In this monthly outlook we shall look at the following:
- Our view on which investing style could take precedence in the new fiscal
- Seeking Alpha. Which part of the market may perform?
- Valuations are now in favour of equities compared to domestic debt
- Key Risks
- Conclusion
In the market place, there are two prominent investment styles which are followed.
- High quality and high growth Style
- Value Style
Between 2012 and now, for a large part of the period, the high quality high growth style performed. From the Covid lows of March 2020, the Value style has been in vogue though lately some come back of the growth style can be seen.
Let us examine the reasons for the same.
- Less availability of credit: The period after 2012 saw Fed tapering which badly impacted Indian companies with forex borrowings. In 2015, we started to recognise banking sector NPAs and this made borrowing led growth further difficult. This culminated in the ILFS fiasco in 2018. With less credit availability for corporates, businesses which had cash on books and had high ROICs (low ratio of external cash sourcing) had a market place advantage and did relatively better. Stock markets follow growth and this was the part which was delivering it and it performed
- Policy Changes and Natural Interventions: The period after 2014 saw several large ticket structural reforms such as De-monetization, RERA, GST, etc and a natural disaster such as Covid. Larger/quality businesses are better able to navigate disruption. As a result, we saw not only a strong move from unorganised to organised but also small organised to larger players. The breadth of the market earnings narrowed and so did the market.
- The net flow of money into the market was mostly FPI money (they were consistent buyers) or domestic pension/insurance money. These are positioned close to the index.
- Because of the above reasons, either the quality space or the larger companies (the index) did well during 2012 to 2020
We have noticed the following changes from the Covid lows
- Strong inflows from alpha seeking domestic investors into PMS, AIF, MFs as well as directly into markets
- Strong industry supportive reforms such as PLI, Ethanol blending policy, Defence indigenisation, Make in India, Import duty protection, lower corporate tax rate, etc which has benefited corporate India in general and smaller companies in particular.
- Breadth of earnings has increased. FY21 saw strong growth in NIFTY earnings though FY22 saw a stronger growth in midcap earnings.
- The value part of the market offered cheap valuations and cyclical tailwinds in spaces like commodities and banks were strong
These factors resulted in strong comeback of the Value style of investing and beaten down spaces did well. The breadth of the market was good.
How do we see the future?
The cheapness in the commodity part of the market and PSUs has been largely realised and this part still looks cheap on many valuation metrics. We expect few trends going forward
- Commodity prices have corrected and margins of corporate India are expected to improve. The space with pricing discipline should see margin retention much better vs spaces with more competition.
- Growth which was omni-present as economy bounced back from Covid lows would now be at a premium going forward.
- Interest rates should peak out. Peaking of interest rates are good for businesses that derive a large part of total value from terminal value.
This implies that as we go deeper into the fiscal, style preference could increasingly change towards growth in new emerging high quality areas, while Value could also sustain performance as there are negative triggers.
Seeking Alpha. Which part of the market may perform?
FY24 is a year when nominal growth of the economy is expected to fall sharply. Budget numbers also build in just 10.5% growth and in a scenario of lower inflation (WPI has already fallen), the nominal growth can be lower than projected. As growth investors we have to seek out spaces where growth can sustain.
At the same time, another influencer is the high US interest yield. When we compare attractiveness of Indian equity vs the US interest rates, Indian equity does not seem attractive. We would have to see further fall in yields so that FPI interest into Indian equities re-emerges.
Q4 results season is on. Many IT companies have declared results and after Infosys missing numbers, it is now evident that there are issues in discretionary spending in the US.
IT is a large weight in the index and is facing headwinds. Larger banks, the other large weight in the index, are also facing several issues such as tackling a large merger, a CEO change and prospects of a NIM decline impacting FY24 earnings growth over FY23. Banks and IT put together are approximately 40% of the index. Commodity prices could be lower as well in the face of lower global growth. Overall for the Nifty, earnings growth slowdown is expected in FY24 as well and Nifty EPS could be sub 950.
This implies that there is a great chance of bottom up stories in Banks and IT to do relatively better. Other growth spaces such as Chemicals on China+1, Hospitals and branded generics on sustained demand, Engineering and Defence on continued order-book accretion and Make in India thrust of GoI, New Age tech as it moves closer to EBIDTA breakeven, Consumer Discretionary positioned at the premium end where the slowdown effect is least and NBFCs on interest rates peaking out, could benefit. These are spaces where we are focussed.
Consumer staple earnings would benefit from commodity price fall led margin increase. However, it remains to be seen if market gives a multiple to this commodity driven margin increase, in the face of high start valuations and sub nominal GDP sales growth.
Tailwinds of slowing earnings momentum in index companies and higher growth in the narrow themes as defined above should result in alpha generation for a quality and growth focussed investor like us.
Valuations are now in favour of equities
External risks are diminishing with our forex reserves again climbing and current account getting more balanced as a consequence of strong growth in services exports.
After the correction in bond yields, the bond yield to equity yield indicator is now in favour of equities. In the new fiscal, the tax increase on bonds has meant that attractiveness of equities on a post tax basis has improved.
Global flows should however, remain muted as global bond yields, despite showing signs of peaking out, are still high. Nifty yield minus US 10 year (inverted) indicator still points to investors preferring US debt over Indian equities.
The earnings growth expectations for FY24 have been brought down and could now be sub 950 levels. The valuations are on fair grounds with earnings growth and nifty compounding converging over 1997 to 2023 and hence, over the next few years earnings growth led price performance should be expected. We have started building in the risk of a sharp fall in the expectations of profits. Sharp fall in global M1 reduces the global growth prospects. A large part of Nifty earnings from commodities and Software have global linkages.
Key risks that we see going forward
Key risk would come from lower forex reserves as a consequence of western central bank tightening.
Banks are a large part of Nifty profits and there is no counterbalancing force to bank profits. Bank NIMs might peak out in Q4FY23. In FY24, banks could see a drop in NIM and would have to grow assets faster to deliver required growth in profits and maintain ROA through lower cost to income. This again could prove difficult as nominal growth of the economy would slow down.
Capex story in India is as yet driven by the government. With a sharp fall in WPI, government revenue growth may fall and could result in stress in the system.
In the face of lower sales growth, if companies lose pricing discipline, the risk to earnings growth would increase.
Conclusion
While there are risks, we believe our positioning is reasonably adequate to withstand the same. Forex levels are rising again and RBI is displaying a degree of independence by pausing rate increase cycle. Banks would see a NIM decline but have levers that can smoothen the earnings trajectory including a still benign credit cost environment. If corporate capex gains momentum, it would provide support to the government initiatives.
Overall, we believe markets are fairly valued and the end of the tightening cycle provides tailwinds to equity investing. We build in earnings growth led market performance over the next few years with high quality growth companies (the names could be different in this cycle) again emerging as key market drivers when achieving growth becomes more difficult.
Best Regards,
Prateek Agrawal
Executive Director – Motilal Oswal Asset Management Company Limited
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