A Safe Haven Market?
The Indian stock market is defying gravity and traversing uncharted territory as it scales new peaks. If all goes well, it seems as if it is just getting started
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It seemed like the usual. He was quite the regular there, coming most late evenings – and sometimes staying into the wee hours. The resto-bar was the same, with the chatter of excited voices inside and the blaring traffic outside drowned out by the thumping music, lights playing on the decorated walls, and the bar all a-glitter, sparkling with bottles of brands, some well-known, some rare.
But things weren’t the same. He was a familiar face to the staff, most of whom he knew by face, if not by name, as well as to the other regulars. But they noticed something different. He wasn’t his normal exuberant self. “Perhaps he’s in his cups,” suggested one. “And perhaps he’s going through a mid-life crisis,” voiced another. “Nah,” prophesied a third. “He’s in the midst of a mid-cap trauma.”
That last certainly said much. For many of the past few years, he had advocated to all and sundry (those who would listen) that mid-caps were the game to play in the market. Quaffing peg after peg, he expatiated on why large-caps were passé. But look at him now. He needed to shed much more than a dollop of weight, and not only on his rotund figure, but also in his hefty portfolio, belly-full with mid-caps (cups). The large-caps, having stolen a march in the markets, he was left gasping, in the lurch holding a basket of goodies that seared like the amber liquid glinting in his glass and swirling down his throat.
He had to switch strategy. But was he too late. Was he too “mid”-heavy to make the requisite shift to large-caps which, having consolidated while the mid-caps were partying, were now racing ahead, drawing the rest eagerly behind.
It is a sign that the times, they are a-changing. The stock market’s euphoria is clearly visible in many parts, reflecting an economy that is driven by a new reforms process.
We, though, at BW Businessworld, are not so flabbergasted. We had published a cover story indicating that the stock markets have what it takes to get into a multi-year run, give or take a few spills, purely based on the macro-economic growth being unleashed by the Modi government’s reforms.
We categorically stated that the bellwether Sensex could smoothly ride to 50000 in 3-5 years. This was when the Sensex was hovering around 26500 levels. Call it good fortune or call it good forecasting, or call it greed, the markets have found good momentum ever since the markets sounded that forecast.
Liquidity flows just from MFs toted up to more than Rs 1.3 lakh crore in the past one year showing that investors are beginning to believe in the power of compounding through equity markets – not traditional avenues like gold and real estate. The foreign investor is absent. In fact, in 2018, foreigners have pulled out as much money from the debt and equity markets as they did back in 2008.
Even then, while some economic strands of our past story have proven true, what is interesting, just as we figured out, is that the Sensex seems to be on course to hit 50000 – for a mere 33 per cent rise can take it to Mount 50k. Earnings, revenue growth, conducive macros, valuations, liquidity, economic reforms – are all converging just at the right time.
This journey, of course, has not been without surprises. One such has been the demonetisation. The implementation of the GST (goods and services tax) also slightly held back growth over the last year. But, in the course of the next few years, backed by a recovery in earnings, the market still has enough belly-power to charge the distance.
Make no mistake, though. This is a sharp and discerning market, where only the best stocks, particularly those that can move up the league tables, are showing that power, though perhaps they may be overpriced.
“While Indian markets are close to all-time highs, we are witnessing the most concentrated performance since 2015, with select stocks outperforming and the breadth in the market lagging. The stocks that have done well appear very expensive and the rest of the market appears reasonably valued,” says S. Naren, ED and CIO, ICICI Prudential Mutual Fund.
The markets are reflecting the new-found earnings potential of companies. The last few years have lagged because the reforms process undertaken had to take root across the economy. And as demonetisation and GST were firmly taking hold, earnings took time to catch up.
“For the past 6-7 years, Nifty earnings have been suppressed at about 6 per cent or so. This is clearly below nominal GDP. Typically, corporate earnings over the long term should track nominal GDP,” says Manish Gunwani, CIO, Reliance Mutual Fund. “This has happened because many sectors went through a down-cycle, whether commodities, telecoms, pharma, banks, etc. The outlook for growth next year is much better, both globally and domestically.”
Macros a concern?
For now, the crucial factor for the immediate future, earnings, seems assured. Analysts expect markets to return over 20 per cent earnings growth this financial year (FY19). “We expect a sharp bounce in corporate earnings growth. The consensus expectation is for Sensex earnings to grow a healthy 20-25 per cent in FY19. The base effect (low, due to GST-related disruption for consumer-oriented companies) and normalisation of provisioning for corporate banks would be the key engines of earnings growth,” says Unmesh Kulkarni, MD and senior advisor, Head Markets and Advisory Solutions, Julius Bear Wealth Advisors.
Sentiment is evenly balanced, of course. But there is a niggling worry in the markets, and if it is not earnings growth that concerns the markets, what is? The macroeconomic situation and a significant matter like inflation, which had been hovering below 4 per cent for very long, has reared its gnawing head. CPI inflation for June has come at 5 per cent, much above the RBI’s comfort zone.
The RBI raised the repo rate, the rate at which it lends to banks, by 25 basis points, to 6.5 per cent. Oil prices, too, have risen over the past six months to around $75, swelling import bills and the current account deficit. This is being seen as bruising the falling rupee and the interest rate outlook.
But these are not factors that could play spoilsport for very long, market experts reckon. In the course of the next year, oil prices could stabilise at these levels or slightly higher, but that would mean that inflation concerns would steady. Hence, the rupee and interest rates are not such huge concerns in the long run.
So, what is the looming concern for the markets? This revival in corporate earnings has to persist. In the past six years, corporate earnings have come in mid-single digits. So it is natural that in a recovery year, when earnings bounce back, the growth rate looks appealing.
Once a higher base has been established, the same growth rates tend to shrink. In turn, if capital expenditure does not revive much and most of the cyclical and core economies don’t start to fire on all fronts, economic growth there could plateau in about two years (in FY20 or thereabouts).
Economic growth has also been driven this past year by the recovery in global growth since 2016. Before that, between 2011 and 2016, global growth was a tepid 2.5 percent. In the last two years, it picked up to 3.5-4 per cent, and had a huge impact on the domestic economy, driving up prices of cyclical commodities.
Global growth now is moving within that zone. Besides, the Indian economy has moved on from the GST and demonetisation. Also, the monsoon has been good for a third year in a row. Moreover, this is the year when a fair amount of election-related spending is expected to be seen on the ground, giving the economy the requisite fillip.
This will keep the markets buoyant for the next 1-2 years. But that is just half the story.
Some market observers, however, reckon that the Indian economy has yet to take off. “The markets are at an inflection point, with consumption being the key driver,” says Ajay Bagga, a veteran market expert. “There is also the wealth effect on farmers. Green shoots are visible regarding capital expenditure. Capacity utilisations are improving. So, the economy will do well. It is but natural that the stock markets are leading the way right now, climbing these all-time highs,” says Bagga.
In a sense, for now, we are clearly looking at (and hyped by the broad consensus) 18-22 per cent earnings growth, largely because we are coming from a low base. If that good earnings momentum persists for another 2-3 years, this euphoria could show more steam. For that, both global and domestic economies will have to do more than reasonably well – but leave that re-evaluation for next year.
The quality factor
Will quality lead the way, though, as the Narendra Modi government has ushered in a paradigm shift in the systems? This calendar year we have seen quality stocks running ahead as investors shifted to large-cap well-entrenched companies with a high degree of earnings growth. This round of churn has seen mid- and small-cap companies being thrashed, while large-caps soared. More than 50 per cent of the BSE 500 stocks have tumbled in the last six months, suggesting that the market movement is not that broad-based.
A few reasons suggest themselves for this shift in investor stance. “You have to see this as a catch-up trade on what has been happening from 2014-17 where for a fairly long period mid-caps outran the Nifty. Usually, in the long term, a mean reversion takes place. Mid-cap valuations at end-2017 were stretched, and you could say the main reason was a reversion to the mean,” says Reliance Mutual Fund’s Gunwani.
Other factors affecting the shift in the investor stance also include the fact that earnings growth in some of mid- and small-caps has not played out as anticipated by the markets. Great growth in earnings was expected last year in some cyclical sectors and even in some core-economy companies. This has still not materialised. Ahead, while these companies could see expanded earnings growth, the BSE Mid-Cap Index is hovering at a price-earnings multiple of 70 times, pointing to a huge valuation gap between mid- and large-caps. This has been tempered to a large extent.
Then, there is another factor - the shift to quality. Not only because many State elections and the general elections are around the corner, but because by and large investors are becoming more quality focused.
“Mr Market is separating high-quality businesses from non-high-quality ones,” says Ashutosh Bishnoi, MD & CEO, Mahindra Mutual Fund. “A high-quality business does well even when the capital market shuts down. Before February, mid-caps and small-caps were overvalued; for that segment this a period of normalisation. However, the rock-steady and highly-focused businesses are immune to this short-term volatility. For example, in a business of readymade textiles, the valuation is still high. Another business in brake linings is going places... there are many examples of quality mid-caps doing well,” says Bishnoi.
But, given the huge run-up now, the markets are paying a good stiff price for earnings. At about 28 times earnings, the historical PE multiple of the Nifty is at its highs. The last time, back in 2008, the markets went into the worst possible tailspin, toppling large investment banks such as Lehman Brothers and taking the global economy to the brink of derailment.
But are we in that scenario now? Bagga dismisses it. “You could say the economies will use what is called the Greenspan put – that is, they will do anything to see that such a crisis does not rear its horrendous head again.” The stimulus of the long-running QE is being turned back, but the counter-balancing QT (quantitative tightening) is being done very gradually at the moment. Plus, leverage levels that prevailed in 2008 are now considerably down, adding to the assurance that we are not in for any major 2008-like plunge, Bagga further explains.
Sensex at 50000
Still, a greater degree of volatility cannot be ruled out. In fact, the last few years have been such that the S&P 500 has not seen a drop of more than 5 per cent, which is a very long stretch of time without much volatility. As the Indian economy is entering an election-phase-driven year, a little extra increase in volatility is on the cards. Further, global trade wars will roil the markets.
“In the near term, we believe that factors such as global uncertainty (trade wars) and any reversal of global liquidity, coupled with a muscularising dollar and rising interest rates (both globally and locally), would keep markets volatile, though dicey because of a slight downward bias,” says Julius Bear Wealth Advisors’ Kulkarni.
Mid-caps and small-caps could see a technical bounce-back because most have already slid 30-40 per cent from their peaks. Nevertheless, valuations are stretched, particularly those of large-caps. Many of the companies are building in optimistic earnings growth for a very prolonged period. Hence, this is not a market where you must look at just quality, but also balance your portfolio (weight) with cyclicals and companies with reasonable valuations.
Gunwani reckons that there are valuation pockets particularly in large corporate banks. “We are seeing value at this point in large corporate banks, where we calculate that credit costs will come down over time and because the retail franchise is still quite strong. Second, pharma firms operating big domestic businesses. Cyclicals such as mid-cap cements are other pockets with valuation reassurance.”
Still, this is a market turning increasingly discerning and choosy, where only companies that demonstrate scaling-up capabilities will deliver in the long run. Further, corporate governance is a factor to reckon with. We have seen many instances in the recent past, where stocks which were darlings of the markets a year back have skidded 50-70 per cent on corporate governance-related concerns.
So while this may be a market that seems to be supported with liquidity inflows and earnings growth, it also means that investors need to do their home work before investing and their asset allocation.
“Given the overall valuation levels, the focus needs to be on asset allocation,” says ICICI Prudential Mutual Fund’s Naren. “We believe that long term SIPs in small- and mid-cap funds for tenures of above 5 years can work out to be another good investment strategy. Stocks with good dividend yields, low leverage and attractive valuations are likely to perform better over the next 2-3 years. We believe that there is value in investing in short term debt / good quality short duration funds.
Even then, there is no denying that the stock markets are seeing one of the best phases of the charging bulls. Bagga likes to call this market “a safe-haven market”, one which has reasonable potential for returns, supported by enhanced liquidity in people’s purses and wallets.
But, one thing is certain: Even if we assume a dollop of a dip in the price-to-earnings multiple on a one-year-forward basis, as earnings growth will be buoyant, we will see reasonable returns in the coming two years. In other words, BW Businessworld’s forecast of the Sensex @ 50000 almost certainly is game on. Or are we shooting too low?