India's equity markets have been among the best performing in Asia this year, and despite the rally over the past one year, the bulls seem to be confidently marching ahead.
On July 17, the NSE Nifty50 index topped the 9,900-mark for the first time in history. The BSE Sensex, too, hit a new high of 32,132.
The reasons behind this rally are many. The key reasons are that foreign institutional investors continue to pour money into India, and, for the first time in years, domestic retail investors have kept up the pace as they continue to invest heavily in equity mutual funds.
The Goods and Services Tax, India's most ambitious tax reform, was rolled out on July 1, and so far there hasn't been any major disruption in business or economic activity, some analysts point out, which has also lifted market mood.
Another reason for the rally has been a circular by the Securities and Exchange Board of India on offshore derivative instruments (ODI). On July 7, the market regulator banned foreign portfolio investors (FPI) from issuing ODIs or participatory notes (P-Notes) for derivatives as underlying.
What the latest guidelines mean is that FPIs will be able to trade in derivatives contracts of a particular stock, only if they hold the underlying shares of that company.
This has led to a massive short-covering rally, sending the bears for cover.
Valuation Concerns
Since the start of 2017, both, Sensex and Nifty have jumped more than 19 per cent. The rally in mid-caps and small-caps has been even more phenomenal. The BSE mid-cap index has surged 25 per cent and the BSE small-cap index 32 per cent.
The markets have had a run-up even as the broader fundamental corporate earnings have still not recovered. This worries a few analysts, who expect there could be a near-term correction.
“There is a concern. Whatever reasons you may give, the earnings recovery has not been seen. Both demonetisation and GST are having a short-term impact,” R. Sreeshankar, head of institutional equities at broker Prabhudas Lilladher, told THE WEEK.
These worries over valuations are echoed by a few large mutual fund managers, too.
“There are concerns in the short term... Valuations are not in the bubble zone yet, but they are reasonably elevated and earnings need to catch up to justify these valuations,” said Chandresh Nigam, MD and CEO of Axis Mutual Fund.
Buoyed by strong inflows in equity funds, Axis MF has now entered the league of the top ten fund houses in India, with assets under management of around Rs 63,600 crore.
Nigam is particularly concerned about lack of value in the mid-cap space. And the concerns are not surprising.
Over the last month, several mid-cap and small-cap stocks have accelerated 50-100 per cent. For instance, ABC Bearing has rallied 100 per cent, Jaypee Infratech has gained 75 per cent, Venky's India is up 70 per cent, Shilpi Cable has risen 62 per cent and Karuturi Global has jumped 60 per cent, to name a few.
Analysts say the huge liquidity in the market is the fuel driving the rally.
Earnings growth key
For the quarter ending March 31, 2017, the net profit growth of Sensex companies was 3 per cent, while the net profit growth of Nifty 50 was around 6 per cent.
All eyes will now be on the first quarter earnings, but analysts don't see any major pickup just yet, as GST is expected to have some impact for one or two quarters and capital expenditure and investments remain on the lower side. For pharma and software services firms, global headwinds, too, remain a concern.
Kotak Institutional Equities expects earnings of Sensex companies to remain flat in the quarter ended June 30. Across its broader coverage universe, the brokerage expects net income to decline 8 per cent.
“The first earnings season of FY2018 begins with the by-now familiar narrative—robust macro fundamentals not yet translating into corporate earnings growth. The narrative of significant policy events disrupting earnings continues in FY18,” said broker Motilal Oswal.
There are several reasons for the expected dip in earnings. In sectors like automobiles and consumer durables, companies rolled out huge discounts and promotions to liquidate inventories before the GST rollout. Across the fast moving consumer goods (FMCG) sector, there was GST-related trade de-stocking, which hurt companies' quarterly growth.
Earnings of software services companies remain under pressure because of regulatory uncertainties in the US, their biggest market. Pricing pressures in the US market, and higher research and development spends are expected to hurt pharmaceutical companies, too.
In telecom, companies will continue to see the impact of the aggressive price war unleashed by Reliance Jio's low data charges and free voice calls, which has forced Bharti Airtel, Idea Cellular, Vodafone and Reliance Communications to launch competitively priced plans.
Banks are likely to report another quarter of muted loan growth, while provisions for bad loans will remain high.
Oil companies are expected to report a quarter-on-quarter drop in earnings before interest, taxes, depreciation and amortisation (EBITDA), due to lower crude oil realisations, weak refining margins and a stronger rupee against the US dollar.
Lower steel prices and usage of high-cost coking coal inventories will lead to a sequential decline in operating margins for steel companies, say analysts, while non-ferrous companies are also likely to report a weak quarter due to lower prices and volumes.
The April-June quarter is usually a weak one for real estate companies. However, in the months prior to the rollout of GST and with RERA also getting implemented, some increase in demand for near-completion and completed projects was seen in some markets like Maharashtra, although sales in south India are expected to have remained weak, say analysts at Kotak Institutional Equities.
Cement companies, on the other hand, are expected to see a further uptick in volumes (around 5-6 per cent growth seen, versus flat growth last year), as infrastructure growth picks up pace.
Non-banking finance companies, too, may report an uptick in performance as the operating environment improves from the demonetisation-led stress.
“GST-adoption-led volatility, at a time when the Indian economy remains weak, should throw ample surprises in the first and second quarter earnings season,” says Nitin Bhasin, research analyst at Ambit Capital.
Bhasin feels that investors should focus more on the outlook this time, rather than near-term earnings.
Market outlook
The biggest dilemma currently is on market valuations, which, some say, are expensive in the near-term, compared to their long-term averages. However, others say that considering the earnings recovery that lies ahead, and in the wake of continued fund flows, the current valuations, though high, may still not be alarming.
The BSE Sensex is currently trading at over 19 times its one year forward price-to-earnings ratio, compared to the ten-year average of close to 17 times.
Investment bank UBS, last month, cut its rating on India's equity market to 'neutral' from 'overweight' over valuations.
“On our models, India no longer looks so attractive, though much of this on the thematic side is down to the impact of demonetisation negatively impacting earnings in calendar 2018,” it wrote.
UBS is also concerned with the widening valuation gap between the mid-cap and small-cap space versus large-cap stocks, and the gap continued to widen due to hopes of accelerating growth and inflows from mutual funds. UBS is not the only one striking a cautious note.
Based on a trailing price-to-equity ratio of 19 times, Ambit Capital has forecast a Sensex target of 31,000 for the year ending March 2018, implying returns this year are likely to be flat to negative from current levels.
“We suggest waiting for lower valuations for investing in the market; we continue to hold cash and remain underweight on financials and IT,” said Bhasin.
Sanjeev Prasad, co-head of Kotak Institutional Equities, said, “The street's tendency to ignore continued weak results and muted earnings outlook in certain sectors and stocks suggests that investors have high expectations about a strong recovery in profits of the favoured sectors and stocks. It would be interesting to see if this blissful state of affairs would continue if global bond yields were to rise on a sustained basis and earnings were to continue to disappoint."
A few analysts still remain positive. For instance, Prabhudas Lilladher's Sreeshankar believes that corporate earnings growth will recover in the second half of the current financial year, which will continue to drive markets higher.
“I am hopeful of earnings recovering in the second half of the year. That and given the strong liquidity continuing in the market, equity markets will remain expensive,” he said.
Pankaj Pandey, head of research at ICICI Securities, expects the NSE Nifty 50 to hit 10,400 points by the end of the year, meaning an upside of close to 6 per cent from current levels. Goldman Sachs, too, had recently raised its Nifty 12-month target to 10,400 points.
Pandey said while some near-term correction in the markets couldn't be ruled out, the trajectory over a longer period remained on the upside. “There has not been any major disruption during the shift to the GST, thus far, which has comforted the market. While there could be some near-term uncertainties on GST impact, over a medium to longer term, it would be extremely beneficial and boost growth,” he said.
He pointed out that unlike the surge in 2008, when markets across the board rose, several sectors this time around, like infrastructure, IT and pharma have not been a part of the current rally.
Most analysts THE WEEK spoke to say that retail investors should continue to remain long-term and buying should be more stock specific, rather than focusing on a particular sector, which will help diversify risks. Particularly, in the mid- and small-cap space, where there may be some froth that has built up, investors need to be extremely cautious and pick stocks with quality fundamentals and growth prospects, they added.
“It is more important to take a longer term call, not just on markets, but on individual businesses," said Nigam. "We still feel confident on a three-to-five year holding period, because we are invested only in the high quality companies with a high predictable growth."
(As appeared in THE WALLET, issue dt July 30)