Dear Investors,
As a process, let us track the various cuts of the Q3 numbers and follow it up with trying to understand what is working in the market and why and valuations. We would look at risks in the system and also see if the theme of China+1 is playing out. Topics covered would be as under:
• Q3FY24 Results. It continues to be time for alpha
• Is the theme China+1 working?
• What part of High quality growth spaces are working and why and Valuation support
• Risks that we foresee and how are we trying to mitigate them
Q3FY24 Results. It continues to be time for alpha
Our philosophy says that markets shall follow the sectors where earnings growth is better and hence tracking earnings growth is important.
The aggregate earnings of the MOFSL Universe companies exceeded expectations and rose 29% YoY (vs. MOIE est. of +19%). Earnings for the Nifty-50 jumped 17% YoY (vs. our est. of +11%). The earnings growth for the Universe was fuelled by domestic cyclicals (such as BFSI and Autos), as well as healthy gains from global cyclicals (i.e., Metals and O&G). BFSI clocked a 22% YoY growth (vs. est. of +17%), while Autos registered a significant growth of 60% YoY (vs. est. of +34%). Metals earnings jumped 74% YoY. OMC’s profitability surged 4.6x to INR120b in 3QFY24 from INR26b in 3QFY23, due to strong marketing margins. While overall numbers were strong, number of companies beating expectations were lower than the number of companies missing expectations.
After the results, the EPS estimates for NIFTY remains at 975 for FY24 and 1150 for FY25. The broader universe is expected to exceed these numbers in terms of earnings growth.
Since the broader universe would have higher growth in earnings, we continue to believe that it is time for alpha.
Is China + 1 really happening globally or is it a wish
We have been talking of China+ 1 for some time now. This move has gained momentum on various counts. To our understanding the following factors contributed:
- Disruption in supply chains that occurred during covid:
During Covid, various countries got impacted at various time frames, in a staggered manner. However, manufacturing was all concentrated in one country which chose to impose the strongest lockdown measures. This disrupted the global supply chains and as a learning from the same, the globe now desires to have more manufacturing within a country or near to it or have multi-country exposure vs putting all eggs in one basket. Japan is incentivizing industry to move back to Japan and to other locations. US is doing the same.
- China’s economic rise has been very strong and sustained. Over a short period of time, it has become the 2nd largest economy in the world and learning from the West, it has mastered manufacturing and is increasingly become leader in many new technologies. It has started flexing its muscles geopolitically, in the South China Sea, against all its neighbours and India and Taiwan in particular. It has been competing vs the US for global influence. This is something the west doesn’t like and would seek to delay acquisition of key technologies by China.
- It would also want to move away manufacturing on geopolitical risks
There are several data points to support this trend taking place. FDI in China has reduced. Research papers jointly written with the Chinese scholars have also fallen sharply. In fact, number of direct flights from the US to China have also fallen. This move is something that economist also notices.
- The decoupling move from China suits our interests as it opens up export markets for our products and also provides the government elbow room to provide incentive to/ protection to the domestic industry, resulting in a sharp improvement in FDI proposals. Bank sanctions for new projects and other indicators of manufacturing activity have remained strong.
How are the valuations?
Market is at a high and this does increase the focus on valuations. Let us understand what part of high growth high quality spaces have worked during different time periods in the market. We have tried to make the discussion as process oriented as possible. Let us focus on the chart where we have divided the long period into 3 periods viz 2003-2008, 2008-2021 and the period beyond 2021.
There are several takeaways:
- The growth in EPS in the 2008-2021 period was just about 5% for Nifty. Midcap index delivered close to 4% and small cap index delivered just about 2.8%. The best EPS growth was significantly lower than the nominal growth of the economy. Mid and small caps, where earnings growth is expected to be stronger than large caps on account of size benefits, actually grew slower. Our philosophy says, market prices follow earnings. Hence, this was a period when the large cap index performance was the best amongst indices. Generating alpha against the large cap index was very difficult for most managers as earnings growth was not there in the mid and small spaces.
- 2008-2021, the highest quality part of the market, eg FMCG index saw strong earnings growth of 12%. Since this earning growth was significantly higher than the index, the highest quality space did very well and provided outperformance almost all through this period. It compounded at 15% for 15 years while the profit growth was 12% and traded at never before valuations. This was a period when the highest quality and highest growth part of the market was nearly the same. In the later part of this period, there were large and successive rate cuts which helped the growth valuations sustain higher. Since the highest quality and highest growth parts were same (nearly), one could interpret the move as rate cuts helping the highest quality part of the market.
- The period after 2021 has seen several changes. The mid and small cap indices are seeing a much stronger earnings growth vs the large cap indices. In this manner, this period is more like 2002-2008 period, rather than the 2008-2021 period.
- The growth in large cap index earnings has been significantly higher than that of the FMCG index earning growth (as an example of highest quality part of the market) which to start with had valuations significantly higher than the valuations in the 2002-2008 period. Highest quality and highest growth part of the market are no longer the same. Market continues to follow earnings growth. This has led to significant underperformance of the highest quality part of the market as was the case in 2002-2008 period.
- The companies doing well in the current period seem to have a very sustainable level of debt. Debt was the cause of problems in the post 2008 period and on this count the companies which are doing well in the present are well placed.
Highest Quality and Highest Growth sector would’nt be the same always
What have we opted to do in the high quality high growth space?
- If we run the DCF process of valuations, highest quality part does get benefitted from lower interest rates but the key beneficiary is the highest growth part of the market. In the current period, when the highest growth part is different from the highest quality part, we believe that the response to rate cuts expected over the next few months could be very different and in favour of the highest growth space.
- Hence given our belief that growth is reviving strongly and would sustain given government policies and reverse globalization tailwinds, we have opted to construct portfolios where the growth quotient was maximized. Team based processes fleshed out several long term high growth themes (we would test China+ 1 in this edition). We made sure that quality quotient was high and put a filter of 15% on ROCE (the average of the market) so that we search for ideas in the better quality half of the market. Typically, our ROCEs are higher than 25% but where they are not, there is cash on books. In a combination of cash and free cash generation from business, we believe that most of our businesses would not need to raise equity money over the next several years for up to 25% EPS growth. By investing into them our clients would get the benefit of non-dilutive eps growth which ultimately results in performance. As a process towards delivering sustainable performance, we have tried to include all growth themes in the portfolios so that whichever theme works in the market something in the portfolio is working for the clients and the investing journey is as smooth as possible. Over and above this we are running high conviction 20-30 stock portfolios with no high concentration to avoid risks associated with this strategy. The processes to rebalance portfolio and recognize and implement stop losses are also well established. We believe that on account of substantial earnings growth delta over benchmark and favourable PEG ratios, even correcting for premium PE paid and costs, there is substantial alpha to be made in this construct.
- While this is our chosen position at the present, if a different construct where quality seems to provide better benefits, we would be flexible to change.
- When we see the valuations segment wise the large cap valuations continue to seem to be favourable. Mid and small cap valuations are higher than long period average. However, in the past, mid and small caps did not have a sustained period of strong earnings growth continuing for any substantial period of time given the disruptive nature of 2008-2021 period which saw Lehman, Taper tantrums, bank loss recognition, ILFS and ultimately Covid crisis. Hence, historical takeaways may not hold.
- In this period of reverse globalization, there is a good chance that the earnings momentum in smaller companies sustain higher than the larger companies which would imply that the space would continue to hold the promise of longer period outperformance.
What are the risks?
• Contrary to expectations of strong FPI flows in the new year on reduced US bond yields, the same continues to be elusive. US bond yields have again topped 4.2% and FPIs have been sellers. US continues to run large fiscal deficit and this would require financing while US Fed continues to Taper as per plan. This could increasingly prove more difficult as we go forward. Moreover, the economy remains robust and unemployment percentage remains low. This can postpone fed rate cuts and the pace of cuts can be slower than expectations with consequent impact on valuations.
- While continued higher than 4% yields in the US, is negative for flows, the positive is that the influence of domestic flows on the market would continue to increase. Domestic flows are more focused on the growth themes which have a stronger presence in the mid and small cap segments, apart from seeking deep value. Moreover, they are structural, mostly through SIPs and this suits our growth style of investing better vs high volume spiking FPI flows.
US Continues to run Fiscal Deficits
• Conflicts around the world and impact on India.
More parts of the world are seeing conflicts. Conflicts which were earlier confined to Russia-Ukraine, have spread to Israel-Palestine and now even the Red Sea area is seeing hostilities. This could endanger supply chains and disrupt trade and result in inflation spikes. To guard against this risk, we are more focused on domestic market focused businesses vs exporters at this juncture. Import substitution theme should work quite well in this scenario. Risk of an Oil price spike remains which could stretch our fiscal deficit situation. However, as explained in the Nov 23 edition, we believe given the low current account deficit this risk is well within tolerance limit.
• Risk of lower global growth
In the coming year, a slowdown in global growth is a real possibility. A large part of the US post COVID growth has been supported by large and growing fiscal deficits. Post elections in the US, the governments should be expected to attempt a fiscal consolidation, which may hurt growth. Even otherwise, vs very low real interest rates, now the real interest rates have increased sharply, again impacting growth sentiment. China, the other large economy, has provided some growth impetus but has its own problems.
- Our belief is that lower global growth’s impact on Indian economy balances itself. Our services exports are resilient and continue to grow. Our goods exports are just about 18% of our GDP and a percent drop in global growth rates impacts potentially our growth by just about 18bps. This drag on growth is compensated by lower oil prices (vs prices in a higher growth period). A $10/bbl difference in oil prices, impacts our import bill by USD13bn approximately.
- Moreover, our exports are benefiting from China+1 which can more than compensate for any slowdown. Recent trade deficit data was favorable and now the expectations are that the current account deficit for FY24 may be just about 1%
Thank you. Happy Investing
May the Good Times Continue
Prateek Agrawal
Executive Director
Motilal Oswal Asset Management Company Limited
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