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Thoughts on Valuations & Markets

Mar 21, 2017


Valuation & Growth

  • Nifty & CNX 500 Earnings Trends
  • Sectoral Analysis


  • Trump Promises Falling Like Dominoes
  • Valuations and Global Recovery

The Ides of March notwithstanding, nor earnings, nor the Fed and elections, equity markets have surged to new highs.

Back in late November, we wrote that equities were at historically low valuations on our relative valuation model, which has a good track record. It was an opportune time to gain exposure and we conservatively suggested forward two year returns would be quite attractive. (“Demonetisation Impacts”, Nov-16 and “Markets & Uncertainty”, Dec-16).

That’s turned out to be the case in a scant three months, as markets have surged strongly. The biggest risk has turned out to be not having exposure to risk, i.e., higher return yielding assets.

P/E, Earnings Growth and the Cost of Capital

Over the longer term, equity returns are driven by a combination of earnings growth and P/E expansion. Cost of capital is the denominator and another key contributor. We use the 10-year as a proxy.

Since the Great Recession of Mar-09, the Nifty 50 has returned 255%. P/E expanded by 94% during that time, while earnings growth grew by 83%.

Similarly, the Nifty 50 has returned 102% since the bottom in 2011. In this case, P/E expanded by 44% and earnings grew by 40%, while the 10-year declined by 17%, again explaining the entire move in the index.

P/E Expansion Has Been the Dominant Factor in the Market’s Recent Move Higher

P/E Expansion Has Been the Dominant Factor in the Market's Recent Move Higher

As we get to more recent troughs – Aug-13 and Feb-16 – the contribution has come almost entirely from P/E expansion and a decline in the cost of capital. From the trough in Aug-13, P/E expanded by 56%, while the 10-year declined by 23%, while earnings only grew 11%.

Finally, since the trough in Feb-16, P/Es have expanded by 26% while rates have declined by 13% on the 10-year, and earnings have only grown 4%.

Forward Returns Will Be Driven By Earnings Growth

Our takeaways are as follows: The P/E expansion story has run its course. With trailing P/Es approaching historical peak levels, currently slightly under 24, there’s limited headroom.

Further, there’s no real case to be made that rates can move drastically lower from here. So, the onus for a continued move upwards on equities rests squarely on earnings growth.

Earnings Growth Appears to Be Picking Up

Unlike the past couple of years, there’s good news on the earnings front as well. Q4 CY16 was the first quarter where it wasn’t necessary to make any adjustments to index reported earnings to get a true picture of company performance.

Nifty earnings have languished in the 360-370 range and shown no growth going back to 2014, primarily due to drags from public sector banks, telecom and materials to a lesser extent. However, it appears that we’ve made a clear breakout to the upside, and the current trailing earnings number for the Nifty 50 sits at 385.20, up roughly 4% year over year.

With Q1 CY2016 comparables in the low 360 range, even a modest continued improvement in Q1 CY2017 performance lets a low teens growth rate for the Nifty looks achievable.

Earnings Growth on the Nifty 50 is Now +5% YoY and Rising…
…Headed Towards 12-15% With a Low Base Effect

Earnings Growth on the Nifty 50 is Now +5% YoY and Rising

Adjusting the P/E for Interest Rates, the Yield Adjusted P/E Appears Closer to Reasonably Priced…

Adjusting the P/E for Interest Rates, the Yield Adjusted P/E Appears Closer to Reasonably Priced…

Our Asset Allocation Indicator Flashed a Strong Buy in November 2016…

Our Asset Allocation Indicator Flashed a Strong Buy in November 2016…

Buying Volume Remains a Supportive Underpinning of the Rally…

Buying Volume Remains a Supportive Underpinning of the Rally…

Relative Valuation Moves Back to Neutral

As we mentioned earlier, our asset allocation signal flashed a buy in late Nov and Dec-16. It’s always been a reliable indicator, and yet again proved to be so. With the recent rise in equities, relative valuation attractiveness moves into neutral territory, but still skewed towards favouring equities.

Domestic Economic Data Not Looking Stellar But Benefit of Doubt Justified

However, there are causes for concern. Bank credit has declined, PMI data has not bounced back, IP numbers remain weak, as is cement production, electricity generation, and capex investment. There does not appear to be much progress on the NPA front either, as NPAs have grown alarmingly yet again in the past year (see Fixed Income). The government recognizes the issue and is taking measures to address the issue.

We choose to give the benefit of the doubt to our concerns on generally mediocre economic data, and the reason for that is the shock that demonetisation inflicted on the economy.

There are pockets of cheer as well. Trade – imports and exports – are up strongly this past month. Auto sales, two wheelers in particular, are recovering. The news on Crude Oil is welcome, as is news of rising prices on specialty chemicals which our country increasingly supplies, as well as news of production cuts out of China on steel production will help our corporate prospects in those industries.

With economic normalisation this quarter, new budget spending coming online, a generally healthy urban consumer, rising global trade, an improving global economy, we remain of the view that the economy will generate additional momentum. It remains critical, however, that the key issues of bank lending and NPAs be addressed, as investment will not come forward and the recovery will remain one legged until this occurs. Happily, the government recognizes this and is acting on resolving this as expeditiously as possible.

Volume Supportive of Market For Now

While a number of indicators on the technical side have faltered and the breadth of the rally remains a concern, volume has been strong and remains the key support underlying the market. As long as institutional and domestic interest remains in place, the market is likely to hold its new levels.

Sectoral Update

Autos continue to demonstrate a strong trend in earnings growth. Autos have featured prominently in our portfolio and the companies we own are well positioned. The strong continuation of earnings growth gives us additional comfort with our overweight position.

Earnings Growth Is On a Strong Trajectory in the Auto Sector…

Earnings Growth Is On a Strong Trajectory in the Auto Sector…

The Bank Nifty Earnings Have Not Shown a Strong Recovery…

The Bank Nifty Earnings Have Not Shown a Strong Recovery…

The Bank Nifty Faces Challenges in Earnings Growth

The Bank Nifty has a number of attractive stocks in its basket, such as HDFC Bank, IndusInd Bank and Kotak Mahindra. Despite this, the drop in growth is a reflection of the challenges faced by certain private sector and public sector banks and there’s no sign of a pick-up in earnings. The story is similar for Financial Services for the same reasons.

Energy Sector Remains Attractive

We’ve been optimistic on trends in the Energy space for almost a year now. This is clearly borne out by the growth we’re seeing in the Energy space. Since the move away from a subsidy and government driven model, the sector’s performance has clearly come into its own.

Meanwhile the Energy Sector Is Growing Strongly, Supported By Earnings Growth…

Meanwhile the Energy Sector Is Growing Strongly, Supported By Earnings Growth…

Further, India has the potential to become a much larger producer and consumer of natural gas by 2022, according to a recent U.S. Congressional report. The report notes that India could see greater demand for energy with its population expected to be around 1.4 billion people by 2022, making it the world’s most populous country.

Our government’s move to halve import tax on liquefied natural gas (LNG) in a bid to promote use of the cleaner fuel will result in Rs. 900 crore savings to gas-consuming industries. A host of industries from petrochemical plants to fertilizer units will benefit from the Budget announcement of cutting import duty on LNG to 2.5% from 5% currently. This augurs wells in increasing the share of natural gas in India’s energy mix to 15% by 2020 from 6.5% at present.

The government is focused on increasing the usage of natural gas in its overall primary energy mix for promoting a gas-based economy in the country.

Metals Showing Growth

Finally, the other sector that has plenty of scepticism associated with it is Metals, and it too has started demonstrating growth. News out of China this week is particularly supportive of the prospects for Steel. Zinc remains in a supply demand imbalance, with demand outstripping supply globally. The metals space looks to be holding its own for now

The market has now absorbed the news that the Trump bonanza on infrastructure will happen later rather than sooner, and is taking it in stride as the global recovery seems to be firming. Commodities will no doubt benefit from a continued recovery in the developed parts of the world, aided by reducing supply equations. The recovery in earnings for the sector re-affirms our view that trends in commodities are likely to move in tandem with the global recovery, with possible upside from the fiscal stimulus plans of the U.S.

The Metals Sector Is Showing a Discernible Uptick in Earnings …

The Metals Sector Is Showing a Discernible Uptick in Earnings …

Pharma Remains a Wait & See Sector

Finally, Pharma is the other sector we’ve highlighted. It’s obvious from the numbers that earnings growth has stagnated over the past couple years. We’d attribute this to the actions of the FDA and remain in a wait and see mode with respect to this sector.


Trump Changes His Tune, Tax Cuts Promise Delayed

The Fed Rate Hike was expected and taken in stride by the markets. Far more important was the incremental news out of the Trump camp last week that they would not be able to get tax cuts done unless they addressed healthcare first. This is in direct contrast to comments by the President a couple of weeks ago that they were working on a massive tax cut plan. Looks like a reality check hit the Trump administration.

Frankly, healthcare is a quagmire and we wonder if Trump might be able to resolve health care at all. The tax cut — one part of the main course of Trump’s economic agenda alongside fiscal stimulus spending — is dead and buried for now. So, the status quo on the U.S. is no new information on infrastructure spending, health care is the top agenda and tax cuts are delayed until further notice. Not exactly what markets had in mind.

Pharma Remains a Wait and See Sector…

Pharma Remains a Wait and See Sector…

Valuation Worries but the Economy is Fine

Valuations in the U.S. remain stretched but the same case that applies to India applies to a less extent to the U.S., as the rate hikes make for a much tougher economic environment. One prop – tax cuts – looks to have been taken away. However, the economy looks to be on a sounder footing, so status quo should continue to prevail. Echoing the case we made in our Outlook for 2017, a rotation of money flows back into emerging markets is likely and we’ve seen the first evidence of that in the past few days, particularly in the action of the USDINR as well as flows.

Japan’s Stealth Tapering Begins

Another trend that we mentioned in the Outlook has been the reversal of liquidity flows that we’ve been witnessing in global markets. Add the BOJ to the reversal of flows list. The BOJ appears to have quietly commenced its own monetary tightening as per Bloomberg’s review of the BOJ’s latest bond-purchase plan. The central bank is on track to miss an annual target, by a substantial margin, prompting the conclusion that the BOJ has commenced its own stealth tapering.

Fixed Income

Both urban and rural inflation trends are under control and the impact of falling crude prices is likely to further subdue inflation trends in coming weeks.

The Spread between 10 Year India G-secs and U.S. T-Bonds Has Narrowed

Foreign investors enjoyed a wide spread between G-secs in India and the yield on U.S. T-Bond until recently. While the dominant trend has been the tightening in spreads, the recent move has been a retracement and led to increased interest in G-sec auctions in the past week.

Resolution of Non-Performing Loans

Indian bank bad loans have surged to Rs. 9.65 lakh crore as of Dec-16, from about Rs. 8 lakh crore a year ago, despite a host of measures to check defaults. The government and RBI have initiated one time settlement of bad debt scheme, penal action for defaulters that have siphoned off loans and a forensic audit of the top 50 defaulters to separate genuine cases from siphoners. The Finance Minister is working on a roadmap in conjunction with the RBI.

Despite the WPI Uptick, Consumer Inflation – Rural and Urban – Remains Benign for Now…

Despite the WPI Uptick, Consumer Inflation – Rural and Urban – Remains Benign for Now…

Despite the WPI Uptick, Consumer Inflation – Rural and Urban – Remains Benign for Now…

The India U.S. Bond Spread Has Been Narrowing Over the Past Few Months…
But a Recent Retracement Has Seen FII Flows Come Back to Indian Debt Markets

The India U.S. Bond Spread Has Been Narrowing Over the Past Few Months…

No Clear Impetus for a Rate Move At This Point

India’s federal government is looking to spend an additional Rs. 148 billion in the current financial year, which may lead to higher borrowing. With 60% of government borrowings slated in the first half of the fiscal year, firming inflation, offset by renewed interest from FII investors, and declining credit growth, it is unclear which factors will dominate and there isn’t any clarity on a directional move higher or lower.

Our view on fixed income remains unchanged.


Equity markets have been ebullient on the back of a BJP victory in the U.P. polls and strong showing in other states. Valuations are extended, but possibly justifiably so. The next trigger for the markets will come from earnings reports for the current quarter. Foreign outflows have reversed both in the equity and debt markets, and the institutional investor is active, suggesting that markets are likely to sustain current levels and any sell-offs will be supported by additional capital deployment.

The government recognizes the need to bring investment by corporates and lending by banks back as the crucial third leg of an economic recovery.

A review of the economic indicators does not support the overly optimistic view taken by the equity markets. However, we believe the benefit of the doubt must be accorded to companies and the economy due to the shock effects of demonetisation. Further clarity will come as we move forward to earnings releases. Inflation trends remain benign for now, particularly as a result of the fall in Crude.

The BJP remains a corporate friendly, investment friendly party. The macro environment remains conducive to investment. As usual, portfolio returns will be driven by a willingness to be patient, prices paid on investments, quality of investment manager and bottom up stock selection.

Technical Strategy

It was a historic week for the market as the Nifty hit record high of 9218.40 on Friday, but lost most of the intraday gains to close at 9160 levels.

The index has been consolidating for the last two years and has formed bullish cup and handle pattern on long-term chart. The breakout has happened with a gap up move and closed above its previous high of 9119 hit in March 2015, suggesting the breakout is likely to sustain. Index constituents have seen broad based rally with few stocks trading near their all-time highs.

Fifty percent of Nifty stocks having 66% weightage are within 10% of their 52 week highs, which if crossed and sustained will propel the index higher initially towards 9300 and then 9700 levels.

In Nifty Call options, 9200 strike price has highest open interest followed by 9300 strike which may act as resistance for the market in near term. In case of any decline, it will be buying opportunity with 8800 becoming critical support level on closing basis. Also, 8800 strike price Put has highest open interest followed 8900 strike price suggesting as base for the market. However, as matter caution one needs to be watchful of INDIA VIX which is a two year’s low level of 11.92; and any sharp up move in VIX could lead to short term reversal in market trend.

Technical Strategy