Investors are rattled by the massive correction in the market that came as a bolt from the blue. Giving them a rude jolt, the bellwether Nifty-50 plunged by 5 per cent and the NSE Mid-cap Index dropped 10 per cent over the past month.
Volatility has also heightened. The India VIX Index was up 27 per cent this month, mainly from unsupportive global developments and domestic policy events.
What makes the market edgy is that the bond yields are hardening while valuation multiples, moderating. Hardening bond yields is a key factor driving market correction across global equities.
Bond yields in India have hardened from 6.3 per cent in July 2017 to 7.6 per cent now and following the rise in bond yields, the market looks expensive, especially mid-cap valuations, say analysts.
The focus now will be on earnings recovery rather than price/equity (P/E) expansion afforded by low-cost capital. The Indian market was looking expensive after the steep rally over the past year, but valuations have come off a bit after the recent correction.
Going forward, analysts expect earnings to drive the market, as the room for P/E expansion seems limited in an environment of rising cost of capital.
While the mid-cap index is still trading at a rich premium to large-cap, the Nifty valuations are far more reasonable. After the recent correction, the Nifty is trading at 17.7 times one-year forward earnings—at a 5 per cent premium to its long-term average of 16.9x. A pick-up in earnings in the current earnings season supports P/E projections for the next financial year.
“After being flat for FY14-17, we see semblance of an earnings recovery, with 2HFY18 and FY19 earnings growth estimated at 21 per cent and 25 per cent, respectively. To that extent, the 3QFY18 earnings season has been healthy so far, with Ebitda and PAT growth largely meeting our estimates for the Nifty and our broader Motilal Oswal universe of stocks,” said Motilal Oswal Securities in a recent report.
“We highlight the stability of earnings estimates for FY18. Unlike FY15, FY16 and FY17 (when earnings underwent sharp downgrades), we note EPS estimates are relatively stable for FY18, despite the GST impact in 1HFY18,” the brokerage said.
More importantly, the quality of earnings is also on the mend, with internals like the surprise/miss ratio and the upgrade/downgrade ratio appearing stable.
Analysts expect corporate earnings to benefit from consumption recovery, a low base of FY18 and bad loan resolution in the banking sector.
The difference between risk-free rates and earnings yield (next twelve month/earnings-price ratio) used to be a good indicator of risk-reward between the bond and equity markets. The yield gap has been higher than 250 basis points over the past few weeks, the highest since August 2007. Yields could now sustain or break down equity valuations.
Says Suhas Harinarayanan, managing director of institutional equities at JM Financial, “For now, we go with the view that the growth estimates are unlikely to see a meaningful revision upwards, as seen from the latest 3Q results wherein for the companies that have reported till date, the earnings growth is running behind estimates even after many quarters of disappointments. Our various sectoral analysts also indicate balanced risks on growth. This leaves yields and domestic flows as factors that could sustain or break down the valuations. At least one indicator indicates that the market valuations indeed look stretched and that it would be difficult to make absolute returns in the market this year.”
The big risk for the market is rising crude oil prices along with higher-than-budgeted fiscal deficit, higher inflation and bond yields. ”Hardening bond yields are expected to continue posing a risk and could result in a P/E multiple de-rating. However, the micro (i.e. earnings) picture is turning around. We expect the market to be driven by earnings growth, going forward– unlike in the past three years, when the low cost of capital aided multiple expansion. This warrants a change in the strategic stance towards growth plays, as lack of growth can exacerbate multiple de-rating,” Motilal Oswal Securities said.
Mid-caps are trading at a premium of 40 per cent to large-caps–an all-time high. The recent correction, however, has moderated this premium.
But Kotak Securities still “find the valuations of the Indian market to be rich. Even assuming no risks to the quantum of earnings growth over FY2019-20E, the quality of earnings growth is quite poor, with incremental profits in a large portion of the Nifty-50 Index.”
Even if the valuations are rich, the market could still prove rewarding for investors in the current falling trend.
According to Shailendra Kumar, chief investment officer at Narnolia Securities, “Though the macro is showing some distress, if we look at the micro parameters, then equity investing looks promising even in the near-term for a period as short as two years. The Nifty EPS for FY18, FY19 and FY20 are pegged at Rs 481, Rs 558 and Rs 642, respectively, and it be noted that our estimates are much more conservative than the street (street’s FY19E EPS is Rs 600+). Now, at the end of CY19, the market will be discounting FY20 earnings. So, if one assigns a PE of 21x, the Nifty target for December 2019 comes to 13482, which implies a return of 28 per cent from the present levels (14 per cent CAGR return). Even assigning a PE of 20x would mean a 11 percent-plus return. In the current market scenario, if the Nifty corrects more, the yield would become even more attractive. So, ‘buying on dips’ could prove to be remunerative.”
Motilal Oswal Securities suggest names that are relatively unpopular but where underlying dynamics are turning favourable, and also those where valuations are at a significant discount to the sector. The brokerage highlight 10 stocks from its universe, in which “growth visibility is healthy and outlook is strong and there has been at least 15 per cent correction from 52-week highs.” These mid-cap ideas are: Havells India, Emami, Jindal Steel & Power, Indraprastha Gas, RBL Bank, Exide, Oberoi Realty, Repco, MCX and Teamlease. Among the large-caps, Motilal Oswal Securities prefers HDFC, ICICI Bank, Larsen & Toubro, Mahindra & Mahindra, Motherson Sumi, Titan, HPCL and NMDC.
Kotak Securities’ recommend a portfolio comprising (1) large positions on sector leaders in preferred sectors (banks, consumer discretionary, including automobiles), (2) reasonable positions in ‘turnaround’ sectors (‘corporate’ banks such as ICICI and SBI with solid CASA and improving asset and return on assets profiles) and infrastructure and (3) moderate positions in sectors with global linkages (metals, RIL). “We generally avoid high P/E stocks in the building materials, consumer staples and discretionary sectors despite the recent price correction in consumer discretionary names as we find their valuations quite high,” said the brokerage