It's too late for investors to dabble in mid, small-caps: Tirthankar Patnaik

Interview with India Strategist, Mizuho Bank

With the earnings season for the June quarter underway, Tirthankar Patnaik, India Strategist at Japan-based Mizuho Bank, tells Puneet Wadhwa that he estimates modest 13 per cent growth in corporate earnings in FY17, as compared to a consensus estimate of 16 per cent. He suggests investors stick to large-caps, as these provide better downside protection and would gain from the overall strength in the markets. Edited excerpts:

How long will the upbeat scenario last across global equity markets?

The recent rally in global markets has been driven by a number of factors, like deferred expectations of a rate hike by the US Federal Reserve (US Fed) after Brexit, renewed comfort on US corporate earnings in second half of 2016, and an orderly slowdown in China. Market dynamics, like the sharp drop in yields after Brexit, have also made global equities attractive.

For India, there's incremental support from a normal monsoon after two years of deficient rain, expectations of an earnings revival after two years of sub-five per cent profit growth, and, to some extent, announcement of the new Reserve Bank of India governor. However, we expect the current dynamics in global equities to continue for a while longer, particularly given the differential with bond yields and, to some extent, the catch-up for equities as an asset class to sovereign bonds and commodities.

We, therefore, remain constructive on Indian equities, given the limited downside for the near term. And, believe tactical positions can therefore be adjusted on earnings performance.

Where do you see the Sensex, Nifty by December-end? What are the key triggers and risks to the rally?

We expect markets to track earnings for the year. Our estimate of earnings growth for FY17 is modest at 13 per cent (vs the consensus 16 per cent). After the recent run-up, we expect the market to return three to five per cent by December, reaching 8,800 on the Nifty50 index, and 28,700 for the S&P BSE Sensex.

However, a one-way trip is unlikely. A number of macro factors need to fall in place for this rally to continue. We do not rule out bouts of profit booking, given the recent advances.

The rally in mid-cap and small-cap stocks has been spectacular. How should investors play these stocks?

Indeed. This has also resulted in some mid-caps now trading at a premium to their large-cap peers. One needs to be cautious here, as in the past such sharp rallies have thrown up names which do very well momentarily but correct sharply as soon as the market trend changes. In our opinion, it might be a tad too late to be adventurous and dabble in mid/small-caps at this juncture. Stick to large-caps, as they provide better downside protection and would gain from an overall strength in the markets, albeit in smaller proportions.

What is your expectation from the quarterly results reason?

Our expectations from the earnings season are quite measured given the relatively high base of the same quarter last year. We expect a flat to low single digit growth in both revenues and bottom-line profits. In terms of sectors, global commodities are expected to report another weak set of numbers, though there could be some sequential improvement. 

Numbers from the financial sector are also expected to stabilise post the kitchen-sinking in the previous couple of quarters, even as the NPAs remain uncomfortably high. Margin gains for domestic consumer companies are likely to taper off after a good run in the past six-eight quarters, which might impact their profit growth. Key trends to watch in this earnings season would be the continuation of recovery seen in the earnings of domestic investment companies and asset quality situation of the banks.

How do cement stocks look in the backdrop of an above-normal monsoon forecast that usually slackens construction activity?

Cement stocks now appear expensive on a historical multiples basis. However, the sector has some strong tailwinds which might continue to support these valuations. Factors such as: a) consolidation in the sector, (b) recovery in rural India and, (c) pick-up in infrastructure activities, all bode well for the sector.

Surprisingly, ground reports suggest cement prices are holding well even after onset of the monsoon. We believe any seasonal weakness in cement stock prices should be used as a buying opportunity.

What are the markets expecting from the monsoon session of Parliament? Would they react sharply if the Goods and Services Tax (GST) Bill is not cleared?

Passage of the Goods & Services Tax (GST) bill would be the key market expectation from the monsoon session, particularly after the relatively weak performance of the Congress in the state elections in May, the relatively simpler version proposed in the model GST Law by the Empowered Committee of State Finance Ministers, and the recent all-party meetings on the issue.

To be sure, Parliamentary ratification of the bill would need to be followed up with similar approval from the state assemblies. Further, the technological and legal infrastructure needed for seamless GST implementation across the country is still some distance away (We believe Apr’18 for full implementation). Hence, we believe markets should not see significant downside if the passage of this bill is delayed to the winter session, ceteris paribus. However, disappointment on the GST bill could well be clubbed with local/global negatives to amplify the reaction.

Should investors avoid the information technology sector, looking at the TCS and Infosys numbers?

More than the currency volatility, the growth outlook for the sector worries us. Add to that the growing protectionism across the world, which would increase the cost of doing business for these companies and impact their margins. One can at best be neutral on the sector, given reasonable valuations.