Dear investor
In this edition let us discuss the following:
- Result season trends in numbers and market reaction. CY24 could see the same growth spaces perform as in CY23
- Investing Style working in the market
- Valuations in the various parts of the market and sustainability of the same
Result season takeaways
CY24 could continue to see many of the same spaces perform strongly for growth investors
- Early trends in IT services results show that large cap IT services growth is significantly lower than mid and small cap IT services growth. Successful Mid cap IT companies are focused on verticals which have tailwinds while large caps are present in all verticals and some would be head winded in a slowing economy
- Large Consumer companies are finding it difficult to deliver volume growth. This is a year when, on account of lower IT services job growth and lower growth in government spend, consumption is head-winded. However, in the consumption space, luxury consumption remains strong on wealth effect of buoyant real estate, equity and gold prices. In this space, jewelry companies and premium builders have shared encouraging growth numbers; detailed results are yet to be declared.
- Banks have barely maintained NIMs in the first quarter and there are expectations of further NIM decline in subsequent quarters. Deposit growth remains a challenge. Some banks have reported increase in deposit rates which would pressurize NIMs going forward. We have an underweight position in banks and have opted to be with high AuM growth banks to enable PAT buoyancy. Results of higher growth DNA banks have been largely in line with expectations.
- Larger capex companies are yet to declare results. Some smaller capex businesses particularly pipes companies have delivered good results. Order book buoyancy has been witnessed across the board. While there could be a lull pre-elections and growth of government spending on capex could be lower in the new fiscal on fiscal consolidation as fiscal deficit reduces from 5.9% to 4.5% over next two years, we believe that private sector ordering, PLI related capex and import substitution capex would help keep buoyancy in this space.
Investing style working
From the bottom of Covid, Value style of investing has been working very consistently for 4 years now. The same style worked in the month of December and January also. Tech services space is no longer a high growth space for example yet it performed well. Similarly, a very large part of the PSU space is seeing strong traction. In the PSU space we do note that newer, smaller companies are now seeing strong performance vs better names in the space which does point to the value slowly exhausting.
We are exponents of the high quality high growth style of investing and our portfolios reflect high growth themes like China+1, Renewable energy, New tech, EVs, Hospitals, etc. Focus on the highest sustained growth spaces has helped our portfolio outperformance in CY23 and remained competitive in the month of January. We believe that as the interest rate reduction cycle sets in over the next few quarters, this style of investing would increasingly find favor, more so also because value itself is becoming scarce.
What would drive growth in earnings as we go forward
Factors driving earnings growth are
- Sales growth
- Operating leverage
- Taxation reduction
- Margin expansion
As we go forward in the new year, we believe that some of these factors which provided tailwinds in the past, such as taxation reduction, have played out. Key driver for sales growth is the growth in the economy, which is being projected to be similar in 2024 vs 2023. For the listed space to do relatively better, shift from unorganized to organized should continue. With the reform intensity continuing to be strong, we believe that this shift would continue and listed space should deliver double-digit sales growth. Some operating leverage should kick in with growth as capacity utilization levels improve further. Margin expansion has been the story of 2023 and this factor could continue to drive profits next year as well. Margin expansion could take place on lower inflationary conditions and could also take place on account of stronger protection that is being accorded to the industry on China+1 sentiment and reverse globalization sentiment sweeping across the world. Our PAT margins are significantly lower than what were seen in the 2005-2008 period and 2015-2018 period and have room for expansion.
Valuations in various parts of the market
Today market is sanguine about the valuations on the larger cap part of the market. Larger caps are trading close to long period averages on one year forward earnings and seem sustainable. We also agree on the same.
General consensus on the Mid and small cap part of the market is that this part has seen a very strong growth over the past year and now trade at a premium to long period average and their valuations are stretched. Here we would like to point out that long period average does not do justice because in the 2008 to 2021 period, their earnings hardly grew overall and were also very volatile. The reason was multiple disruptions that the economy saw in that period from domestic and global factors which larger companies were better able to tackle and in addition, onslaught of globalisation. Averages hence are lower than potential. If we see the period from 2021 onwards, mid and small caps have delivered much faster earnings growth vs the larger cap part of the market. To our mind, this is on account of reverse globalisation and China +1 sentiment sweeping across the world. Till it sustains, we believe that the new ecosystem that is being created to enhance domestic manufacturing capabilities and fuel import substitution, driven by a new breed of entrepreneurs, would continue to provide earnings growth which are higher than the larger cap part of the market.
Our thought is that if growth delta in the small and midcap part of the market sustains favourably vs large caps, their valuations would also sustain. We see a good chance of this happening. On the flows side, strong sustained growth in the SIP book which has been more directed at the small and mid-cap part of the market would also help sustain market valuations. We hence continue to believe that it is Time for Alpha.
What risks do we see?
- Contrary to expectations of strong FPI flows in the new year on reduced US bond yields, the same has not happened. US bond yields have again topped 4% 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.
- In-spite of all the rate increases in the US, 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.
- Rate cuts themselves can be seen as a response to evidence of slowing economy
- 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. Oil price spike could stretch our fiscal deficit situation
- While FPI inflows have been strong for us, more stable FDI inflows have seen a slowdown. Number of Unicorns are lower than the year before impacting start up sentiment.
Summary
Overall we believe in a good possibility of rate cuts and continued buoyancy in the economic growth and believe that margin increases would be a key driver of profit growth even in this year. Fiscal consolidation by the government may not impact as households and corporates take up the baton for capex. Valuations have caught up but are defendable and near earnings growth returns should be expected on the index while higher growth outside of index should provide alpha generation tailwinds to managers.
Thanks and Regards
Prateek Agrawal
Executive Director
Motilal Oswal Asset Management Company Limited
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