Despite the change in the political scene, outstanding corporate numbers and strong liquidity drove stock prices in the past year. In a two part series to usher in Samvat 2061, we bring you the overall outlook for equities, the sectors to watch out for and the stocks that will hold the key to the Sensex's performance.

Oil may still be at $50 a barrel, the Indian cricket team maybe woefully out of form and India Inc's margins a wee bit under pressure, but the market's in a mood to celebrate. It's been a cracker of a performance from the benchmark Sensex, which touched a seven-month high at 5891, all set to usher in Samvat 2061.

The corporate sector may not have been at its best in Q2 but the long-term India growth story is on course and the government continues to surprise us with its pragmatism. And with $6 billion worth of stocks in the kitty this year, foreign institutional investors are convinced that India is where the action is. With the Sensex trading at 12-13x FY06 earnings, the markets are not too expensive.

Says Sukumar Rajah, chief investment officer, Templeton AMC, "Given that GDP is expected to grow at an average of 6 per cent, we expect corporate profit growth to be in the range of 12-15 per cent in the next three years. In light of this, the markets appear to be fairly attractively valued."

Anup Maheshwari, Head (equities), DSP Merrill Lynch, too, feels that the market is not so expensive. "Earnings should grow at around 15 per cent in FY06 and one could expect market returns to be in line with earnings growth."

While there are good picks among large caps, many are trading at not-so-compelling valuations. And that's what is increasingly driving fund managers to look at mid-caps.

What's more, many more global funds are now becoming active in India and not all of them are looking for large cap picks.  FIIs are now buying into stocks with market capitalisations as small as $50 and $100 million.

So the addressable market for FIIs, estimated at around $60 billion, half of which has already been bought into, is now growing.  With interest growing in mid-caps, many of these stocks could soon become more liquid and eventually turn into large-caps.

India has been traditionally a stock picker's market, but the strong macro story in 2003 prompted many to switch to a top-down approach. However, Rajah feels that long-term investors are better off adopting a bottom-up approach.

Adds Maheshwari, "Stocks and not sectors will be important. We are looking for stocks that have pricing power and are able to deliver above average returns. Stock picking skills will be crucial since the time-span between the time that results are reported and the price moves in the market, will become shorter, given the strong liquidity."

The Q2 numbers give us some clues about which companies could stay ahead of the pack. In a difficult quarter which saw a trucker's strike, soaring raw material and fuel prices and rising interest rates, the winners have been those with operating leverage and those that have been able to pass on the higher costs.

Some big players, especially in the tech sector, and even automobiles, have managed to grow sales even on the higher base of FY04. Net sales for a sample of 120 firms {market cap over Rs 1,000 crore (Rs 10 billion)} were up a handsome 25 per cent y-o-y though EBITDA margins were down at 19.44 per cent.

The set of smaller companies {market cap Rs 250-Rs 1,000 crore (Rs 2.5-Rs10 billion)} notched up impressive increases in margins both y-o-y and q-o-q, though it must be said that the results are skewed by individual performances and the strong results of some sectors such as steel and alloys, engineering and shipping.

Though several sectors have been in a sweet spot with both cyclical and structural factors in their favour, that the corporate sector is resilient is beyond doubt. The performance of many of these second-tier companies should make them attractive investments.

While the sector approach has all but been abandoned and stock picking appears to be the way to go, fund managers do admit that some sectors will prove to be better hunting grounds for stocks. Technology, for instance, where market conditions currently are favourable, looks good.

The bigger players, incidentally have seen better growth than their smaller competitors in Q2, remain firm favourites. Says a senior fund manager, "If Infosys is hiring 5,000 people a quarter, it must have some visibility". With billing rates stable, volumes on the upswing and offshoring here to stay, techs should continue to sizzle.

Engineering is the other exciting play. Infrastructure spend, more capex by corporates to expand capacities, and the export opportunity in the Middle East will drive growth. Orderbooks are bulging: Bhel 's book is worth nearly three years' sales at around Rs 23,000 crore (Rs 23 billion), L&T's is around Rs 10,000 crore (Rs 10 billion).

The huge investments in the power sector with equal spends on T&D as on generation should result in big orders for capital goods manufacturers. For Q205, margins for engineering firms were eaten into by higher raw material costs.

However, earnings are tipped to grow at a CAGR of 25 per cent over the next three years and margins, too, should expand by about 100-150 basis points. That's because newer contracts have been signed up at better margins and some price-escalation clauses built in. While its too early to predict pricing power, firms are able to pass on costs.

Moreover, with the topline growing, operating leverage will begin to kick in. Valuations at around 10-12 P/E on estimated FY06 earnings are attractive, say analysts. Pharmaceuticals is another sector that fund managers like though there is a difference of opinion on which segment could do well.

The large-cap generic players seem to be out of favour for the moment and second-tier firms making generics, active pharmaceutical ingredients, intermediates and doing contract manufacturing are in demand. MNC firms, too, are on fund manager's radars, given that patent protection is round the corner though the impact may be felt only in 2006-07.

There's a clear divide on banking. While loan growth was a strong 24 per cent in HI, net interest margins of many of the banks have fallen. Investments books have been cleaned up, but from here on asset growth will be the key to better net interest margins.

Many banks need fresh capital to be able to grow their asset books and will be forced to tap the markets. Fund managers appear to prefer banks where deposit repricing has not happened fully and are attractively valued, such as SBI or where the value of subsidiaries is high, such as HDFC.

It's almost a no-entry for auto stocks. Margins are clearly wilting under the weight of higher raw material costs and higher diesel prices aren't going to make things better.

Two-wheelers are troubled by keen competition and the lack of pricing power, though valuations are not demanding. The reverse is true for textiles where the environment post-quotas could stimulate growth but valuations appear stretched.

All in all, no one's complaining about the lack of stocks given that companies have emerged stronger in the last few years and have bigger balance-sheets and mounds of cash. As a fund manager says, "going forward, Indian firms should be able to leverage the excess capacities across the globe using their lower costs to their advantage, whether for goods or services."

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