Dear investor,
In this edition, let us discuss the following:
- Macro Picture is seeing headwinds
- FPI turned sellers and supply of paper is strong
- Risk Factors
- Valuations
- Time for Alpha
Macro picture is seeing headwinds:
Q2 result season is on and the first flush of results have been overall lower than expectations. Banks and Autos have delivered lower than expected though IT services have delivered mixed results. Capital market players including brokerages and AMCs have delivered good numbers. Cement companies delivered multi-year low EBITDA1 per bag. The result season has affected the earnings expectations for FY25 negatively.
Industrial activity has been weak during the period as rain spread and intensity has been more than last year. CPI1 inflation has risen primarily on food prices and this, along with strong FPI selling and drop in forex reserves, could delay start of rate cut cycle. Amongst quick indicators, vehicle sales are seeing a slowdown, as are GST collections.
However, these indicators are not surprising. Government spending was strong before elections and took a pause during elections. Elections were quickly followed by a strong monsoon period that suppressed industrial activity. Now government ordering is showing signs of restarting. Post monsoons, expectations of good farm income is high and economic activity may resume soon.
FPI turned sellers and supply of paper is strong:
FPI, which were significant buyers in Sep to the tune of USD 5.9bn, turned strong sellers in October as the Chinese market rebounded sharply. The intensity of sell off is high. Until 21st Oct, their selling had crossed USD 10bn. Unless this reverses, this is the highest monthly sales by FPIs in a month. While the Chinese market has entered a consolidation phase, FPIs have continued to sell on weaker corporate results and rising US bond yields. Large index sectors like banks are still over weight in FPI portfolios and have seen weak result season hence the space has seen FPI selling.
FPIs have reduced under-weight positions in Autos, IT, staples, and utilities while they have reduced over weight positions in discretionary, energy and real estate, apart from financials. We believe that spaces where the result momentum is weak could prove to be most vulnerable.
While FPIs have been selling, domestic institutions have mostly matched the selling.
However, this is a period when India Inc is raising record amounts through new IPOs, offer of sales, QIP, etc. Hyundai, one of the largest ever IPO, has been completed. We watch for good outcomes from IPOs. Hyundai has not made money for investors yet and could affect new investor sentiment. Strong fund raise is also crowding out the secondary market. As yet, the new investor momentum as measured by new demat openings seem to be sustaining.
Eye on Risk
Geopolitics risk has increased with escalation of Israel-Hamas- Iran conflict. However, lower oil prices have endured, while there was a brief spike. Strong FPI selling has resulted in our record high USD reserves falling below USD 700bn mark. US yields which were declining till the last rate cut decision have shown a sudden spike and 10 year is again over 4% and may be another reason for continued FPI sales. Chinese market has been buoyant and is sucking in liquidity from around the emerging markets. This could delay the onset of any rate cut action in India.
However, the move to China could have ended as Chinese stimulus was short of expectations and the sharp rally there is being followed by a correction.
Valuations
Market indices have been at the same level since July. With an over 12% earnings growth outlook, a 4-month market consolidation over Jul-Oct has resulted in nearly 4-5% valuation correction. With the correction in the Chinese market, there is a good chance that our markets also stabilize, especially if the US bond yields also soften.
Indian market is seeing PAT/GDP ratio improve from FY2020 onwards. This is on account of reversal in losses in Banks, a large part of the market, and also because of revival in the manufacturing spaces. China+1 sentiment has played a large role. Focus on indigenisation in various spaces and PLI1 schemes have also helped. Corporate profitability is buoyant for similar reason. It is also aided by operating leverage. We believe that with higher protection accorded to corporate India and with benefits of operating leverage kicking in, there are good chances that the past peak profitability could be crossed in a year or two.
Higher margins is a significant driver of free cash flow generation, ROE and ROCE1. Higher free cash flow generation has resulted in leverage in corporate India falling sharply. Higher richness of business results in valuations sustaining at a higher level.
While quality of business is the key driver of valuations, growth in earnings (indicator of growth in free cash flow) and discount rate are the other two factors. If we look at the long period delivery of earnings in India, the averages are around 12-13%. Current outlook of earnings growth is in the similar range, while last few years had seen a significantly higher growth. Interest rates have declined and volatility associated with Indian markets have also declined. This implies a reduction in discount rate vs historical levels. Going forward, there is a possibility that rates decline more, further aiding valuations. We hence believe that with large caps trading at average levels of past 10 years, there is a good chance of market, at least, sustaining the levels.
Overall, markets seem to be holding out quite well. Once the FPI selling subsides, do expect the market to bounce back as domestic flows continue, big IPOs are behind us and post Q2, earnings outlook for the second half could get stronger.
It continues to be time for alpha
As the result season progresses, we are seeing relative weakness in earnings of banks, cement, grocery retail, refineries, and autos vs expectations. Large IT companies have delivered mixed results vs. expectations but their YoY growth rates are low. We do expect to see Renewables, Capital goods, Midcap IT, Jewellery, Capital market plays, Defense, New tech, to deliver strong results. Our funds have a stronger presence in these spaces. We believe that these spaces have earnings growth tailwinds and the same may provide alpha opportunities to managers.
Wish you all a Very Happy Diwali and festivities
Happy Investing.
May the Good Times Continue
Prateek Agrawal
Executive Director
Motilal Oswal Asset Management Company Limited
Data as of Oct’24. Source: primedatabase, RBI, CLSA, ValueQuest, S&P Global.
1EBITDA – Earnings before Interest Tax Depreciation and Amortization. CPI – Consumer Price Index. PLI – Production Linked Incentive. ROE – Return on Equity. ROCE – Return on Capital Employed
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