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Expect a PE de-rating in 2020; IT, Insurance and realty sectors look positive

Author: Kumar Shankar Roy/Wednesday, January 22, 2020/Categories: The Finapolis Conversation

Expect a PE de-rating in 2020; IT, Insurance and realty sectors look positive

Not many fund managers will call the share market over-valued when it actually is. They will still argue and justify why markets may be in a good state, when they are not! Meet Amit Kumar Gupta, Portfolio Manager, Adroit Financial Services, who is not the sweet-talking financial wizard with a permanent blue-sky scenario for investors. Amit likes to say things as they seem to him. And, he is not apologetic about it. With over a decade of experience in investment analysis and portfolio management, Amit in this week's Finapolis Conversation with Kumar Shankar Roy provides an honest opinion on market valuations, the need for corporates to deliver material improvement over next 9-12 months, why midcaps still appear to him most attractive, etc. Read on.

The 2019 was a year of surprises, volatility and outperformance of select ‘Quality’ large-cap names. Why did it happen like this?

While the benchmark equity indices have returned ~11% YTD 2019, the broader markets have given up most of the gains made in 2017. During July quarter, new norms related to broker margins and off-market transactions, after-effects of Budget announcements, many corporate governance issues cropping up and economic slowdown led to quality large-cap names getting most of the inflows. It was only post corporate rate tax cut, we started seeing broader markets getting some attention with a possible valuation bottom.

I think this was a phase created with a combination of regulations, slowdown and liquidity positioning. The polarization amid m-caps has not been seen before in Indian markets even though the global trend has been pointing towards this for quite some time. Like FAANG stocks dominating the inflows and captures almost 50 per cent of the m-cap in US, Indian markets also get a taste of it. Whether it is sustainable or not is a matter of debate. I continue to maintain that time correction in some of the quality names will be seen for some years to come. We have seen this before in HUL (2001-2008) and Reliance (2008-2016).

How does 2020 look for markets? Is it going to be more of the same, or things will be markedly different?

The corporate fundamentals would need to show material improvement over next 9-12 months to sustain the present valuation levels for the benchmark indices. The current implied earnings growth over FY21 is well over 25 per cent. If we consider the historical perspective, in a slowing global growth environment with virtually no credit off-take to start the year, the earnings growth of over 25 per cent does not appear attainable.

Even if we can manage this kind of earnings growth (not my base case) due to very low base (almost no growth for over four years now), FY21 could be a challenge. I therefore expect a PE de-rating in 2020. Discretionary Consumption is the space that may suffer the worst. IT, Insurance and large Realty are the sectors that look positive for 2020. Amongst others, agri input may do well as food inflation drives higher spending power in the sector.

Some say smallcaps look attractive compared to largecaps and midcaps. What is your view?

I would say on comparative basis, midcaps remain the most attractive. Even though rather than concentrating on market cap, I would look more into balance sheets expansion, earnings growth and quality of the management. Some of the small names are battered beyond belief, so some kind of bounce back is expected. But we should not rule out retail and even HNI supply in these names as they move higher. The better way of modeling the portfolios, at least for us, has been to stay with quality mid cap names.

The December quarter earnings coming in. What are your expectations from Sensex and Nifty firms in terms of revenue and profit growth? Are earnings signalling a mild recovery?

The results may miss even the modest expectations and lead to further downgrade of earnings. The consumption demand outlook may particularly disappoint markets, even if some early signs of cyclical bottoming appear on the capex side.

In Q3FY20, aggregate profit of Sensex companies is expected to grow at a healthy 26.2 per cent as compared to Q3 FY19A, which will be much better as compared to the disappointment seen in the past few quarters. We expect the financials segment (mostly private corporate banks, strong NBFCs and a large PSU bank) to contribute primarily to Sensex companies’ aggregate PAT growth. Apart from financials, capital goods companies too are expected to post higher profit growth (as compared to Sensex’ aggregate earnings). An earnings de-growth is expected in energy and telecom sectors while sectors like FMCG are expected to lag  Sensex earnings.

In Consumption, estimates are at sharp divergence insofar as the revenue growth is concerned. However, not much variance exists insofar as the contraction in margins is concerned. Real Estate is another sector, where the consensus is expecting a sharp improvement in both revenue and profitability. We continue to remain positive in top-end Real estate names.

Economic growth has been sluggish. Things are not expected to improve quickly. In that backdrop, how do we interpret the latest IIP numbers? After three successive months of contraction, IIP grew 1.8% in November 2019.

While manufacturing PMI did hit a 7-month high of 52.7 in December 2019 (51.2 in November 2019), the recovery will be in gradual mode as the government spending will remain muted. The number this time was aided by low base (as Diwali in 2018 was in November, so inventory buildup happened in Sept-Oct 2018). 10 out of 23 manufacturing industries remain in contraction. Primary goods and consumer durables also saw negative growth. It will take time for growth to get back on track. IIP growth might improve in H2FY20 on the back of base effect and clearance of excess inventory.

What are markets expecting from the Union Budget? Does the government have wiggle-room to offer goodies?

Expectations are high as the economy is witnessing one of the sharpest slowdown in more than a decade. The business and consumer confidence has collapsed. More than half the population is witnessing stagflation, with no to negative change in wages and consistent rise in cost of living. The unemployment is on the rise and manufacturing growth is contracting. Till we don’t see structural changes being done to boost employment and wages, status quo may occur.

The central government has limited room to surprise this time. Their hands are tied with fiscal situation (even you take into fact that there will be up to 0.5% of GDP relaxation in fiscal target). GST payments are not picking. Payments from most government department to vendors are stuck. Divestment money is bound to take time to come amid opposition from RSS, labour unions and legal issues. 

It is being speculated that Income-Tax rates for individuals may be cut in Budget. Will this help the economy?

Rationalizing of tax slabs up to Rs 5 lakh may be done, but overall it may well be zero-sum game as tax on the slabs above Rs 25 lakh may increase. My suggestion is that the government must also look at an Asian style model where the peak rate of tax is limited to 10 per cent up to an income level of Rs 20 lakh. This could be a huge consumption boost for the economy and the equity markets. We need to break the Stagflation conditions as cost of capital has been ridiculously high for some time now.

Credit growth in the country has not picked up. What can be done to boost credit offtake?

A sharp pullback in credit from NBFC sector caused growth to slow dramatically post September 2018. But efforts to deal with the problems facing them have been stepped up, while fiscal and monetary policies have been loosened, this should lead to a gradual recovery in investment and household spending over the coming quarters. ‘Gradual’ is the keyword here. I think there will be still some more corporate skeletons in the closet for us to say we are finally out of the woods. RBI missed a trick by not going for a ‘whatever it takes’ rate cuts to boost sentiment and corporate confidence earlier in the rate cycle. Now, with higher food inflation and lesser expectations of a rate cut, we are running in circles.

Given the markets and economic situation, how have you positioned your PMS strategies?

Good prices and good news are unlikely to come together in the next 12 months. Larger portfolio allocation towards midcap stocks which are at attractive valuations and likely to have robust cash flow generation on the public limited side is our way to expect generate an alpha. Our portfolio is a mix of large- and mid-cap stocks with decency solvency ratios and operating leverage. We are avoiding any active churning in 2020 by choice. In our special situation scheme, opportunities are far more in number. As economy consolidates in the wake of IBC, GST, RERA and other regulatory norms, we will see big becoming better. This will lead to many M&A, demerger, spin off kind of stock plays in the market. Many agri input and specialty chemical companies are also coming out of a capex cycle and provide exciting opportunities.

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