Questions that keep investors from sleeping at night

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Despite a significant disruption led by the second wave of Covid, markets have reached new highs and have done so without any significant correction. The last 1,000 points of the Nifty-50 benchmark were added in just 19 trading sessions. Both a noticeable disconnect from the realities on the ground and the pace of the rise have raised many questions in the minds of investors.

Is India’s Profit Cycle Changing After A Decade?

Corporate profits have increased from 7.8% to 1.8% of GDP over the past decade, due to the destruction of profit pools of several companies, including commodities, telecommunications, industrial products, corporate lenders and American generics, to name a few. Most of these profit pools are being rehabilitated. Analysts predict that even if corporate profits to GDP return to long-term averages, we could maintain strong profit growth of over 20% from 5% over the past decade.

Has the first quarter of fiscal 22 started on a good note?

The first quarter of fiscal 22 marks the fourth quarter of robust quarter-over-quarter revenue growth. Corporate earnings in the first quarter of FY22 were in line with high expectations, helped by the deflated base of 1QFY21 and localized and less stringent lockdowns compared to 1QFY21. 1QFY22 has been an online earnings season for the MOFSL universe. Attractive sales were online (50% yoy; est. 48%), while EBITDA / PBT / PAT growth was 41% / 103% / 101% yoy (est. . 38% / 89% / 94%). Among Nifty constituents, 42% reported beats on PAT ratings, while 34% missed expectations.

With the increase in the number of vaccinations and the opening of the economy after the two waves, fiscal 22 started off strong. Earnings per share of NSE500 companies hit a 52-week high of Rs 534.97 on August 23, 2021, a year-over-year growth of 82%. The BSE500 companies have made giant strides in their efforts to reduce debt on their balance sheets. With a net debt / equity of 0.6 for the components of the BSE500 index currently, it is the lowest since 2016. Thus, the real GDP forecast for FY22 stands at 11% against – 8% a year ago.

Are the profit estimates stable?

Profit estimates were in line with high expectations for the first quarter of 2022. Due to increased domestic and global demand and policies promoting growth, we see all the ingredients for a resumption of the Capex cycle. We believe profits could increase over the next three years. Higher profits would fuel real GDP growth and profits, so that a virtuous circle unfolds with a naturally associated positive impact on the stock price.

Will benchmarks continue to rise throughout FY22?

From April 1, 2021 to date, Nifty-50 has generated returns of 11.9%. In the short term, it is difficult to draw a conclusion. Longer term, given that net debt to equity is currently declining and economic activity is picking up, we see corporate profits returning to average. Consensus estimates suggest Nifty EPS growth of 24% CAGR up to FY25, which could result in a Nifty price CAGR of 23% over the same period.

Are the markets overheated?

We are seeing a recovery in corporate profits because there is a recovery in economic activity after the second wave. The EPS, in turn, arrived as such, the Nifty-50 PE Ratio cooled down a bit. It stands at 25.59 as of August 26, 2021, and with the projected earnings growth of brokerage firms being 26% CAGR of FY20-22E, the PEG estimate is around 1x. A PEG of 1x implies a perfect correlation between the market value and the profit projection.

Is there a bubble in the midcaps?

The Nifty Midcap 100 index generated 149.4% against 118.6% of the Nifty-50 returns since the lows of March 23, 2020. But if we see it over a longer period since January 1, 2017, Nifty Midcap 100 generated yields of 17.6%, which is lower than the 19.4% yield of Nifty-50. Since January 2018, there has been a massive multiple downgrade of the PE in mid and small caps. We can say this in hindsight, as no one would have predicted the series of problems that would arise from 2018 to date – A combination of i) 3 consecutive years of declining GDP growth rates ii) crippling regulations like demonetization and the GST iii) NBFC crisis iv) post-RERA real estate crises and finally v) global pandemic like the Covid has created a deluge of bad news for these companies. Never in history have small businesses experienced periods of stress for more than the past three years.

In the meantime, the big players have taken advantage of it. This was rightly reflected in consecutive years of underperformance against large caps. But does this change? The disruptions during the Covid waves forced them to rework their business models, from sourcing to manufacturing to distribution. Many small businesses have adapted and embarked on prudent cost-cutting measures and cleaned up their balance sheets by reducing their debt. Interest rate cuts and the likelihood of a low interest rate regime are welcome news for mid-cap companies.

Is this earnings cycle reminiscent of the 2003-08 era?

A host of complementary factors in addition to corporate profit growth, namely, i) moderate interest rates, ii) robust FII flows, iii) stable rupee and healthy foreign exchange reserves, iv) investment growth and v) higher savings and investment are very similar to 2002.

The final P / B went from 2.0 in mid-2002 to 6.6 in 2008. There were several corrections throughout the trip. The trend appears to be similar now, with a P / B rising to around 3.9 from the lows of 2.2 reached in March ’20. FY25 resulting in a possible CAGR of the Nifty price of 23%.

This shouldn’t sound incredible as the same happened in 2002-08 with Nifty BPA growth at 24% CAGR and Nifty price growth at 29% CAGR.

In conclusion, while these questions are relevant, markets ultimately tend to revolve around earnings growth. The risks for the above assumption are a) subsequent covid waves, b) an earlier than expected rise in interest rates and hence bond yields, and c) rising commodity prices.

(The author is product manager, Motilal Oswal AMC)


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