Dear Investor
In this edition, we shall be discussing about the Union budget, Q3 result season, valuations, key themes that we are focussed on (particularly capex) and our belief that it continues to be time for alpha.
Union budget observations
We saw the Union Budget being tabled last month. The budget continued to focus on capex led growth and consolidation even in a pre-election year. Taxation was largely left unchanged which was welcomed. In capex, railways scored highest growth. Defence saw an 8.5% increase. The tax arbitrage between bonds and MLDs was removed. Overall, the budget maths was credible. Removal of tax benefit for debt has made equity asset class relatively more competitive vs debt for investors.
Q3 result season takeaways
The 3QFY23 corporate earnings season ended. Nifty profits saw a 12% increase during this period.
• Consumption slowdown was seen across sectors like FMCG, Durables, Discretionary, 2-Wheelers, and Retail. This pack has seen earnings downgrades as well.
• Commodities – Metals, O&G, Cement – dragged the quarter with a 63%, 19% and 28% earnings decline, respectively.
• Banking and Financials remain the most consistent performer with a solid 40% profit growth on a high base. Autos did well
- Excluding metals and oil & gas, Nifty and the coverage universe delivered a solid 29% and 31% earnings growth respectively.
- Nifty EPS has seen a small 1% cut for FY23E to 812 due to earnings downgrade in Metals. FY23 Nifty earnings growth is now expected to be 11.6%. Our Nifty EPS for FY24E remains largely unchanged at INR 993.
Higher interest costs seems to be impacting the discretionary spends. This trend should improve as the economy provides more jobs to the deprived sections supported by another round of wage increases.
Valuations
We have maintained that market should trade between 18x-18.5x one year forward earnings. With FY24 earnings still estimated to be close to 1000, it implies a fair market level of between 18000 and 18500. Debt continues to look more attractive (on a pre-tax basis), though when compared to the last period, its attractiveness has reduced with some rally in bonds and fall in equities. However, more importantly, the post-tax attractiveness of debt has reduced considerably for Indian investors on account of changed taxation on MLDs. This should result in better allocation from HNIs into equity in the new fiscal year.
Key themes that we are focussed on
We had shared the key themes in the last edition. The focus spaces like defence on indigenisation, hospitals in the healthcare space, banks on continued lending growth and benign credit cycle, engineering and cap goods on manufacturing renaissance, chemicals on China +1 continues. We believe that autos have taken care of the worries with respect to technology platform changes and present a relatively more attractive opportunity vs other consumption spaces.
Focus on the capex cycle
As compared to the past, when consumption was the sole driver of growth, capex is now gradually becoming the new growth driver. Data set around order inflows, short-cycle revenues of machinery and consumables, and capital goods imports together paint a picture that investment cycle is building at a faster pace. Investment cycle seems to have skirted the pitfall of macro headwinds and commodity price volatility resulting from the Russia-Ukraine war.
Multiple drivers of this cycle may make it larger and sustainable vs the narrow focus last time. We see several sectoral drivers of an investment cycle and this breadth can make it larger and more sustainable, despite scepticism about the size. This is contrary to the narrow power sector driven cycle last time. Sectoral leadership can be driven by:
(1) Manufacturing including defence (significant government push)
(2) Public spend on key sectors (road, rail, water and urban infrastructure); and
(3) Energy transition (renewable, storage, EVs and hydrogen). Real estate, metallurgy, logistics (warehousing, etc.) and data centres, among others, could add to the momentum.
Capacity utilization levels, though, are hovering ~75%, need to inch up for stronger capex cycle as one of the gross indicators. However, lot of the capacity in India may be redundant and need replacement/retro fitting and technology upgradation which will benefit the companies that can provide cutting edge solutions.
In Q3, Capital goods companies have reported strong margin expansion. This is usually a good lead indicator of strong demand outlook (so that competitive intensity is less), better capacity utilisations or new capabilities that are not yet commoditized.
It continues to be the time for Alpha
As we go forward, manufacturing margins should see an expansion and the compression in earnings breadth that was seen in Q3 should reverse. Broader earnings growth should help the market breadth. Moreover, new spaces like defence and chemicals which are long period compounding stories have emerged and provide alpha opportunities helped by alpha seeking domestic money flow.
Best Regards,
Prateek Agrawal
Executive Director – Motilal Oswal Asset Management Company Limited
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