Questions that are keeping investors awake at night

Despite a significant disruption led by the second Covid wave, markets have scaled new heights and have done so without any meaningful correction. The last 1,000 points on the benchmark Nifty-50 index were added in just 19 trading sessions. Both a perceptible disconnect with the ground realities and the pace of the rise has raised many questions in the minds of investors.

Is India’s earnings cycle transforming after a decade?

Corporate profits have fallen from 7.8% to 1.8% of GDP over the last decade, led by destruction in profit pools of several businesses, including Commodities, Telecom, Industrials, Corporate lenders and US Generics, to name a few. Most of these profit pools are in the process of getting rehabilitated. Analysts predict that even if corporate profit to GDP reverts to the long-term averages, we could sustain strong earnings growth of over 20% vs the 5% that have witnessed for the last decade.

Has Q1FY22 begun on a strong note?

Q1FY22 marks the fourth quarter of robust quarter-on-quarter (QoQ) revenue growth. Corporate earnings in the first quarter of FY22 have been in line with the elevated expectations, aided by the deflated base of 1QFY21 and localised and less stringent lockdowns v/s 1QFY21. 1QFY22 has been an in-line earnings season for the MOFSL Universe. Nifty sales have been in-line (50% YoY; est. 48%), while EBITDA/PBT/PAT growth has come in at 41%/103%/101% YoY (est. 38%/89%/94%). Of the Nifty constituents, 42% have reported beats on PAT estimates, while 34% have missed expectations.

With vaccination numbers rising and the economy opening up after the two waves, FY22 has started strong. The earnings per share of the NSE500 companies touched a 52-week high of Rs 534.97 on August 23, 2021, a YoY growth of 82%. BSE500 companies have made leaps in their effort to reduce debt on their balance sheets. With Net Debt/ Equity at 0.6 for the BSE500 index constituents currently, it is the lowest since 2016. As such, the real GDP forecast for FY22 stands at 11% against -8% a year prior.

Are earnings estimates stable?

Earnings estimates have been in line with the elevated expectations for the first quarter of 2022. Due to increasing domestic and global demand, growth favouring policies, we see all the ingredients for a revival of the Capex cycle. We believe the earnings could grow over the next three years. Higher profits would feed into real GDP growth and back into profits, so a virtuous cycle unfolds with a naturally associated positive impact on the share price.

Will the benchmark indices continue to run up all through FY22?

From April 1, 2021, to date, Nifty-50 has delivered 11.9% returns. In the short run, it is difficult to make any conclusion. Over the longer term, since net debt to equity is on the fall currently, and with the economic activity seeing a resumption, we see corporate profits returning to mean. Consensus estimates suggest a Nifty EPS growth of 24% CAGR through FY25 resulting in a possible Nifty price CAGR of 23% over the same period.

Are markets overheated?

We are seeing corporate profits reviving as there is a resumption in economic activities post the second wave. The EPS, in turn, has come up as such the Nifty-50 PE Ratio has cooled down quite a bit. It is standing at 25.59 as of August 26, 2021, and with the projected earnings growth by brokerage houses being at 26% CAGR from FY20-22E, the PEG estimation comes to around 1x. A PEG of 1x implies a perfect correlation between market value and earnings projection.

Is there a bubble in midcaps?

Nifty Midcap 100 index has delivered 149.4% vs 118.6% of Nifty-50 returns since March 23, 2020 lows. But if seen over a longer period since January 1, 2017, Nifty Midcap 100 has delivered 17.6% returns, which are lower than Nifty-50’s return of 19.4%. Since January 2018, there has been massive PE multiple de-rating in midcaps and small-caps. We can say this with the benefit of hindsight as no one would have predicted the series of issues that would crop up from 2018 till date – A combination of i) 3 consecutive years of declining GDP growth rates ii) crippling regulations like demonetisation and GST iii) NBFC crisis iv) real estate crises post-RERA and lastly v) global pandemic like Covid has created a deluge of bad news for these companies. Never in history have smaller companies been through stressful times than in the last three years.

In the meantime, the big players have benefitted. It has rightly so reflected in consecutive years of underperformance vis-a-vis large caps. But is this changing? The disruption during Covid waves forced them to rework their business models right from sourcing to manufacturing to distribution. Many smaller companies have adapted and embarked on prudent cost-cutting measures and cleaned up their balance sheets by reducing debt. Interest rate cuts and the likelihood of a low-interest rate regime has come as welcome news for Midcap companies.

Is this earnings cycle reminiscent of the 2003-08 era?

A host of complementary factors besides corporate profit growth, viz., i) benign interest rates, ii) robust FII flows, iii) stable rupee & health forex reserves, iv) Capex growth and v) higher savings & investment are a lot similar to 2002.

The trailing P/B went from 2.0 in mid-2002 to 6.6 by 2008. There were multiple corrections throughout the journey. The trend seems to be similar currently, with trailing P/B rising to around 3.9 from the lows of 2.2 made in March’20.This, coupled with corporate profits returning to mean, consensus estimates suggest a Nifty EPS growth of 24% CAGR through FY25 resulting in a possible Nifty price CAGR of 23%.

It shouldn’t look unbelievable because the same had played out in 2002-08 with Nifty EPS growth at 24% CAGR and Nifty Price Growth at 29% CAGR.

In conclusion, while these questions are relevant, eventually, markets tend to pivot around earnings growth. The risks to the above hypothesis are a) subsequent covid waves, b) an earlier than expected increase in interest rates & hence bond yields, and c) rising commodity prices.

(The writer is Head of Products, Motilal Oswal AMC)