Aug 22, 2017
“It ain’t what you don’t know that gets you into trouble. It’s what you know for certain that just ain’t true” – Mark Twain
Domestic Equities
With Big Reforms…
A case can be made that reforms such as GST, demonetization, real estate reform, unique ID, regulatory reform, targeting willful defaulters and shell companies and so forth are leading to a subtle but significant shift in the economy.
Big, Organized Corporate India Appears to Be Benefitting…
Organized India appears to be benefitting. In particular, big corporates. Nifty 50 companies have delivered stronger top line sales growth than the CNX 500 this past quarter to date. Nifty 50 sales growth is up an acceptable 8.7%. In contrast, CNX 500 sales are up 7.5%.
Large caps have also led the index to new highs in recent weeks, as their smaller cap brethren have struggled to keep pace. Reliance Industries, HDFC Bank, ITC, HDFC and the like have dominated index performance.
As Big Flows Are Coming to Large Caps…
With the deluge of money from domestic investors, and foreign flows, investment managers are also being forced to put money to work in larger cap stocks. We may have entered a period where the big are about to get bigger. In that case, big is the new black.
Nifty 50 Companies Are Delivering Stronger Top Line Growth Than the CNX 500
Many Large Cap Nifty Companies Have Shown Strong Year-Over-Year Top Line Growth
…Half the Nifty 50 Universe Has Delivered Acceptable Top Line Growth…
…Half the CNX 500 Universe Has Delivered Top Line Growth As Well
While Sales Have Done Acceptably Well, Earnings Have Been Dismal…
Net Profits for the Nifty 50 have been dismal. There are no adjustments that can be made, or mitigating factors. Only 20 companies have delivered what we consider above par results, i.e., above 10% profit growth. The other noteworthy fact is that the profit distribution curve is barbell in nature, suggesting a bifurcating market, a market of haves and have nots.
Only 13 Nifty Companies Have Delivered Profit Growth in Excess of 20% YoY
Distribution of CNX 500 Earnings Is Barbell Shaped As Well…
The numbers for the CNX 500 tell the same tale. There’s 121 companies in the universe that are delivering strong profit growth. The distribution is yet again barbell in nature, but another fifth of companies are treading water with no growth. As we have noted, investors are chasing these 121 companies that are delivering strong growth.
121 Companies in the CNX 500 Have Delivered Profit Growth in Excess of 20% YoY
At the Industry Level, Insurance, Capital Markets, Metals & Mining, Airlines and Infrastructure Are Leading…
…While Industry Level Profits Are Highest in Electrical Equipment, Defense, Consumer Services and Communication Equipment
There Are No Major Adjustments We Can Propose on the CNX 500 Either…
Over the past few quarters, we’ve made the case that earnings at the index level were skewed by large losses from PSU banks and telecom companies. This quarter, there are no meaningful adjustments we can propose for the Nifty 50. Adjusting for energy company losses, Bharti Airtel and Tata Motors only takes net profit growth up to 6.5% year over year.
CNX 500 Earnings Performance Has Been Equally Dismal As the Nifty 50…
The picture for the CNX 500 is similarly woeful. The numbers are roughly the same, down 8.7% for the CNX 500 and down 8.3% for the Nifty 50 year over year, with 465 companies reporting. The takeaway is simply that profit growth has been disappointing for the market.
Companies Are Blaming Destocking and Rising Input Costs…
With solid top line growth, the key question is why companies have not been able to convert it to bottom line profits. A few theories can be proposed. One, Consumer Discretionary results have been heavily impacted by GST destocking and rising input costs. Two, the Energy sector has swung from massive profits to large losses, with a 26.9% decline in net profits on inventory losses. Three, Healthcare has traditionally been a strong and stable contributor and it has been decimated, down 43.5%. Finally, Telecom continues its consistently horrendous performance, down 172%.
What’s done well is a smaller list: Financials, Industrials and Materials.
The Key Question: Is the Economy On Healthy Ground and GST de-stocking a one-off?
Are Indian corporates materially slowing or is the slowdown in the previous quarter a one-off? Secondly, was the RBI early in seeing the data that prompted the rate cut?
The Weakness in Telecom, Healthcare and Destocking Add to Existing Investment & NPA Woes
With corporate earnings largely being driven by consumption, and to a lesser extent government investment, the additional pressure of worsening prospects for Healthcare, Energy and Telecom suggest that a recovery, if and when it does occur, is likely to be mediocre in strength.
Global
Geo-political Risks Are Rising…
While we are enthused by the pickup in the global economy, the Steve Bannon ouster, building pressure on President Trump, North Korea, rising terrorism tensions in Europe, as well as tensions between India and China are all serving to raise the geo-political risk sweepstakes.
Keep an Eye on the Dollar
We’d look for a rising Dollar as a clear indication of a capital flight to safety. A rising dollar in an environment of chaos in Washington, sliding Trump approval ratings and lower treasury yields would be the harbinger of a coming risk off trade.
Fixed Income
The Foreign Debt Investor Is Back…
Foreign portfolio investors (FPIs) have pumped in over $29 billion in inflows this year into India, of which around $19.8bn has been into Fixed income. FPIs have utilized 97% of the permitted limit of Rs. 1.87 lakh crore in central G-secs while long-term FPIs have utilized 83% of the allotted limit of Rs. 54,300 crore. Further, foreign investors have utilized 98.6% of the permitted limit of Rs. 2.44 lakh crore in corporate bonds.
And India Appears to be the New Carry Trade Destination
India appears to have become the carry trade destination of choice. With low inflation, India’s real interest rates – 10 year g-sec less CPI – are amongst the highest in the world. With a stable INR, unhedged exposure to Indian debt now makes sense relative to near zero yielding debt in developed markets. Absolute bond yields are high, political outlook is stable, there is reform momentum, fiscal discipline, strong leadership, benign crude and gold prices and the balance of payments situation is strong. To top it all, a case for additional rate cuts can now be made.
To date FPIs have stayed away from state papers (SDLs) over lack of transparency on state finances. Given that limits on other forms of Indian debt have been reached, we could see interest emerge in this category.
Reliance Group Boosts Duration
Incidentally, the Reliance Group has boosted the duration of its debt portfolio, moving about Rs. 70 billion ($1.1 billion) from short-term funds to income funds in anticipation of a fall in interest rates. This move appears predicated on the expectation that the central bank will cut rates further.
Is Duration Back in Play?
The consensus today is a move to accrual funds and away from duration. The media and advisors have been telling investors to taper their return expectations. Not so fast.
Given the weakness in earnings, a strong economic recovery looks unlikely. So even if an economic recovery takes hold later this year, it will be a while before we see upward pressure on interest rates. Given FPI interest in Indian debt, it’s arguable whether rates will rise substantially, if at all.
Game tree analysis then argues for a ‘heads I win, tails you lose’ scenario. Should the economy weaken, rate cuts will likely come through. Should the economy recover, we don’t see a strong revival, and it is unlikely to lead to upward pressure on rates. A skewed risk reward scenario emerges.
One takeaway is that if the economy is weakening, another 25-50 bps are coming, then low double digit returns look achievable for duration exposed debt investments.
We Prefer Corporate Bond Funds Over Credit Opportunity Funds…
In light of the rising risk of the economy weakening, accrual funds remain a safe place for investors. Within accrual funds, we prefer corporate bond funds over credit opportunity funds on lower credit profile and lower quality paper held in credit opportunity funds.
We would further advise a credit profile review of existing debt funds to ensure that the credit profile of the fund is aligned with return expectations. For investors with a pessimistic view of the economy and attendant risk appetite in debt, adding duration may position portfolios for a more effective risk reward scenario.
Another option for investors concerned with 3 year holding periods would be dynamic bond funds, which we recommend on an exception basis. 7 of 10 dynamic bond funds raised their gilt fund exposure earlier this year and are delivering respectable returns.
Outlook
With Dismal Earnings Due to Destocking and Rising Input Costs…
In our last commentary (Déjà vu All Over Again, 7-Aug-16), we had been hopeful that earnings would give us confirmation that the recovery is underway. Unfortunately, earnings this quarter can only be classified as disappointing for reasons elicited earlier.
Valuations Remain At Elevated Levels…
We raised concerns previously that valuations are at historically high levels. The Nifty 50 trailing P/E is at 25.1 times. With index earnings growth for the previous twelve months up 7% for the Nifty 50, and even lower for the past three years, the PE/G ratio for the Nifty is above 3. A healthy PE/G ratio is roughly around 1.
Market Technicals Remain Weak…
In our previous commentary, we made the case that volume would be supportive of the rally. That still remains a likely scenario. The recent sell-off has sucked the frothiness out of the market. A huge pile of cash remains on the sidelines. However, buying volume has not been as strong on the recovery witnessed in the latter half of the past week.
IF the Economy Is Weakening, An Additional 25-50 bps in Rate Cuts Is Likely
It’s been our view that the economy would see a modest recovery in the second half of the year. However, with the dismal earnings performance, we must comply with Keynes famous refrain – “When the facts change, I change my mind. What do you do, Sir?” – and consider alternative outcomes. If there is in fact a slowdown, there will likely be another 25-50 bps in rate cuts.
Asset Allocation…
For long term investors, any sell off will be a blip. But for moderate risk and conservative investors, the wise choice is often emotionally difficult. Our recommendation remains a review of asset allocation and rebalancing as prudent options at the asset allocation level. In particular, trimming equities and allocating to debt makes sense given the rationale we walked through. If the slowdown thesis is in play, duration exposed debt funds could return double digits returns over the next 12 months.
Structured products and hedging are additional options to protect profits while preserving upside potential. The cost of implementing these suggestions is minimal and restructuring portfolios to protect against downside, while reducing volatility is a sound strategy.
Stock Selection Remains Critical As Always…
Another way to over-ride these concerns is through stock selection. While index returns have been sub-par over the prior three years, stocks have delivered astounding returns far in excess of the index. A portfolio of reasonably priced stocks is another defense against over-valuation. With wobbly earnings prospects, raising exposure to large caps with strong franchises, at reasonable valuations is another way to reduce potential downside volatility.
In a world where big is doing fine, we recommend a shift to larger cap mutual funds, PMS strategies with valuation discipline, principal protected products, and actively managed equity portfolios for fresh capital deployments.
Stock selection, sectoral and asset allocation all have an impact on forward portfolio returns. While recognizing that forecasting is an exercise fraught with risk of error, an evaluation of portfolio positioning and risk appetite – and recalibration – remains a worthy endeavor.
Technical Outlook
The Nifty saw some pullback last week to close up by 1.3% at 9837 level for the week. Profit booking was seen in the market as Nifty was unable to sustain above 10100 levels which is the rising channel resistance line. But the basic structure of higher tops and higher bottom still remains intact on weekly basis which is a positive for the market. Index bounced back from 9700 levels last week where the rising trend line and previous swing highs are acting as support for the market. Now holding above 9700 levels, index may see rally towards 10000 levels and trade in this range going forward. Nifty Put/Call ratio has come down to 1.14 along with decline in Nifty suggesting call writing and capping the upside. Also, Nifty Call option with strike price 10000 has the highest open interest which will act as resistance for the market. On the downside, breaking below 9700 levels index may see decline towards 9450 levels which is the previous swing low seen June. India VIX has seen up tick after consolidation and is currently at 14.57 levels; further up move in volatility is going to put pressure on the markets.
