Dear Investor/Partner,
In this month of Market Outlook, we shall be discussing the following topics:
- Early trends of the Q1 result season
- Strong continued inflows into the Small and Mid cap space
- Time for alpha
- Macros and Valuations
Q1 FY24 result season
IT sector, as usual, has been the first to declare results. While the softness in numbers was expected, the deal momentum was seen practically across the board and surprised positively. In some sense, soft future commentary and good deal momentum seem to be contrary trends. Mostly, spends are being controlled on economic slowdown and could move up as economic outlook becomes better. AI is the new focus area. Companies want to be AI ready. This change would mean a lot of work for IT companies over the next few years.
Our focus continues to be the smaller IT companies which are focussed on tail winded verticals like auto tech, telecom technology, travel and leisure or getting tailwinds from region focus (Europe generally doing better than US on outsourcing growth), or benefiting from size cohort change (now being eligible for larger deals also). This space has held up much better compared to its large peers.
Few banks have also delivered results. While growth in AUM has sustained for retail banks, there has been a significant NIM compression. This has occurred a tad before expectations. NPAs have also crept up. Banks have dipped into provisions made during last few years to report strong profits. The gap in AUM growth between banks with high retail presence and banks with significant corporate book has increased.
HUL reported just 6.5% revenue growth of which volume growth was just 3% as pricing led growth tapered off. Gross Margins, however improved by 279bps yoy and 137bps QoQ as input costs remain favorable.
Overall, the result season is expected to be strong. Autos, refining, lending spaces are expected to drive growth in profits.
Midcaps and small cap funds continue to receive inflows
Indian investors have continued to sustain faith in the equity markets and inflows into MFs have continued to sustain. We have noticed inflows reduce during strong months and are stronger when the markets consolidate or are weak. Buying on dips is increasingly being adopted by investors. FPIs have also continued to buy and with large institutional classes buying, market has continued to remain strong. For 3 months till July 24th, Indian market has been one of the best performing market globally.
Of the various market cap cohorts, domestic investors have continued to favour the mid and small cap categories. To some extent it is supported by the long period growth themes that we have been sharing.
However, continuous flow of money into the Small and mid space has had some effect on valuations. Midcaps which have on an average traded at a 13% premium to Larger caps are now trading at over 20% premium. However, this is still significantly below the peaks seen in the past and are, as yet, sustainable.
FPI flows have also been positive for the last 5 months and have been very strong over the past 3 months. Insurance flows though have been negative.
Time for Alpha
For alpha, in the past we have shared several thoughts on why this period should prove to be a good period for alpha generation. Let us look at developing the same thought differently and find the right spaces to focus on in a focussed high conviction strategy. If correct spaces are identified, alpha creation can be significant.
IT and banks are two large spaces in the Index and typically don’t perform together (one can visualise this as one space becoming the source of money for other spaces). It is hence important to have a view on how the banks and IT sectors would behave as we go forward. The thought is that in a still capital starved country like ours, both the spaces typically don’t work together and money moves from one to the other space. We believe that going forward, there could be a situation where for some time, neither of the two indices may do very well. This is in line with the themes that we have shared in the past. Many large banks are seeing change in their leadership and market would want to wait and see the new leadership perform. Insurance space, MFs and capital market players may lead performance in the BFSI vertical. Similarly, the larger cap IT names have declared soft results and have indicated continued softness for some more time. Here again, we favour New Tech companies and mid cap IT spaces for performance. Midcap companies have seen many leadership changes and unlike the banks, the leadership change here brings with it new business opportunities which is positive.
The other two spaces to compete are the consumers and capex plays: For a long while, particularly the 2012 to 2021 period, the consumer space performed better than the capex plays. Factors like taper tantrums, bank loss recognition and ultimately ILFS crisis all contributed towards souring investment sentiment apart from disruptions like Covid and structural reforms, which needed time to be digested. In this period, consumers continued to do relatively better and market performance followed. However, now with sustained momentum seen in various parts of capex such as housing, private industrial capex, continued government capex, defence indigenisation, and positive policy environment, the participants of this theme are increasingly drawing attention. In our portfolios we have chosen to be with the capex theme over consumer staples. In consumers, we believe the space of luxury consumption and fast fashion would hold out better.
Macros and Valuation
Economic activity continues to sustain. GST collections for Jun23 (underlying May activity) were up 11.7% YoY, in line with the 3 month trends to Rs1.6Trn. The Domestic component of GST was up 18% YoY. GST collections are a good representation of the health of the economy. The central government fiscal data for May23 shows a sustained capex push with capital spending +68% in Apr-May’23; road + rail spending is +54% YTD. In this pre-election fiscal, the government could accelerate spends to keep the growth momentum strong. Forex reserves have continued to be buoyant and have crossed USD600bn after a long while. This should result in continued policy freedom for our central bank and our interest rate increases could continue to lag that of the west, with a good chance that we don’t see any further rate increase. We are a country with large unemployment and growth is an imperative vs the West which has close to a 100% employment.
We have been sharing our construct for valuations as 18-18.5X one year forward earnings. On a FY25 Nifty earnings estimate of 1100, if we apply the top end of this range, we get a target of 20,350. From current levels of the index, this is just about 2% away. As we have noted earlier, the midcap space is valued in line with the large cap space. With this reality, one should expect a period of consolidation in the market. A quarter of consolidation corrects valuations by 3-4% given a 12 to 16% compounding expectations of the index earnings. At the current juncture, given the current taxation structure, the hurdle for equity returns for HNIs to opt for equity over debt is around 5.5% and hence if we get a period of consolidation of say a quarter/ a drop of around 5%, we do expect stronger domestic flows into equities. This has happened in the past and trend should continue.
We believe that since the growth themes such as Hospitals, Chemicals, EMS, defence, engineering, new tech, 2nd rung tech companies, retail focussed banks, etc are best represented in the mid part of the market, this is the part to continue to focus on for investing and alpha.
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