Apr 30, 2018
“It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price” – Warren Buffett
Looking back at the past few months, North Korea’s sabre rattling has turned out to be noise, as expected. Trade war rhetoric is also looking to be largely noise, as expected. For that matter, central banks have contributed to the noise in the markets for years.
Current Crude Levels Remain Below Levels That Have Led to Prior Corrections
What’s not been noise is Crude. Crude has been, directly or indirectly, a contributor to recessions going back to 1973-74. The chart today shows similarities to 2006 and 2010. 2006 led to a painful but short correction, with prices rising to $74, but markets recovered swiftly within a couple months. It took crude rising to $93, sub-prime and a general economic slowdown to start the great recession.
2010 had crude rising to levels of $94.75 in Jan 2011 at the market peak, before investors raised the white flag and a painful correction ensued with the Nifty falling 26%~. The upshot is that the past two cycles suggest that current crude levels – particularly inflation adjusted – are tolerable at current levels, but a further rise in crude could lead to a slowdown and a sell-off.
Insights from Comparing the Nifty 50 with the CNX 500 Excluding the Nifty 50
This week we focus on the CNX 500 Ex Nifty, or the other 450 stocks in the CNX 500 outside of the Nifty 50. While the Nifty 50 has grown profits at 9.7% CAGR over the past three years, the CNX 500 excluding the Nifty 50 has grown earnings at 18.8%. That’s twice the PAT growth rate of the NIFTY 50.
The Prior Two Cycles Saw Crude Approaching $93-94 Levels Before a Serious Correction Unfolded…
…There Was, However, a Swift Correction in May 2006 With Crude at $74 That Lasted Two Months
The CNX 500 excluding Nifty 50 Stocks Has Grown PAT at 18.8% Vs the Nifty 50 at 9.7% the Past 3 Years… …And is Expected to Grow PAT at 32.8% Versus 19.6% for the Nifty 50
The CNX 500 Ex Nifty Sells at Essentially Similar Valuations to the Nifty 50… …And Surprisingly Had Similar Volatility As the Nifty 50 During Sell-offs in 2015 and 2011
Secondly, the expected profits growth for the Nifty 50 over the next three years is 19.6%, while that for the CNX 500 ex Nifty 50 is an even more impressive 32.8%. Granted, forward estimates are often unreliable, but the relative spread is meaningful, and remains above 12 percent points.
The CNX Ex Nifty Sports An Attractive PE/G Relative to the Nifty 50
Despite these meaningful differences in growth rates, it is notable that the relative valuation for the Nifty 50 in FY19 is only 5.5 percent points lower at 21.4 times versus the CNX 500 ex Nifty 50 at 26.9 times. The spread is similarly low for FY18 as well, at 6.9 percentage points and valuations are essentially even at FY20. For a slight premium in valuation, investors receive nearly twice the growth rate in the CNX 500 Ex Nifty universe. Another way of stating it is that the trailing PEG on the Nifty 50 is an expensive 2.8 times versus a more reasonable 1.8 times for the Ex Nifty.
And Surprisingly Good Performance During Sell-offs
Finally, we wanted to test the oft stated refrain that the smaller cap Ex Nifty universe sells off aggressively during sell-offs. During the sell off in 2015, the differential between Nifty 50 and CNX ex Nifty was actually the opposite of what most would expect. The CNX 500 Ex Nifty delivered a positive return peak to trough in the 2015 sell-off. This was true in our portfolio as well, where quality mid cap growth delivered a positive return. In 2011, the differential was 5%, hardly a concern given the significant outperformance the CNX Ex Nifty has delivered.
Sales and PAT Growth Is Tracking at 10%+ YoY On Early Earnings…
Sales Growth Is Tracking at 11% YoY…
…While PAT is 9.9% YoY for the Nifty 50 and 13.4% for the CNX 500
As Expected, Financials Have Delivered 20% Top and Bottom Line Growth…
…Info Technology Has Been Lacklustre, Despite Market Euphoria
Q4FY18 Earnings Flash – So Far So Good
The early data, as is usually the case, has been encouraging, particularly in private financials and mid cap IT. Sales and profits are up double digits for most companies reporting to date.
A Truer Picture on Earnings Will Emerge in Coming Days
A truer picture will emerge on earnings as we head in to the second and third leg of earnings season. In the prior quarter, a healthy 269 companies grew top line by at least 10% year over year, and an equally healthy 256 companies grew earnings by 10% year over year.
Growth this quarter is likely to come through as well, and hopefully will move the needle lower on index valuation. However, divergences in the PSU space are likely to remain an overhang. The Nifty 50 P/E is at 26.5 times. Should the extremely rosy analyst forecasts of 16% sales growth and 19.6% earnings growth come through, that leaves the index close to fair value.
No Change on Fixed Income
The announcement by the RBI to allow foreign investors to invest in shorter term bonds should allow rates to fall marginally, and could possibly bring additional flows into the market, bringing much needed relief. There is no change to our fixed income outlook.
Worsening Fiscal Situation Remains a Concern
Rising crude, weakening FDI flows, weakening Rupee, a widening trade deficit and stretched government finances have been negative contributors to the fiscal situation. However, India also sports strong growth, low inflation, strong forex reserves, a healthy consumer and strong fiscal discipline. Talk of a hike in rates appears premature to us.
The Rupee has generally been joined at the hip with the USD Dollar index over the years. The weakness in the dollar has been reflective of the prospects of the U.S. economy and the move higher in Crude. The key call remains crude, and the rapidity with which shale bottlenecks are addressed will determine future crude oil price movements.
In our asset allocation models, we are slightly underweight equities, slightly underweight Gold and correspondingly overweight fixed income. We’ll look to up our weight in equities should valuations revert to reasonable levels. On a further extension of over-valuation, we’ll look to further reduce our allocation.
The Rupee Is Joined at the Hip With the U.S. Dollar…
…We’re Not Convinced the Dollar’s Sustainably Reversing Course…
…And We Expect Crude to Roll Over in the Second Half Once Shale Bottlenecks Resolve
This week’s analysis reinforces our view that the CNX 500 ex Nifty 50 remains an attractive choice as long as the fundamentals of the economy remain healthy. While much of the noise can be ignored, valuations, rising crude and volatile rates remain concerns. Portfolio forward returns will continue to be driven by sectoral allocation, stock selection, and investment discipline.
Our Portfolios –Cautious in the Short Term Due to Weakening Technicals But Fundamental Backdrop Healthy
For our actively managed portfolios, we are concerned about the weak technicals of the rally. Election volatility poses a further unknown. Given the macro backdrop, we continue to favor hedging and will be looking to re-enter protective hedges in a staged fashion. To summarize, we are cautious on the short term while recognizing that the economic fundamentals remain generally healthy.
A Perfect Complement for Mutual Fund Portfolios
Incidentally, our fundamental portfolios own less than 10 Nifty 50 stocks combined – Titan Co, Reliance Industries, Maruti Suzuki, Kotak Mahindra, Eicher Motors, IndusInd Bank, HDFC, HDFC Bank and Bajaj Finance and Finserv – across both portfolios. That works out to a roughly 15%~ overlap with the Nifty 50 benchmark. It’s another reason to consider our PMS offering as a complement to mutual fund portfolios, which are usually far more aligned and weighted in line with benchmarks.
Market saw positive start to May series with the Nifty gaining 0.7% to close at 10692 levels. Index had been facing resistance at 10630 odd levels which was the February month congestion zone high during the fall. Nifty has seen consolidation in narrow range last week and it has given breakout above 10630 level with a rising gap and continued to show strength throughout Friday’s session. Index has closed above the resistance with bullish candlestick for the day and continues to hit higher highs for the rally. Though some profit booking was seen above 10700 and closed below it. Here 61.8% Fibonacci retracement level of the whole fall from 11171 to 9951 levels is seen. Also, the falling gap area of 10702-10736 will act as resistance for the market. Thus, resistance can be expected in this region of 10700-10736 levels. Crossing above this level on sustainable basis index can rally towards 10850-10910 levels. In Nifty Options, maximum open interest for Put stands at 10500 while for Call it is at 11000. Open interest addition was seen strike price 10500, 10600 and 10700 while in Call options strike 11000 and 10900 witnessed OI additions; suggesting range is shifting higher for the market. On the downside market needs to hold above 10620 odd levels for the rally to continue. Breaking below this index can test levels of 10540-10500. India VIX currently at 12, has witnessed steady decline throughout the April month which is also supportive for the market.
Nifty Daily Chart