The Nifty 50 has rallied 84% (March 2020 lows to Dec-20) in just nine months and the rally has been driven mainly by a global liquidity surfeit. Therefore, forecasts and estimates go that extra mile only to get more erroneous than they usually are. Given this strange combination of heady markets and uncertainty, we decided that identifying opportunities for investors in equities and debt may work better than giving bare-bones forecasts. We covered the debt opportunities (and gold) earlier this week. Now, here’s our equity outlook.
3 pointers to profitability
Let’s take stock of where valuations stand. The Nifty consolidated PE at about 34.8 times (trailing 12 months to September 2020) currently is clearly out of sync with the 10-year average of 17.3 times. Consensus estimates for December 2021 require a 67% jump in Nifty 50 earnings from the current trailing EPS (Rs 402) – not an easy leap.
To this extent, you should be aware that you cannot afford to pay high valuations unless the growth story seems sustainable in the stocks you pick.
In suggesting rebalancing in August 2020, we called it too early as the Nifty moved another 22% by December 2020. But given the difficulty of calling market tops, if you did not act then, it is perhaps time for you to rebalance now.
The points mentioned in the profit-booking article remain largely intact except that the following trends are coming out clearly now than before.
- Any further valuation expansion can be afforded only to companies with top line growth.
- Don’t get swayed by India Inc’s margin expansion in 2020 as it came from cost savings which may not continue
- There is no one clear trend of value or growth styles doing well. Both have their places, and we discuss the segments where you could find them.
These pointers are not to suggest that we believe markets will continue to move up. They are meant to help you identify opportunities that will hold good whether in a rally or in a correction. Now, the details.
In our equity outlook for 2020, while we had no clue that Covid-19 pandemic would cause the havoc it has, we still got one thing right. We suggested deploying in mid and small caps as opportunities to catch on lows and provided fund recommendations for those. Those have panned out well (even if some took off only in the last 6 months) However, given the rally, you should consider them as rebalancing candidates when you rebalance your portfolio.
Look for top line growth, and not just profit growth
At this juncture, all key indicators starting from production activity to GST collections to the September quarter earnings and margins have shown a rebound from the previous two Covid-hit quarters.
The Nifty 50 companies consolidated earnings jumped 132% for the September 20 quarter over June quarter. Not just that, profit growth has been a strong 37% over the September 19 quarter. The earnings growth for Corporate India cannot be overlooked, as the bounce back also comes after sedate earnings growth for several years now.
But here’s the catch – the rebound has been driven by growth in profits and not revenues. While the Nifty 50 companies’ sales expanded 24% (27% for the Nifty 500) sequentially for the September quarter, they are still 7% below their September 2019 quarter levels. This suggests that profit growth came from cost savings rather than topline growth. We have discussed this aspect of earnings earlier.
Revenue growth, therefore, becomes the key factor to watch to determine the sustenance of recovery and identify strong firms that can continue to deliver. Companies could to see topline growth coming in through improved product realisations or through resumption in volumes and demand. Whichever the route, it is clear that sustained revenue growth is necessary for further PE expansion.
In the broader Nifty 500, over 80% of the companies saw a sales rebound in the September 20 quarter over June 20. However, just half the universe saw sales increase over the September 2019 quarter, pre-Covid levels. And as data below will tell you, sales growth even in sectors that did manage it has been sedate. Telecom, banks and insurance have surpassed their pre-Covid sales of a year ago. These are sectors that need watching.
Still, the sector-wise data may mask some individual revenue growth stories. For example, auto and auto components have not performed as a sector. But there are several companies that have managed to grow sales over a year ago.
Hence, from the Nifty 500, we looked at individual companies with sales growth in each sector. This throws up many companies that are growing – these opportunities are bunched up in pharma, finance, auto, FMCG, bank and capital goods sectors.
The market rally factored growth in sectors such as pharma or metals. But in others such as banks, finance, chemicals, packaging, cement or even auto, the price rally in 2020 is lower than the broader market. Stocks from these segments also remain at lower valuations compared with a year ago (Dec-19) on price to earnings or price to book ratios.
In our stock coverage this year, we will look for companies that have the potential to show strong top line growth, even as Covid-19 aided cost benefits diminish.
Don’t get swayed by 2020’s margin expansion
India Inc. managed profit performance in the September quarter through costs. Lower raw material costs and production costs, besides other rationalization such as staff costs, travel expenses and ad spends companies improved profit margins in the past 2 quarters.
For the Nifty 500 companies EBITDA margins were at a solid 20% (ex-banks and ex-finances) for the September 2020 quarter, compared with 13% a year ago. The cost push to margins, though, may taper off for the following reasons:
- One, as normality in production activity resumes, the variable cost savings on reduced activity will normalize. Power and fuel costs played a big part in bolstering margins in the previous quarters for manufacturing companies; in the June ’20 quarter, for example, power costs shrunk by 35% over the year ago for the top 500 companies, while it dropped 13% in the September ’20 quarter. Further, though the WPI indices for electricity and fuel have so far remained stable, rising global prices of coal and natural gas, and the volatility in crude oil may eventually push costs higher.
- Two, prices of other raw materials are inching up. Global prices of commodities such as coal, aluminum, zinc, and copper are up over 5% in the past 3 months alone. Domestic steel prices have increased with WPI indices for some steel products are up over 8% since August 2020. Prices of other commodities such as cement and packaging material, are also up. Agri commodities, such as soybean, palm, edible oils, rubber, and cotton swelled over 20% since March 2020 and over 5% in the past 3 months alone globally, with a similar trend in domestic markets.
This essentially means that the period of easy margin gains may be coming to an end. Companies will either need to grow their revenue or be able to command higher pricing power – passing through the costs comfortably or improve their product mix in favor of high-margin segments – to make up.
Thus, it may be necessary to focus on companies that are able to show top line growth or pricing power in 2021.
Look for pockets of both value and growth
Though the 2020 wave lifted several stocks, there are pockets of opportunity still. For example, if you take the Nifty 500 companies, there are about 70 stocks that have seen an earnings expansion but seen their price earnings or price to book still trading lower than December 2019 levels. The trend can be broken into five themes overall:
- Finance: Banking & finance stocks show pockets of value with many trading below their year ago price to book but with earnings expansion. Do note, though, that they could well be value traps as well once the post-moratorium fate of assets is known. With the right due diligence done on asset quality, these might offer short-to-medium return opportunities as they have been forsaken by the market in 2020.
- Value: Select engineering, capital goods and construction companies too are seeing improvement in top line and earnings that is not factored into valuations yet. Overall, the pockets of value appear to be present in cyclicals.
- Select PSU: Similarly, PSU has been an entirely neglected space (1-year return of -15% for the PSU index) and for valid reasons. However, in the process, opportunities in select infrastructure, capital goods and oil & gas spaces cannot be entirely ignored as valuations provide significant moat and sound balance sheet reduce quality concerns.
- Growth: In pharma, while the rally has taken stocks to new valuation levels, there are a few where earnings have outpaced market expectations. Identifying those will be critical to managing returns. The IT space is one that has managed to remain stable with valuations lower than historic levels. While there is no PE compression here from a year ago, the fact that ‘optimized costs’ could be a new normal for this segment could mean a ‘growth’ story to look out for here than look for value.
- Commodities: As mentioned in our section on margins, global commodity prices across metals and Agri-commodities have seen a hike as well. While this spells trouble for companies using them as input, the metal and gas-producing companies can well see an uptick. And remember, the PE expansion is not a bad thing for commodities as returns are often directly proportional to growth in PE as cycles turn.
At PrimeInvestor, these will be our guiding principles for this year, in addition to the regular screeners we use, to select investment worthy stocks. In a few weeks from now, you will see our list of Prime Stock recommendations that have some stocks directly derived from the above pointers.
With inputs from Bhavana Acharya
Read our debt & gold outlook here.