the US economy. BCA Research, the Canadian independent research outfit, recently noted that while the number of press articles containing a reference to “inflation” and “recession” has increased dramatically, references to yesterday’s favourite “Goldilocks” have dropped off a cliff.
However, they conclude that the inflation is temporary and that “it is worth noting that in the current cycle, producers were unable to pass on commodity cost increases to consumers when times were good, so it will prove even more difficult a task to raise prices in the face of a material slowdown in global activity.
Bottom line: Concerns about inflation are misplaced and the recent spike in headline consumer prices globally is a transitory development as the impact of food and energy on inflation has peaked. This will ultimately pave the way for the major central banks to follow the Fed in easing policy to preserve growth.
US Fed chairman Ben Bernanke agrees, believing that inflationary pressures will moderate in future.
However, there’s another school of thought that doesn’t try to justify the Fed rate cuts on the ground that inflation is a lagging indicator of economic activity. Instead, proponents of this view believe that the Fed is actually interested in stoking inflation, rather than curbing it. They point to the steepening of the US yield curve, because, while the Fed has forced down short-term rates, inflationary expectations keep long-dated yields relatively high. That helps banks, who borrow short and lend long, to make profits and, over time, to rebuild capital. And it helps borrowers by inflating their way out of debt.
According to this view, it’s part of the Fed’s grand design to stoke the inflationary fires.
If the view is correct, it would mean a weaker dollar, stronger commodities and new highs for gold. Perhaps it’s no coincidence that these are precisely the trends in the global markets at the moment.
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