As corporate earnings slow down, brokerages raise red flag on valuation

A slowdown in corporate earnings and India’s headline economic growth is forcing many brokerages to raise red flags on equity valuation on D-Street.

“We wonder if the Indian market and ‘growth’ stocks will trade at current high multiples if the current slowdown in the Indian economy was to be more prolonged than the market’s current expectations?” ask Kotak Institutional Equities analysts, led by Sanjeev Prasad, in their latest report on the Indian equity.

They say the Indian market has hardly seen any correction, despite growing growth pangs.

The 30-stock BSE Sensex is currently trading at a close to record valuation of 28.2x its underlying earnings in the trailing 12 months, despite the Street expectation of a subpar growth in corporate earnings during the April-June 2019 quarter.

For the first time in nearly a decade, the core index companies (excluding banks and financials) are expected to report a contraction in earnings during the first quarter, while top line growth is expected to hit a decade low.

Not surprisingly, the analysts at Motilal Oswal Financial Services also see divergence between performance (read earnings growth) and valuation in the equity market.

“The corporate narrative on consumption has weakened in the past six months. Valuation headroom for the Nifty is limited in an environment of continued earnings downside risks, in our view,” say Gautam Duggad and Bharat Arora of Motilal Oswal in their latest strategy report on the Indian equity.

According to them, the biggest worry is the continued polarisation in the market, with a handful of stocks accounting for most of the gains in the benchmark indices.

“As markets consolidate, the picture has turned more polarised, with a few stocks accounting for the gains in the Nifty. That divergence between these two segments of the market has become quite stark, in terms of both performance and valuations,” says Duggad.

According them, while the performers are trading at a substantial premium, other stocks are available at a huge discount due to their long-period average valuations.

This, the brokerages say, opens up the possibility of a correction and valuation derating in some of the expensive stocks in sectors such as fast-moving consumer goods, retail lending, cement, and consumer durables, among others.

“We are not sure if multiples of ‘growth’ stocks will hold up at the current high levels in case the Indian economy was to see a prolonged slowdown or settle at 5-6 per cent real gross domestic product growth rates. Growth stocks in the consumer staples, discretionary, and financials sectors trade at very high multiples,” write the analysts at Kotak Institutional Equities.

They say the derating can be quite severe, as has happened in the case of automobile stocks once the market reconciled to a ‘longish’ period of weak volumes.

However, most brokerages expect equity valuation to get support from the sharp decline in bond yields in India and the rest of the globe recently. A lower yield on treasury yields lowers the attractiveness of investment in risk-free assets, such as government bonds and bank fixed deposits, and forces savers and investors to search for yields in riskier assets such as equities.

“We expect the market to get valuation support from lower bond yields. We increase our target multiple to 17x (from 16x) on FY21F earnings to arrive at our target of 12,900 for the Nifty50 index,” write Saion Mukherjee and Neelotpal Sahu of Nomura in their recent report.

Yields on 10-year treasury bond is down nearly 110 basis points (bps) in India and 63 bps in the US since the beginning of the current calendar year, reducing the savings and investment options for risk-averse investors. Historically, there is a negative correlation between bond yields and equity valuations.