Dear investor
In the last edition, we had discussed about various risks which were cropping up and examined tolerance limits along with our portfolio positioning. Happily, two of the major risks we examined have seen improvement.
- Risk of Oil prices flaring up: Oil prices have receded sharply and are now below USD80/bbl on slower Chinese/European growth and prospects of more Venezuelan crude coming to the market. We had discussed last period that as an economy our tolerance limit here has improved to over USD100/bbl. Lower than USD80/bbl crude should help improve current account deficit projections.
- Risk of higher US bond yields sustaining for longer: Lower than expected inflation reading caused US bond yields to sharply correct. From close to 5%, 10 year yields have dropped to approximately 4.5%. However, this is a marginal change and while it can cause some amount of short covering led inflows, case for structural FPI inflows is still weak.
Quarter 2 result season: Tailwinds for alpha generation continue to be strong
- The 2QFY24 was strong on margin tailwinds. Domestic cyclicals such as Automobiles, BFSI and Cement drove the beat. Forward earnings for Nifty were revised upwards by ~1% each for FY24/25.
- The aggregate earnings of the MOFSL Universe companies rose 48% YoY (vs. est. of +40%). Earnings for Nifty-50 posted a solid 28% growth (vs. est. of +21%). The earnings growth in MOFSL Universe was led by domestic cyclicals, such as BFSI (33% growth) and Auto (112% growth). OMC’s profitability surged to INR266b in 2QFY24 vs. a loss of INR27b in 2QFY23, owing to strong marketing margins. Ex-OMCs, MOFSL earnings grew 30% YoY, which were also above our estimate of 23%.
- Nifty delivered a beat with a 28% YoY PAT growth (vs. est. of +21%). Ex-OMCs, Nifty’s earnings grew 22% YoY (Vs. est. of +15%). Ex-Metals & O&G, Nifty earnings were up 32% (Vs. est. of +27%).
- The earnings momentum of the broader universe continues to be stronger than narrow large cap indices. Since market performance is expected to follow earnings, this implies that the tailwinds of Alpha Generation are still strong.
Time for Alpha: Harnessing the tailwinds
- Where is earnings growth higher: Higher growth in new emerging spaces with tailwind of reforms vs larger older businesses. This is a sharp change from what was witnessed in the 2008-2021 period. If we look at sharpness of earnings increase and spread of earnings, it feels more like 2003-2007 period vs 2008 to 2021 period. With most of the new themes in the small and midcap part of the market, this space should continue to deliver outperformance.
- Our portfolios are well positioned for emerging growth themes and have a high growth quotient.
- Side step FPI selling pressure: FPIs own mostly banks and large software and this is the space that is seeing the brunt of selling. With yields continuing to be high in the US, it is still pre-mature to expect any inflows into Emerging market funds. However, India would benefit from increasing weight in the MSCI indices. On the other hand, domestic flows are proving to be structural. They strengthened in the past period when the market was confronted with several uncertainties, again proving the long term faith in the equity markets. Around 50% of domestic flows are going to mid and small cap MFs, providing strength to this part of the market.
- Our portfolios have presence across market cap. Since themes are more present in the small and midcap part of the market, this space is well represented.
- Sharp portfolio. Have low, if any exposure to head-winded sectors: IT and Banks in the larger cap indices continue to be head-winded: In the past period, RBI increased risk weight on unsecured lending (with a few exceptions like MFI) and NBFCs (excluding MFI, gold and housing loan NBFCs). Increased risk weight would slow down lending to the personal loan segment, which was the fastest growing segment for banks and also for most fin-techs. Lower growth prospects or lower return ratios would have to be digested by the market. Similarly, large IT continues to face headwinds from prospects of global slowdown and relatively weaker health of the BFSI space in the US, the largest source of business.
- Moving money to newer growth areas hence should deliver alpha. Similarly, with manufacturing seeing a renaissance, exposure to this theme should deliver alpha vs general consumption space while luxury consumption can hold up much better.
- Our portfolios are heavier on engineering and make in India vs consumption and are under-weight vs index in Large cap IT and Banks.
Valuations continue to be sustainable
Valuations continue at the upper end of the sustainable band. Our construct for the market is 18-18.5X one year forward earnings, which gives us a target of around 20350 for Nifty on 1100 nifty earnings for FY25. This leads us to expect a slightly lower than earnings growth returns over the next few years. However, stronger than past long period average earnings growth over next period should help and net results for investors should be good. Midcaps are trading at a small but sustainable premium over large caps. Given the strong presence of the growth themes in the midcap space, we do expect the space to continue to perform on a relative basis on continued policy support.
Thank You
Happy Investing
May the Good Times Continue
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