In 4 market lessons every investor must heed, Prashant Jain, Executive Director and Chief Investment Officer of HDFC Mutual Fund, shared some lessons every equity investor must make note of. Here he takes a broad look at the macro scenario and explains his bullish stance on the stock market.
GDP growth has slowed down. Earnings growth is low. However, the belief that the market is expensive is not borne out by P/E multiples.
GDP growth - sharp improvement ahead
GDP Growth has indeed slowed down in last few quarters. However, this is, in all probability driven by demonetisation and GST, two very significant reforms that have caused temporary disruption in the normal functioning of the economy. However, as things normalise, growth rates are expected to recover smartly over the next few quarters.
Monthly data for July, August and September in auto volumes, steel production, power generation, rail cargo volume, airline passengers, IIP and non-oil, non-gems & jewellery exports, already points in that direction.
It is evident that in the quarters around demonetisation (Dec 16) and GST (Jun 17) various parameters like auto volumes (both passenger & goods) did experience a sharp slowdown. The data for July, August and September is however very encouraging. Auto volumes, power generation, rail cargo are all showing good improvement in growth rates.
The medium term outlook for the economy is even more encouraging. This view is driven by a likely acceleration in infra capex, affordable housing and a revival in private capex. As per recent news flow, there are reasons to be optimistic about revival of private capex in the not too distant future primarily led by metals sector.
One more important point that needs to be explained is the low growth in mature categories. As a country and society progresses, certain categories of goods become increasingly affordable and penetration therefore increases. After reaching a certain level of penetration these categories witness natural fall in growth rates. For example: Salt which is highly penetrated is unlikely to grow at healthy rates. Certain consumer staple categories like soap, shampoo, toothpaste etc. have become affordable and are thus well penetrated in India, resulting in slower growth.
As income levels rise, consumers move to more expensive or discretionary products in the same category. This explains the faster growth of motor cycles compared to bicycles in last two decades and the faster growth in 4 wheelers compared to 2 wheelers currently; this also explains the faster growth of air travel compared to rail travel and so on so forth. Slow growth in mature categories should therefore not be attributed to economic slowdown and is not a cause for concern. It is in fact a cause for celebration as it suggests that the masses are able to afford that category or are moving to better substitutes.
Earnings recovery is imminent
Expectations in financial markets move much faster than the real world. It typically takes two years to build a house, one year to renovate it, but we expect the economy growth to surge, NPAs to resolve, earnings to recover and much more in few quarters. Unfortunately, to bring about changes in the real world and more so in a large and complex country like India takes longer. Besides the environment is not static and sometimes while you fix one problem, another one crops up. Take for instance the fall in steel prices to near 15 year lows in 2015 unexpectedly. This set back not just the steel sector but also the banks by a few years.
The earnings disappointment in recent past has been weak mainly due to the sharp fall in profits of sectors like steel, engineering & capex and corporate banks. This however, is all set to change.
With the sharp recovery in steel and other metal prices as the above chart indicates, with the peaking of provisioning costs in banks and with a slow but steady improvement in infra capex, earnings recovery is underway and it should become increasingly evident with each passing quarter.
The last quarter's results are already pointing in that direction. In the table below it can be seen that corporate banks and metals that witnessed a fall in profits in Q1FY17 have reported decent profit growth in the Q1FY18 albeit on a low base. The biggest disappointment in earnings this year in Q1FY18 was in fact in pharmaceuticals!
Further, barring the large hedging losses in Tata Motors (profit down 90% YoY) and the inventory losses in OMCs (profit down 70% YoY) which clearly are adventitious, earnings grew by 4% (vs de-growth of 8% as reported).
Promising markets
The index has trailed nominal GDP growth by 8% p.a. for the last 10 years (SENSEX CAGR of 6% vs Nominal GDP growth at a CAGR of 14%). As a result, India’s market cap to GDP on CY18 is 72%, which is low. This will be lower still for next year.
Even in terms of P/E, markets are reasonably valued. In fact, as earnings growth improves, the P/E's should look more reasonable and move lower.
New sectors should lead earnings growth over next few years
The table below gives the profits growth sector wise for last few years and the estimates for the same for the next few.
It is interesting to note that there is a significant divergence in the profit growth across sectors between the past and estimates for the future. For instance: profits for capital goods de-grew by 22% CAGR between March 2012 and March 2016, are expected to grow at a CAGR of 36% between March 2016 and March 2019. Similarly, healthcare, where profits grew by 20% CAGR between March 2012 and March 2016 are likely to grow by only 5% CAGR between March 2016 and March 2019. This divergence in profits between the past and future opens up prospects for new sectors to gain leadership in the markets going forward.
Conclusion
India is an economy that has delivered secular growth in the past and is likely to deliver continued growth for many years to come.
The last few years have witnessed a spate of reforms that have improved the macroeconomic fundamentals of the country and future growth prospects. Two important reforms viz., demonetisation and GST while being very beneficial over the medium to long term have adversely impacted growth in last few quarters. This slowdown in growth should not be extrapolated into the future and in fact there are reasons to believe that the economy should bounce back strongly in next few quarters. Profitability in general and specifically for some sectors is cyclical.
As explained earlier, profitability in few sectors has been weak over last few years and this has hurt aggregate profit growth. This again should not be extrapolated into the future and in fact there are factors that suggest profit growth over next few years should be strong. Lower interest rates, peaking NPA’s and higher metal prices etc. should aid this.
Equity markets have lagged nominal GDP by 8% CAGR over last 10 years and are consequently at attractive market cap to GDP ratio. In p/e terms, markets are trading near 17x FY19(e) and 15x FY20(e), which are reasonable, especially given the low interest rates.
In view of the above, there is merit in increasing allocation to equities or in staying invested as the case may be (for those with a medium to long term view and in line with individual risk appetite).
Successful investing needs more patience than intelligence. The track record of a few mutual fund schemes over decades and the experience of those investors who have stayed invested in these funds for long periods amply demonstrates this.
Let me end this long note once again with a thought attributed to Gautam Buddha: “If the direction is right, all you need to do is to keep walking"
Hopefully, even the most ardent critic of economy or of stock markets, will agree that the direction is indeed right.
