The year 2019 saw one of the most roller-coaster riders ever for Indian equity markets. Marked by big events like a global trade war, a slowing economy, general election, a tax surcharge on the super-rich and its partial rollback and corporate tax rate cut, volatility was spread throughout the year. The Nifty 50 gained over 7% since the beginning of the year till May 23—when Narendra Modi-led NDA returned to power with a bigger mandate. The gains continued further, until July 5, when Finance Minister Nirmala Sitharaman presented the Union Budget 2019-20. The 50-stock gauge began to decline as an increased tax on the super-rich, including foreign portfolio investors and buyback tax spooked investors. That led to the index erasing 2019 gains. The finance minister, on August 23, however, decided to roll back the enhanced surcharge on overseas investors. The markets continued to fluctuate until September 20, until Sitharaman surprised by slashing corporate tax rates. Since then, the Nifty surged 13.3% and hit a record high of 12,293.90 on December 20.
During the year, the 50-stock index returned nearly 13%. The broader markets, however, continued to remain under pressure. The NSE Nifty Midcap 100 and the NSE Nifty Small cap 100 declined for the second consecutive year, falling 4.9% and 10.7% respectively.
Bottom-up market
As data suggests, the 2019 rally has been helped by top 10 or so large-cap stocks while mid-cap and small-cap remained in the shadow performing miserably. While most market participants agree that we are in a bottom-up market, most are not sure if the recovery will be swift or not. There is a strong possibility that mid-caps and small-caps would catch up in 2020 as the economy recovers, global trade war abates and corporate earnings catch up. However, here are a few important things that are needed to be considered for better understanding of the health of the market.
Corporate Profitability: Unrelenting grey skies
Analysis by IIFL Securities suggests that the largest 500 companies (by market cap) point to sharp decline in profitability over the last decade in both, financial and non-financial firms. While poor asset turnover and declining Ebit margin were a key drag on RoE, the tax-rate creep has hurt profitability in recent years. Improving commodity prices, a declining share of unproductive assets (CWIP) and underinvestment have helped improve RoE in select sectors. However, PSU and private wholesale banks have struggled with NPAs. That said, the financials universe, even after excluding such troubled banks, does not cover the cost of equity, though within that, the best banks individually do.
Capex – little chance of recovery in near term
Corporate Capex has been anaemic for several years now, due to excesses of the previous cycle and weak growth. Our RoE based, quintile-wise disaggregation suggests that a bulk of Capex was done by low-RoE companies that are struggling to cover the cost of equity (CoE). Only the top-2 quintiles, in aggregate, have been able to maintain profitability above the CoE. Capital-intensive companies, principally in the power, metals, energy and industrial sectors, are usually in the bottom-3 quintiles. They struggle to cover the cost of capital and this has, over time, curbed their investments. The economy is likely to struggle to crawl out of the problem of stalled projects, especially in power and real estate, and the investment cycle is unlikely to revive in the near term, given the weak domestic demand and declining commodity prices.
Lower tax burden masks weak earnings
Weak demand and declining commodity prices weighed on 2QFY20 corporate earnings, as aggregate sales (ex-financials) declined 3% YoY. Interest growth has been rising sharply, even as Ebitda growth has moderated in line with weak sales growth. As a result, interest burden has jumped up and interest expense, in aggregate, now accounts for 22% of Ebitda compared with 18% a year ago. While the aggregate PBT declined 3% YoY in 2QFY20, corporate tax cuts have bumped up PAT growth to 23% YoY. The weak operating performance continues to weigh on FY20 estimates, as the BSE200 EPS has been downgraded by 1% since the commencement of 2QFY20 reporting.
Resetting our Expectations
The aggregate RoE of our sample of 500 companies has seen a widespread collapse of more than 10ppt from its FY07 peak. Barring FMCG and IT, most other sectors have suffered – examples include corporate banks and industrials from aggressive debt-funded investments that yielded poor returns, pharma from US generics price erosion, auto and telecom from high regulatory costs. The recent RoE recovery has been limited to a few sectors, and led by a modest commodity price revival, under-investment and some capital-WIP unwinding, and even after this less than half the companies cover the cost of capital. Weak growth has inevitably followed prolonged low capex intensity. If a capex revival happens, a shrunken pool of domestic savings and combined fiscal deficit likely breaching 10% suggest that the cost of capital will adjust upwards to tap the global savings pool. Incrementally ICICI Bank, Axis Bank, SBI, Gujarat Gas, Deepak Nitrite, Nestle and IPCA Labs are stocks that will see large RoE improvements.
(The writer is CEO, IIFL Securities Ltd)
