It’s a little difficult to be optimistic about the year ahead when news headlines and social media debates are all about Covid counts and the mysterious symptoms of Omicron (or is it Deltacron?). Indeed, as we write this, two-thirds of PrimeInvestor’s tiny team has also been struck down by Covid-ish symptoms.
But as with life, in investment too, to unearth good investing opportunities, you need to look beyond near-term uncertainties. So, here’s an attempt to capture how we at PrimeInvestor see the equity markets shaping up in 2022. We also try to identify where pockets of stock-picking opportunity will lie.
Omicron will be short-lived
We’re not epidemiologists or mathematicians. But after reading the opinions of both these kinds of experts, we retain hope that India’s third wave of Covid will not wreak as much havoc on the economy or on companies as the second wave did. This is based on two observations.
One, experiences with countries already in advanced stages of the Omicron-led wave suggest that despite galloping case counts, this wave peaks and recedes rapidly, usually taking a 30-day window to peak and a similar time frame to recede. South Africa saw its third wave begin on November 20-21 and peak out by December 15. The United States began this wave in early December and is seeing its caseload plateauing now.
There’s also increasing global evidence that while this wave has broken new records on daily cases, hospitalisation rates and death rates are far lower than earlier waves. In India, current hospitalisation rates are estimated at 3-4% of detected cases (detections are severely underestimated as most folks with mild symptoms don’t test), against 20% in the Delta wave. This lends credence to mathematical estimates by the IIT Kanpur SUTRA team that this wave may peak by mid-January and recede by end-March.
Epidemiologists are also holding out hope that the relative mildness of Omicron could signal the end-stage of the pandemic, but let’s not count our chickens before they hatch on that. (Refer this article)
Two, Indian State and city administrations, aware of the damage that lock-downs inflict on livelihoods are taking a more pragmatic view this time around and avoiding blanket restrictions. With everyone and their uncle getting it, the fear factor surrounding Covid is also fading in people’s minds.
Thanks to all this, we think that the end of the third wave in India by end-March will bring about a significant resurgence in the animal spirits of consumers. After being cooped up for so long, we expect them to indulge not only in a spree of ‘revenge’ tourism that will benefit sectors such as travel, hospitality, entertainment, but also splurge on ‘revenge spending’ on discretionary, feel-good items. We expect demand for jewellery, personal care, apparel, luggage and new-age consumer services to gain traction from Q2 of 2022.
Demand for residential housing may take wing again. In India, the IT sector has always been the largest formal sector employer and its strong growth and hiring trends through this pandemic will support both discretionary spends and housing demand.
Equity PEs will de-rate
In the last 2-3 years, whenever anyone’s brought up worries that equity valuations in Indian and global markets were too expensive, bulls have trotted out the ‘record-low interest rates’ argument to justify the equity valuations. There is sound theoretical basis for this, as interest rates are inversely related to equity valuations.
But if record-low interest rates helped prop up equity valuations, a reversal of those low rates globally will have the opposite effect and puncture equity valuations. With interest rates rising across the world, we think equity investors globally (and in India) will need to brace for equity price earnings ratios (PE) to shrink (de-rate). The detailed reasoning for this is explained in our earlier article here. The US Fed has promised three rate hikes in 2022 and has doubled the rate at which it is winding down its bond purchases.
Bond markets are running ahead of central banks in pegging up rates, effectively forcing them to act. In India, rates have risen sharply the past year (our debt outlook for 2022 explains the situation). Central banks withdrawing the record amounts of liquidity that they’ve been pumping into financial markets, will accelerate this shrinkage of equity PE.
How de-rating will play out
While it’s easy enough to say equity PEs will shrink, what all of us would like to know as investors is how much it will shrink and the extent of correction this could trigger in the market indices.
To gauge this, we need to estimate two variables:
- the Nifty 50’s expected earnings
- the likely PE after de-rating
On earnings, given that we’re close to the end of FY22, markets are likely to be discounting earnings for FY23, instead of looking back at FY22. The consolidated earnings of Nifty 50 companies for the 12 months ended December 2021 was at about Rs 686. Analysts generally project that these earnings will shoot up to Rs 736 in earnings by end-March 2022 and Rs 877 by end-March 2023 (about a 19% growth). However, Street estimates usually carry a bullish bias, so we modelled various Nifty scenarios assuming lower growth rates of 10% and 15% too to gauge how a correction may pan out.
Price earnings ratio
Looking back at history, the long-term average PE on Nifty 50 (based on consolidated earnings) averaged 18 times in the 15 years leading up to the latest round of rate cuts/QE by the US Fed. During corrections, the Nifty PE has historically bottomed at anywhere between 10 and 15 times. We think that, as domestic flows into equity markets have seen structural increases in recent years, any correction is unlikely to take the Nifty PE below 15 times as money on the side lines is likely to jump in.
The table below tells us that in the worst-case scenario of FY23 earnings growing only 10% and the Nifty PE bouncing off 15 times in a correction, the index could go as low as 11,880 levels (not precisely but thereabouts). In the best-case scenario where the Nifty earnings grow 20% and the PE de-rates only to 20 times, the Nifty can hold up at 17,520 levels.
We however think that moderate earnings growth 15% or so and a PE de-rating to 15 or 18 times, triggered by FPI pullouts, is the more likely scenario. In 2022, we would expect any correction triggered by global rates to take the Nifty 50 down to the 12,500 – 15,000 range. In this range, investors should deploy cash and swoop in on buying opportunities rather than develop cold feet.
Other likely trends
If that’s the overall market scenario, it doesn’t mean a lack of buying opportunities. PrimeInvestor’s own stock recommendations will be guided by the following:
- Given that we do expect an FPI-pullout induced correction in 2022, we will try to time our buys to better valuations (based on levels above) to protect downside for investors. However, we believe that pockets of reasonably valued opportunities exist even today.
- With liquidity and rates not likely to support high PE multiples, we think that earnings momentum will be the key driver of stock price returns for individual companies and sectors from 2022. We will thus be looking for stocks capable of delivering double-digit earnings growth. We believe that the ‘coffee can’ and quality-at-any-price styles of investing will be taking a back seat henceforth. We will be weighting valuations and growth more than quality in our stock screening models.
- We will stay away from sectors and stocks where bull market re-rating (that happens often in low interest regime), or ambitious IPO pricing has created a large mismatch between prevailing valuations and the earnings growth potential of the firm. These are likely to suffer the most withdrawal symptoms from higher rates and a withdrawal of easy money.
- We will be taking a fresh look at cyclical and core economy sectors that can rebound from a return of animal spirits to the economy.
- We do not go by the conventional wisdom that large-caps as a class are safer, offer better quality or are more defensive bets to own ahead of a correction. In India, there are quite a few market leaders and high-quality businesses tucked away in mid and small-caps and quite a few low-quality firms figuring in the indices and among large-caps. We will continue to select stocks based purely on sector and company prospects without much attention to market cap. In fact, we think large-caps may be quite vulnerable to a correction given the high FPI ownership of large-caps versus high DII ownership of mid/small-caps.
The chart below on Where we see opportunities offers a snapshot of the sectors and themes where we are currently scouting for opportunities. If you’re doing your own stock-picking, it can serve as a guide on where to dig for potential buys. While we may not issue stock calls on all of these sectors, we will be paying special attention to stocks in these sectors. Of course, market behaviour will also play a role in our own picks even within these sectors.