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

Letโ€™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) โ€“ 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.
  • Donโ€™t get swayed by India Incโ€™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 hereโ€™s the catch โ€“ the rebound has been driven by growth in profits and not revenues. While the Nifty 50 companiesโ€™ 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.

Donโ€™t get swayed by 2020โ€™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 โ€™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 โ€™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 โ€“ passing through the costs comfortably or improve their product mix in favor of high-margin segments โ€“ 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 โ€˜optimized costsโ€™ could be a new normal for this segment could mean a โ€˜growthโ€™ 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.

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21 thoughts on “Outlook 2021 – Equity”

  1. How do we interpret the cash flow metrics in the current scenario, when we compare the cash flow of 2020-21 to yesteryears? I will quote a random example. Granules India – the free cash flow was in the negative in the past few years but this year alone, the free cash flow became positive. With an uptick of pharma sector + sound fundamentals of the said company + as described in the current article cost savings, there can be multiple factors for this. But as a broad trend how do we look at cash flow metric in the current year?

    1. It is not possible to make broad interpretations like that sir ๐Ÿ™‚ Many manufacturing cos can have negative cash flow from operations and hence FCF may be nagetive. One needs to understand the business, the sector to know how cash flows work. You may want to read the many materials of Prof Aswath Damodaran to know when and how to apply FCF. thanks, Vidya

  2. Is this not the principle that every investor should look at while analyzing a stock: value + room for further growth, whether market is overvalued or not, extraordinary situation like covid and liquidity pumping or not. Or is this principle of value + room for growth specific in this bullish situation? If the markets take a significant correction as anticipation and the stock prices fall, do we have a scenario where most of the stocks do come down to their appropriate price or value and we can thus then focus on just the growth potential?

  3. Good article and it has come at the right time also as the valuations have reached unreasonable levels.

  4. Wonderful article madam, Happy new year to you.

    My goals are at least a decade away. My equity portfolio is only through Mutual Funds. Does it make sense to redeem the profits alone, pay tax (for STCG & LTCG) and invest that elsewhere or later? I know later can never be predicted but even i feel that this rally is purely liquidity driven.This way i can secure my gains.

    Between Equity and Debt , my asset allocation is 85 and 15% but if I consider my other assets (RE inherited which i am planning to sell, barring the house for consumption), my Equity comes to just 54%. So, I am not bothered about high equity concentration of 85% now. Asset allocation of 70:30 or 65:35 is planned to be done only when I clear off my RE assets. I would like to remain invested. Please suggest your thoughts on my idea.

  5. Dear Vidya
    Great article as always.

    After reading the outlook on Equity, Debt and Gold over the last few days and the things you suggested, I have a specific query. Taking a que from your statement in the first paragraph “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.”

    (a) For a simple straightforward investor, is it a good option to start moving some holdings to good Hybrid funds – specifically the Dynamic Asset Allocation, Equity Savings and Multi-Asset Allocation categories ?
    (b) If yes, which of these categories is preferable ?
    (c) Should we look for funds from within Prime funds or outside as well?
    (d) If we do move some holdings to these, should it be from our Equity portion, or Debt portion?

    And yes, we continue to eagerly wait for ‘Prime stocks’ ๐Ÿ™‚

    Regards
    Raspreet Singh

    1. 1.No. We have mentioned in our earleir articles and our year end perfomance review hybrid is a slippery slope.
      2. Answered earlier. If tax is your primary criteria then equity saving..otherwise please avoid the nosie of fund managers and keep asset alloated equity and debt.
      3. Entirely your call ๐Ÿ™‚
      4. I woud say avoid. So does not apply.
      thanks ๐Ÿ™‚

      Vidya

  6. Thank you for the useful article again. Is there a review of Prime Funds also in the pipeline? I believe it would be highly useful to rebalance the portfolios to those MFs which have high potential growth (for aggressive investors). For e.g, it may be useful to take some profit off the Multicaps and move into Banking and Finance sectoral MFs?

  7. Satya Sudhakarudu Jonnalagadda

    Respected Madam,

    Your broad analysis is good.

    However, it is better Prime Investor analyses

    1. Prime funds once again

    2. NIFTY 50 or NIFTY 100 stocks say sectorwise.

    3. Why I am suggesting this is because in the same sector
    there are good stocks and bad stocks.

    4. As you rightly say, the increase in profits is largely due to cost reduction but not due to higher sales.

    Similarly, current increase in share prices of individual stocks is more due to increase in liquidity and huge inflow of foreign portfolio investors.

    5. Your analytical examination of shares helps the retail investors and. Ew entrants into stock market to exit stocks which are likely to fall .

    Conversely, your good analysis can help retail investors to accumulate good shares.

    Sudhakarudu.

    1. Thanks. We do analyse Prime funds every quarter and it will come up in few weeks. Rest well taken.

      Vidya

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