Feb 20, 2017
The Illusory Truth Effect
Consider these statements. We only use 10 percent of our brains. Eating carrots improves eyesight. Vitamin C cures the common cold. Crime in the United States is at an all-time high. These are commonly believed as fact. The truth is however, that none of these are true. What’s happened is that persistent repetition has led to belief.
This is the illusory truth effect, a glitch in the human psyche that equates repetition with truth. Adolf Hitler knew the technique. “Slogans should be persistently repeated until the very last individual has come to grasp the idea,” he wrote in Mein Kampf. Marketers know this as well, as evidenced in TV ads.
Here’s one more statement. Donald Trump is great for the U.S. economy. That’s a 180 degree from the perception pre-election and it emerged out of nowhere. There’s no real data to support it, except repetition. It’s critical, however, that Mr. Trump get key initiatives launched in the first six months, or by July. It’s easiest in the early months. Or Mr. Trump’s stellar business reputation may suffer, with implications for developed markets. In contrast, Indian corporates have delivered growth in truly challenging circumstances. And that’s a fact.
Nifty 50 Companies Have Delivered Impressive Sales Growth and Operating Earnings Growth
On the domestic front, the message from quarterly earnings reports is that the market has delivered impressive numbers, in the face of demonetisation, led by large caps. The corollary is that the numbers seem to suggest that the organized sector appears to have benefitted and taken market share from the unorganized sector.
Impressive Top Line Growth of 7.8% YoY
Specifically focusing on the Nifty 50, 47 companies have so far reported Q3FY17 results, delivering top line year on year sales growth of 7.8%. In a quarter that was widely expected to be dismal, this is creditable performance.
Despite Demonetisation, Operating Income Growth Is Up +13.8% YoY
If ever there was a quarter where company managements had to scramble to manage their fixed and variable costs, this past quarter was it. Their performance bodes well for India’s future.
In a Demonetisation Driven World, Large Caps Performed Better Than Mid & Small Caps…
With Industrials, Financials, Energy and Materials Leading the Way
Nifty 50 companies were able to deliver operating income growth of 13.8% year over year. This is the first quarter in over a year where we haven’t made any adjustments for one-offs. Eliminating the negative impacts of Telecom, the numbers would have been even better.
PAT Growth is Up +20.2% YoY, But Skewed By PSU and One Offs
The outsized PAT growth was primarily skewed by Financials. Bank of Baroda swung from a loss of INR 3,342 cr. last year to a profit of INR 253 cr. State Bank of India delivered a huge profit of INR 2,610 cr., up from INR 1,115 cr. Since we adjusted for losses the prior quarter, it’s only reasonable to discount stellar PAT growth this time around. Negative contributors were as usual, Bharti Airtel, Axis Bank and Idea Cellular.
CNX 500 Universe Operating Earnings Growth Is Up +14.3% Year over Year
Within this umbrella of 500 companies, so far 358 companies have reported latest quarterly earnings. Operating earnings growth was similar for the Nifty 50 and the CNX 500. Earnings growth was 14.3% across the universe of companies reporting. Sales growth was 7.6% yoy, very similar to NIFTY50’s 7.8%.
Sectors: Financials, Industrials, Energy & Materials Delivered Standout Performance
Performance was driven, as usual, by Financials, followed by Industrials, Energy and Materials. Margin metrics were solid across sectors, and higher for the NIFTY50 at 27.9% vs. CNX500 at 23.7% demonstrating the strength of the corporate sector in pricing power, as well as management’s ability to deliver operating leverage on single digit sales growth.
Incidentally, Materials and Energy were the only sectors that delivered double digit sales growth in the Nifty 50 and the broader market.
Notably, operating profit growth was dismal for the Consumer sector, evidencing that the sector did in fact take a large hit as a result of demonetisation.
Information Technology, Telecom and Real Estate Were Underperformers
Telecom delivered horrible top line and negative bottom line growth. The sector continues to have believers as the stocks have performed well on expectations of consolidation and reduced competition. However, a capital intensive industry, with high regulation, declining core voice revenues, saturated domestic markets remains unattractive.
In a Demonetisation Driven World, Large Caps Performed Better Than Mid & Small Caps…
…Surprisingly, PAT Growth Was Best for Small Caps Highlighting Non-Operating Contributions Or One-Offs
Information Technology delivered low top line sales growth and negative operating leverage, a sign that the sector is challenged not only on top line but also on bottom line.
Health Care underperformed for obvious reasons – the FDA and Trump.
Capitalization: Large Caps Outperformed
Demonetisation was also evident in the cap breakdown. Small caps, which operate in the largely unorganized and cash dominated segment, delivered sub-par performance on top and bottom line. Mid-caps underperformed large caps as well. Large caps delivered the bulk of the outperformance. Anecdotally, this would confirm the view that the organized and larger players benefitted from demonetisation. We would point out that the numbers were however, skewed by wide swings in earnings reported by PSU banks.
Earnings Revisions: Energy Leads, While Large Cap Telecom the Worst Hit
Demonetisation led to seemingly severe earnings revisions at the index level. However, the numbers are skewed due to Telecom. Ex Telecom, the revisions data is actually quite benign and a positive for future prospects.
The same trends were visible in the broader indices as well. Energy remains the clear winner, being the only sector with positive revisions over the past one and three months. Materials is the other sector that is noteworthy in terms of negative revisions.
Earnings Revisions By Cap
Paradoxically, in light of previous data we’ve shared, the Nifty 50 witnessed the largest percentage change in revisions over the past month. But the numbers are skewed by the impact of Telecom majors.
Earnings Revisions: Energy Leads While Telecom & Materials Suffer Large Negative Revisions…
While Mid Caps Have Witnessed Positive Upward Revisions…
Mid-Caps Witness Positive Revisions Momentum
Offsetting their underperformance in reported earnings, Mid-Caps again lead the pack, being the only capitalization category with upward momentum in earnings revisions within the Nifty 50. Across the broader universe, Mid-Caps outperformed the other cap categories on a relative basis.
Earnings Scorecard: Large Caps Dominate
A consistent trend across all capitalizations was positive surprises versus expected earnings. This is in-line with what we have been hearing from management discussions that the fears of demonetisation were actually largely unfounded.
Large caps across all sectors weathered the demonetisation storm better. Of the 81 large caps that have reported so far in the CNX 500, 57% surprised positively. Correspondingly, a lesser 51% surprised on the mid-cap space.
Comparison between the Nifty 50 and CNX 500 highlights the overall resilience of large caps. Despite the multi-cap CNX 500 being weighed down by muted Real Estate sector earnings, it wasn’t really all that far behind on fundamental delivery versus large caps.
Materials, Financials and Industrials Lead the Way On Earnings Surprises…
Top-Down Sector View: Auto and Energy Emerge Winners
Autos and Energy appear undervalued trading at -17% and -4% discounts respectively to their 3-year average trailing P/E valuations. Further, the underlying fundamentals in both sectors have actually seen a robust improvement in the past year. Of the two, Energy clearly trades far cheaper and at a large discount to all sectors, despite having robust growth prospects.
Energy Continues to Remain Reasonably Valued, With Strong Earnings Growth…
While FMCG, Media and Realty Are Expensive, With Negative Earnings Growth
IT and Pharma are cheaply priced relative to their historical valuations. With the year-on-year improvement in earnings seen this quarter in both sectors, they remain on our radar. Volatility in price levels in these two sectors are the only deterrent at this stage which can easily be tied to the macro concerns highlighted earlier regarding these sectors.
FMCG valuations have run up 13% since demonetisation and are now back to premium valuations. Returns here have primarily been driven by this valuation re-rating and while underlying earnings have demonstrated resilience, we would remain slightly cautious and recommend entry only on dips.
While we got the call right on the RBI holding rates, we did not expect the RBI to move to a neutral bias. As a result of the surprise move, large numbers of traders of G-secs unwound their long positions, resulting in a spike that took rates on the G-sec up to 6.85 levels. G-secs have further retained their levels on the back of inflation data that was higher than markets expected.
With the resultant rise in inflation, a shift to shorter duration for new deployments is warranted, and we favour accrual funds, and credit opportunity funds. In addition, select AT-1 bonds continue to remain attractive. For aggressive investors, a speculative play on duration and a move lower on rates could be considered with a competent duration fund manager, while acknowledging risks; in particular, commodity prices and inflation are rising.
Companies have clearly delivered impressive results in a quarter that was expected to be challenging. In particular, large caps seem to have held their ground particularly well and made gains. Small caps fared relatively badly.
Indian corporates have demonstrated great capability in delivering earnings growth in a stressed environment. This bodes well for a continued pickup in growth later this year as the budgeted initiatives, 7th Pay Commission and interest rate transmission benefits kick in.
Prices for Agriculture Commodities Continue to Show Strength…
Inflation, however, is a cause for concern and will be monitored. Further, despite the numbers reported, the markets soaring, the breadth of the market remains a cause for concern and something that we remain watchful of.
We also recognize that valuations remain elevated for all indices, and are vigilant on a change in fundamentals that may warrant a change in posture.
For now, the best strategy for new deployments is to target funds that are value oriented, or growth at a reasonable price. This would help in muting the risk of elevated index valuations.
India’s Nifty 50 Is Amongst the Top Performing Markets Year To Date…
The gap up opening on Friday made high of 8896, but the Nifty eventually closed at 8822 levels with marginal gains for the week. On closing basis index ended above its last two week’s sideways range, but it was off Fridays high which is a damper for the market. On weekly chart index has formed a long legged doji candlestick pattern which is neutral in nature and indicates stalemate between bulls and bears. Momentum indicators have also flatten out at higher levels. FIIs have been net buyers to the tune of Rs 2148 crores in index futures last week, except for the Friday when fresh short build up was seen. Still index remains the range of 8700 to 8820 levels. Thus, Nifty needs to hold above 8820 levels first, for it to move towards 8967-9000 levels. In Nifty options 9000 strike price call option has the highest open interest which will act as the resistance for the market. On the downside 8700 odd levels which is the lower end of the range for of last couple of week becomes the critical support level in the short term for the market. Breaking below index is likely to test 8550-8500 levels.
A long legged doji candlestick pattern has formed, which is neutral in nature and indicates stalemate