Premium valuations and lack of big triggers will weigh on Indian equity markets in the near term, believes Mahesh Nandurkar, India Strategist, CLSA. In a conversation with Sheetal Agarwal, he talks about the earnings, foreign institutional investor inflows and overall market outlook. Edited excerpts:
Do you believe the recent rally in markets is sustainable?
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We don’t think so. We believe that there have been a few triggers for the markets over the past two to three months, such as a reasonably good Budget, decent monsoon forecast and the US Federal Reserve’s dovish statement in February. So, the market has had a decent run. But, going forward, I don’t see any big positive triggers for the market. In fact, I think there could be a few sentiment dampeners.
Of late, there has been some excitement around the high frequency indicators, which have improved quite a bit. As we go into May or June, many of these will soften as the base effect normalises. Also, the earnings expectations are still high and we will still see some earnings downgrades. We believe the Sensex could give five to seven per cent returns over the next 12 months.
Are the Indian markets over-priced?
By consensus estimates, the Nifty trades at 16.1 times earnings on a one-year forward basis. This is an 11-12 per cent premium to past 10 years' average of about 14.5 times on unrealistically high growth expectations. As against 23 per cent earnings growth expectations, if you look at a more realistic picture of 14-15 per cent, then 16.1 becomes 17.5 times, which is a higher premium and does not look sustainable to me. The fair valuation should be 15-15.5 times, which is average valuation plus some premium on account of corporate profitability bouncing back from its lows. But, it is still a de-rating from current levels..
Are we at the bottom of the earnings downgrade cycle?
Downgrades this year will be lower than last year. The market seems to be expecting 23 per cent earnings growth from Sensex companies in FY17 and reality will be closer to 15 per cent. So, it is still a downgrade.
Which sectors will drive earnings?
The effect of a low base in earnings will play out in FY17. Earnings growth will look up for companies that reported very badly last year. Corporate banks, for instance, because last year in the December and March quarters, they took big write-offs, driven by the Reserve Bank's asset quality review. That is not going to happen again next year. Non-performing asset ratios will still rise in FY17 over FY16 but the pace will be much lower. Similarly, health care companies had to do acquisitions-related write-offs in FY16 and will benefit in FY17, due to a very low base. The numbers will be good to some extent from cement companies as well. A lot of this, though, is base effect-driven and appears unsustainable.
Excluding this base effect, which sectors will do well?
We believe IT, private sector banks and select energy companies will post good numbers. I don’t see much of an improvement though. They have been good they will continue to be good. But I don’t think the 15 per cent growth will become 20 or 25 per cent.
What are the key investment themes in this market?
The single biggest theme we are looking at is earnings visibility where you will see least amount of earnings downgrades. Apart from that, disruption is a big theme and is not restricted to e-commerce. For e.g, a Patanjali trying to disrupt the consumer goods space space or Amazon web services having some negative impact on information technology companies. If there is a new entrant on the telecom side, then existing players will get impacted. You will see a lot of this disruption. We need to see to what extent these companies will get disrupted. Where you will see the least amount of disruption would be relatively safer bets.
How does India stack up vis-à-vis other emerging markets?
In 2016 so far, India has under-performed all other EMs, except China. With some rebound in commodities, the commodity-driven markets benefit more than us. But, on a structural basis, my talks with most investors suggest India remains a more attractive bet for the longer run as compared to Brazil, Russia.
Indian markets have seen healthy FII inflows in 2016 so far. Is this sustainable?
While India has seen inflows, the other markets have seen larger inflows. It’s a global risk-on and India has had its own share in that..
At the international level, since 2009, every bad economic news is considered to be good news for the equity markets. Because the bad economic news will mean that the central bankers will do QE (quantitative easing), rate cuts, etc to fight deflation and then that money will come into the financial assets. But I think we have played this game for a pretty long period of time now. At some point markets will start questioning the efficacy of central banking actions. We did see impact of that earlier when BoJ (Bank of Japan) cut rates deeper into the negative territory but the local Japanese markets actually collapsed. Something similar happened in the case of ECB (European Central Bank) as well.
So my own sense is that this tendency will increase going forward which is a global risk for emerging equity markets including India. In this context I believe the possibility of these flows sustaining is low.
Are we seeing any signs of uptick in capex?
There are three types of institutions that do capex - government, private corporates and households. Government capex is clearly on an upmove and that trend will continue. But I do not think that private corporate capex will pick up because the capacity utilisation rates are pretty low at 62-70 per cent. I think household capex which is largely property can drive delta in the near term. In the last 2-3 years we saw a negative trend on the household capex both in the volume terms and the prices terms. A lot of people ask me that if the government capex is up by 30-40 per cent why it is not reflected in the numbers. This is because while one segment is growing by 35-40 per cent, the other segment is growing at a negative rate leading to an offsetting impact. I am hopeful about the household capex trend changing. Maybe it will take another 3-4 quarters but the property market will begin to bottom out.
Which are the sectors that you like and the ones you will stay away from?
We continue to be positive on the IT sector where the valuations are between 15-17 times on one-year forward basis and double digit earnings growth appears highly likely. Second sector is private sector banks. Even though the credit growth for the market will be as low as 12-13 per cent but the private banks can still grow by 20 per cent. Continued market share gains and the fact that they don’t need to raise equity despite the higher NPA provisioning are key positives. We also like select OMCs (oil marketing companies), some refining companies where the valuations are quite attractive. Few names in pharma and power utilities sectors too look promising.
We stay away from consumer staples because of rich valuations and the Patanjali factor. Also, these companies will witness deceleration in earnings growth in FY17 as compared to FY16 because FY16 had the benefit of margin improvement. While you will still see some margin improvement in FY17, but I think the best of margin improvement is now behind us. And revenue growth is going to be somewhat similar as FY16. I will also stay away from capital goods because the investment cycle recovery is nowhere to be seen. We have an underweight on healthcare and materials as well.