Wednesday, December 6, 2023

indian stock market: Where will we see the biggest earnings trajectory from here on? Vinod Karki answers

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Vinod Karki, Equity Strategist, ICICI Securities, says, “we will have a reasonable amount of inflation, but rates will also be there at a reasonable level. That is going to be the case. Equities generally are conducive to such an environment because when you have this kind of environment, the nominal numbers are quite strong, so corporate profits are good.”
I want to understand a few of the big factors which have happened globally in the last few days, which seem to have changed the narrative for equities as an asset class. One is that the US yields have come down very sharply, sparking hopes that interest rates may have peaked out; in fact, possibilities of cuts led by the US by mid next year is one factor. Dollar index has also reversed. Will equities as an asset class get support and by the middle of next year rate cuts start?
Earlier I also thought that at some point, rates will be cut and things like that. We are in an environment where rates will be higher for longer simply because if you look at the top three economies in the world, four if you include India – US, China, Japan and India – the latest GDP prints were all above expectations. So, growth seems to be ahead of what people initially thought. There were estimates that we will soon be hitting a recession in especially developed markets. So, all that is not panning out.

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We are seeing quite resilient growth. The immediate corollary to resilient growth is that the inflation will also be there, if not very high, but at least it will be there. So, the rate cut is more of a situation where you get into a sharp slowdown recession and the central banks come to the rescue in terms of cutting rates and all. I do not think that environment is going to pan out. It is going to be quite robust growth but peak inflation is behind us. So, we will have a reasonable amount of inflation, but rates will also be there at a reasonable level. That is going to be the case. Equities generally are conducive to such an environment because when you have this kind of environment, the nominal numbers are quite strong, so corporate profits are good. Let us talk about high growth. You must have taken stock of how the earnings this quarter went by. What were your thoughts on, say, top 100 companies, top 200 companies or your universe which you track? Were you happy with the growth? Did you see a good semblance of 20% plus kind of growth?
The first thing is the overall corporate profitability in India. If you look at that trajectory, it formed a bottom somewhere in FY2021 when it hit below 2% of GDP and since then it has been on an uptrend. In 23, we saw a kind of a slowdown where the profits did not grow higher than nominal GDP because nominal GDP was very high. But this time around, the profit to GDP has sharply increased to 4.7% of GDP, So, overall corporate profitability is nicely nudging up. The peak India corporate profitability was achieved in 2007-08 when it hit close to 7% of GDP and that is a long way to go. But the good thing is that it is trending up.

So, from a cycle perspective, we are looking quite good in terms of corporate profitability. If you look at the investable NSE 200 universe, the aggregate profit growth was somewhere around 34% and this profit growth, 95% of the delta in this profit growth was from cyclicals which is lenders, industrials and others, while the defensives were slow in terms of IT or consumer staples and others where the growth was weak. There were a bunch of loss pools in metals and telecom. But in that, internet companies reduced the loss pool. Overall, the profit cycle continues to be trending upwards in terms of profit to GDP. Even within the NSE 200, which is the investable universe, the cyclicals are driving earnings growth.

Some of the areas of the market have not shown earnings growth for a very long time. Chemicals is one certain area. But in the last one month, a lot of funds, domestic PMSes and some small to mid mutual funds have started nibbling in those areas. Is there merit in looking at those areas or is there any light at the end of the tunnel because it has gone through a very brutal corrective phase in the last four-five years?
One should not equate chemicals with franchise companies. They are industrial companies and undergoing their own cycles. So, if the profit cycle has broken to some extent and the valuations are not to the extent typical industrial valuation you would get, industrials typically trade less than 20 times and things like that. Chemicals are industrials but if their valuations are north of 30-40 times forward and the profit cycle is showing uncertainty, I do not think it is very favourable.

You may be trying to catch something where you have some more faith on certain companies, which is possible, but as a group to my mind, these are industrial companies, very cyclical in their nature in terms of pricing, demand and things like that and they should be commanding not anything more than 20 times earnings or thereabouts.Where do you see the biggest earnings trajectory from here on? Do you think financials have a good earning cycle for the next three-four years?
Absolutely. In fact, banking is the best in my view. Structurally, what is happening is even in FY24, we are forming the bottom of the NPA cycle while the corporate re-leveraging cycle has just not begun. It is only retail credit. If you see that 15% odd growth in the system, the industrial credit has yet not picked up and we know that if we are saying that we have an investment cycle and the GDP growth is picking up, there is no way that the corporate re-leveraging will not start at some point in time. So, it is just a matter of time and these banks are well poised in terms of their capital adequacy ratio, in terms of NPAs and the credit cycle, so they are well poised and we are seeing the profits.

The maximum beats and upgrades we saw were within financials and some of the industrials, the typical cyclical companies. All the indications are that they will do well as the economic cycle keeps expanding and the valuations are extremely reasonable in this space.

Which part of the power value chain are you finding most merit — power financiers, transformer companies, wires and cables, legacy power gen companies or renewables?
So, I think power overall looks structurally positive, but one should only get into areas where they get valuation comfort. These are capex intensive sectors, industrials, where leverage is required. There are companies where the valuations are quite reasonable. Some may be in the PSU space but keep an eye on valuations because growth will be coming for sure in this sector. The way it is panning out, the economic recovery is there, power demand is going up but do not lose sight of valuations, that is key advice here. But the sector is structurally moving up.

The other area of the market has been consumers. Volume has not been there. In fact, even QSR as part of consumers has started faltering. If Westlife’s result this quarter was any guide, even Jubilant. Plus the Zomatos of the world are giving good competition to a lot of QSR chains. When will volumes come back to consumer stocks and your thoughts on QSR?
Yes. In QSRs, across the board there were downgrades and disappointment and in the case of broad-based FMCG companies, volume growth was quite muted. But what stood out within consumption, in my view, was clearly auto and housing and some of the travel, tourism and leisure companies, which have really picked up.

So, there are pockets of high growth within discretionary consumption but broad-based consumption and some of these spaces like QSRs have seen weakness. Broad-based low key consumption items in general were showing weak trends especially because the rural income growth still remains a concern due to deficient rains and agriculture output being a little challenging but there are pockets of discretionary consumption where things are looking good.

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