Valuation divergence narrows as sectors revert to mean

Divergence in valuations falls 40% from 10-yr high in May

The difference in valuations in terms of earnings multiples between different sectors in the market have been on a steady decline since around May, when it was at its highest level in a decade.

The variation has declined nearly 40 per cent since, according to an analysis based on data compiled by Citigroup Global Markets.

A Citi scale on this variation showed the gap had hit a trough during early 2009, slipping below 0.2. The variation then followed a rising trend to more than double at around 0.5 in the middle of 2013. This was the highest level since the end 2002-early 2003 period.

A Citigroup Global Markets India Equity Strategy report dated October 1 said the gaps between sectors should continue to narrow in the days ahead.

SHRINKING DIFFERENTIAL

• The variation across valuations hit a 10- year high earlier in 2014
• Recent rise in markets has narrowed the gap by 40%
• Non-defensive sectors already beginning to contribute more than before to corporate earnings
• This is in contrast to the past two to three years, when defensives contributed to bulk of Sensex earnings
• Trend of narrowing valuation gap may reverse  after recent correction, as sectors that ran up may correct more
• However, longer-term trend is expected to show a decline in valuation gap

“Valuation divergences have tended to narrow in rising markets…trends should be similar this time, too,” said the report, authored by Aditya Narain and Jitender Tokas. “...Some of this you are already beginning to see…between the most defensive premium in the down-market (Staples)…and the highest earnings growth revival expectations currently (capital goods).”

The valuation premium between the BSE Fast Moving Consumer Goods (FMCG) and BSE Capital Goods indices shows a sharp decline from a near 150 per cent premium in September 2013 to less than 10 per cent in September 2014, according to the Citi Data.

Pankaj Pandey, head of research at ICICIDirect, said the trend was part of a larger move away from concentration of earnings growth in a few sectors.

“In the past two-three years, Sensex earnings growth has largely been driven by information technology, pharmaceuticals and FMCG companies. This quarter, we expect both top line and bottom line growth to be in single digits. However, the quality of earnings is expected to improve, with sectors such as cement and automobiles likely to see some margin expansion,” he said. He added that growth was expected to be more well-rounded. Some defensive sectors are likely to see some margin contraction. If growth is more balanced, then the valuations are expected to reflect this.

Deven Choksey, managing director at K R Choksey Securities, said: “I am confident that in this quarter and the second half of this financial year, there should be an improvement in the old economy sectors, including banking. Infrastructure must also begin to catch up, eventually.”

Deepak Jasani, head of retail research at HDFC Securities, said the recent trend might well see a reversal, though this could be temporary. “The difference in valuations might widen a bit in the light of the recent market fall. Sectors which have risen recently will fall more during times of decline. While the gap could widen for now, it could begin to narrow again as and when sentiment revives, provided the government is able to deliver on reforms,” he said.