A fresh spark for equities as macro clouds lift, says Aniruddha Naha

PGIM India's Aniruddha Naha says easing macro headwinds, reasonable valuations and resilient earnings have improved the risk-reward for equities

With macroeconomic (macro) headwinds beginning to ease and valuations at reasonable levels, this is a compelling opportunity to build equity portfolios, says Aniruddha Naha, chief investment officer (CIO) — alternatives, PGIM India Asset Management. In an email interaction with Abhishek Kumar, Naha adds that smallcaps offer the best long-term investment opportunity, followed by largecaps and midcaps. Edited excerpts:

 

The equity market is showing signs of recovery even as tensions in West Asia persist. Has the market bottomed out, and how do you see Samvat 2083 panning out? 

In the last Samvat, Indian markets were caught in a vortex of negative global macro events, including conflicts that led to higher crude oil prices, inflation, and widening twin deficits. The prolonged euphoria surrounding the artificial intelligence (AI) trade aggravated the outflow of money from India to other markets, which also put pressure on the currency.

 

The start of this year has seen many of these macro negatives already being factored in, even as earnings continue to surprise positively across market capitalisations (mcaps).

 

With some unwinding of the AI trade, strong earnings momentum, reasonable valuations, and India being an underweight position in global portfolios, the risk/reward equation in the market has shifted considerably in favour of the upside.

 

We expect this Samvat to surprise investors positively in terms of returns.

 

What are the key triggers to watch out for that could add to the pressure on Indian equities or change the market’s course from here? 

The price and sustained availability of crude oil, and more specifically diesel, at reasonably stable levels will be critical for Indian markets. These have a direct bearing on inflation and the twin deficits, with implications for interest rates and the currency.

 

Any major flare-up in West Asia could affect not only the crude oil basket but also sulphur and fertilisers.

 

Finally, the developing situation on the El Niño front could affect crop output and rural incomes.

 

The global slowdown in the AI trade, strong earnings momentum, and reasonable valuations make India a reasonably compelling investment destination. Any waiver or reduction in capital gains tax could also trigger strong inflows from global allocators.

 

How are you positioning your portfolio amid these macro headwinds? Which sectors offer relative comfort, and which ones are you cautious about? 

We have always focused on building portfolios with strong operating cash flows, good earnings predictability, and reasonable valuations. In August-September, macro headwinds were quite strong, and valuations were stretched. Accordingly, we had raised cash levels to around 20 per cent and waited patiently. With macro headwinds now easing and valuations improving, there is a compelling opportunity to build strong portfolios.

 

We continue to see strong earnings momentum and remain positive on capital goods, which stand to benefit from the ongoing investment cycle. Given the festival season, low-ticket discretionary consumption is likely to benefit from demand growth. Besides, market-facing businesses should benefit from the financialisation of the Indian economy.

 

Lastly, the correction in healthcare stocks due to regulatory uncertainty has created opportunities in a sector that has a long growth runway in India.

 

Midcap and smallcap stocks have outperformed largecaps despite the uncertain environment. Is the trend sustainable? 

Stock performance, while it may be swayed by emotions and liquidity in the short term, is ultimately driven by incremental earnings relative to valuations. The recent outperformance of midcap and smallcap stocks was driven by continued strong earnings, while largecaps lagged because their earnings profile was relatively tepid. Going forward, an improving earnings profile, reasonable valuations, and resilient business models could help largecaps participate meaningfully in the market recovery.

 

Where do valuations stand currently, and which mcap segment is in the sweet spot in terms of earnings growth potential and valuations? 

We look at valuations through the price/earnings-to-growth (PEG) framework, which measures the price-to-earnings (P/E) ratio relative to earnings growth. Based on this framework, valuations across the market are far more reasonable compared with their recent history. This is because sustained earnings have kept P/E multiples reasonable, while resilient earnings growth has helped the denominator in the PEG formula.

 

We believe that, given the higher cost of capital, stocks are unlikely to see any major P/E rerating. Going forward, stock prices will be driven by earnings.

 

Given the current market conditions, we continue to prefer smallcaps, which offer the best opportunity from a long-term perspective, followed by largecaps and then midcaps. While midcaps continue to report strong earnings, their valuations appear relatively less attractive than those of smallcaps and largecaps under the PEG framework.

 

The second-quarter (July-September/Q2) earnings season is underway. What is your assessment of the results announced so far, and has the West Asia conflict started to weigh on corporate performance? 

The earnings season has continued to be quite strong, with generally positive earnings surprises across mcaps. Some of the effects of the West Asia conflict are reflected in margin compression, but there seems to be no major slowdown in demand. We continue to track demand closely, and the market is currently demonstrating strong demand.