Institutional brokerage firms expect FY25 to be a year of normalization of revenue growth but see banks meeting reasonable valuations and strong earnings growth.
Edited excerpts from the conversation on Q2 earnings season, market valuation and investment opportunities:
Q2 earnings season wasn’t quite as good, mainly because of the market’s sell-off valuations. What’s your take on the overall numbers so far?
In the Q2FY25 reporting period to date, NSE500 aggregate PAT growth (YoY,%) has been around ~6%, driven by IT (~11%) and BFSI (~10%). Profit growth of the NSE500 ex-BFSI and IT has turned negative at -0.6%, dragged down by Cement & Building Materials and O&G.
But earnings momentum (PAT QoQ%) for BFSI, other domestic cyclicals and FMCG clearly slowed down. Overall, the outlook for consumer demand remains weak; urban FMCG consumption is weakening along with discretionary products. However, the RBI bank lending survey showed optimism about loan demand in 3QFY25, which is positive. Let’s see how the festive season goes
AgencyDo you think earnings could be the biggest risk to the market in Samvat 2081? What strategy do you follow at this stage of the market where FIIs are withdrawn, DIIs and retail investors are super-bullish and Q2 results are causing a decline?
Yes, this is one of the biggest risks especially when the market value is high. With the margin expansion lever (CPI-WPI spread) no longer available, earnings are expected to normalize. Demand conditions are showing signs of weakness. As long as earnings growth is strong, rich valuations are still sustainable but this will be risky in the current environment when earnings growth slows and earnings downgrades increase. The CPI-WPI spread tends to have a positive impact on the company’s gross margin, but now this lever is no longer supportive.
Our strategy is simple – follow the stocks that generate the best earnings (strongest momentum) and witness the best earnings revisions, when earnings fall on the spectrum. Empirical evidence shows that this is a winning strategy that has outperformed benchmarks at over 5% CAGR over the past 2 decades. In particular, the best earnings momentum stocks in midcaps outperform their benchmarks most often during significant corrections.
AgencyWhat is your outlook on Samvat 2081? Do you think Nifty will double in New Year too?
Sensex returns positive for eighth consecutive calendar year in 2023, longest since 1985. We expect normalization in Nifty to return as market drivers ie, earnings growth, earnings revisions, valuations, interest rates and sentiment reflected in RBI Surveys ‘t inspire confidence. It is unlikely that the Nifty will make a double profit this year.
It is a stock picker’s market. The shrinking correlation between index returns and average stock prices suggests that, going forward, stock selection will be key to generating alpha.
This is probably the most non-polarized market we have seen in the last 2 decades. The concentration/polarization of the index is at one of the lowest levels since 2005. We expect polarization to produce this and we need to prepare for a reversal in the excellent minions (small and mid caps).
AgencyDo you think a correction in the PSU and capex play is imminent now before the market starts refocusing on Budget 2025?
The correction could continue with quality factors and low volatility making a comeback amid declining earnings. Amid PSUs, we like PSU banks, which have good asset quality and credit-deposit ratios. On the capex front, as of Aug ’24, the Center has spent 27% of its capex target vs 37% in 5MFY24. Capex has contracted ~19% YoY, largely due to lack of spending during election months (Apr-June). Country capex (of 17 major countries) was 8% lower than the previous year. However, it should be noted that in the last 2 months the state’s capex has picked up (capex in July and Aug’24 is ~2x of 1QFY25) and the Center has achieved 95% of its capex target in the last 2 years. Historically, government capex spending has increased as we move into the financial year with spending in 2HFY typically higher than in 1HFY.
However, moderation in tax collection (especially GST) will be a key risk to the FY26 capex budget, while rising populist measures by state is another key risk to state capex spending. And, like investing in playing capex can be risky unless the green shoots in personal capex remain sustainable.
Speaking of the US election, if Donald Trump wins, do you think there will be a lot of Chinese bulls in the market left?
Yes, we agree with the thought that with the possible imposition of trade barriers/tariffs by Donald Trump on China there may be pain for the Chinese cow. From a long-term perspective, China can be seen especially if the central bank delivers stimulus and can overcome structural obstacles. The Shanghai Composite Index stands at 15.3x TTM PE marginally above the 5-year average of 14.6. However, depressed earnings grew by only 2% in the last 4 years and at normal earnings, multiples would look better.
With little or no support from earnings, do you think large pockets of the market are overvalued even now?
Yes, the market appears overvalued among equity cohorts. While large-caps do not look expensive on an aggregate basis, and trade marginally above each 5-year average in TTM P/E and 1-year fwd. basis, there is a significant difference between BFSI and Ex-BFSI. The ex-BFSI Nifty universe is trading at ~45% premium to BFSI on a 12-month P/E basis.
AgencyBanks are the only sector included in our sectoral framework, which looks at the market capitalization contribution along with the profit contribution. Banks’ profit contribution to the NSE500 profit pool is ~25%, while Mcap’s contribution is only 12%. Our analysis shows that the profit contribution will be sustainable in FY25.
FY25 is expected to be a year of normalization of earnings growth and banks are at the intersection of reasonable valuations and strong earnings growth. Therefore, the high difference between Mcap and profit contribution should be reduced. Also, never in the last 2 decades, when the Bank Nifty / Nifty ratio fell to -2 Z-score, banks underperformed in the following year.
Tell us which market pockets have the most opportunities in Samvat 2081.
Over the past two years, factors like value, alpha, high beta, and momentum have outperformed, while quality and low volatility have underperformed. However, this trend is changing. Over the past 5 months, quality and low volatility have outperformed other factors.
Studies of investment factors in the US have established that the period of slow growth is associated with “quality” outperformance and can be used as a metric for exposure time to quality factors. With India’s EPS growth expected to normalize in FY25, we expect quality factors & low volatility to improve, a trend that has just begun.
AgencyIn addition, the heavyweight division is expected to make a comeback. The cycle of underperformance of the Nifty index through Nifty EW is likely to reverse in FY25 as the heavyweights are expected to lead small companies in the index in FY25/26 through top-line and bottom-line. The weight of excellent stocks (top 10) fell from a peak of 62.3% in Mar-20 to 55.7% in Sep-24. This has resulted in the performance of the EW good index better than the Nifty which usually lasts around 3-3.5 years, with the current cycle starting on July-21. With forward earnings growth forecasts skewed in favor of the heavyweights, we expect the Nifty’s outperformance over the EW index to materialize.
