Vijay Kumar Gaba

Mad (-cap.) dash (Kotak Securities)

We see limited point in trying to find fundamental reasons behind the steep increase in stock prices of several mid-cap. and small-cap. stocks. There is no meaningful change in the fundamentals of most companies; in fact, they have worsened in many cases. The primary driver of the rally appears to be irrational exuberance among investors, with high return expectations (and purchase decisions) being driven by the high returns of the past few months.

Varying degrees of exuberance in the mid-and-small-cap space

We do not see many fundamental reasons for the meteoric rise in the stock prices of many mid-cap. and small-cap. stocks in the past few months. The fundamentals of most sectors have not changed much. However, market sentiment is quite exuberant, based on

(1) steep increase in the prices of many mid-cap. and small-cap. stocks;

(2) large inflows into mid-cap. and small-cap. mutual funds; and

(3) huge number of new retail participants in the mid-cap. and small-cap. funds. The strong performance of the mid-cap. and small-cap. indices has possibly pushed up return expectations among retail investors.

Stocks with great history (but potentially less favorable future)

Most of the traditional favorite mid-cap. stocks of institutional investors in the broader ‘consumption’ sector have been large laggards in the ongoing mid-cap rally, given weak consumption demand in general. However, the valuations of these companies have stayed high or gone to historical-high levels due to earnings cuts. We see risks of (1) lower profitability and (2) lower valuation multiples due to weakening business models (erosion of business moats of brand, distribution market structure and product).

Stocks with great purported future (but mediocre history)

Many of the new favorite mid-and-small-cap. stocks of institutional and retail investors are in the broader ‘investment’ sector (capital goods, defense, EMS, railways, real estate, renewables). These stocks have delivered eye-popping returns in the past 3-6 months, led by the broader ‘investment’ narrative.

We expect a decent investment cycle, but we are not sure about the quality of many of the stocks given their historical weak execution and governance track-records. In addition, many of these sectors fall in the B2G (business-to-government) or B2B categories, which raises issues around execution and profitability both. We believe that market expectations for both revenues and profitability may be too optimistic across these sectors.

Stocks with no history or possibly future (but why not?)

The last lot of the new favorite mid-and-small-cap. stocks fall in the dubious category of ‘turnaround’ stories. Many of these companies have been through serious operational and financial challenges (including bankruptcy) in the recent past, but the market has high hopes of these companies doing well in the future. We are not sure of the basis of the market’s confidence.

Strategy - Nifty Weight Analysis (Phillips Capital)

A snapshot

·         Index leader – banks – near its peak weight in August 2023 (18.4%/25.4% in N-500/N-50 adjusted for HDFC Ltd).

·         Highest weight increased in investment-oriented sectors, driven by industrials and metals. Basically, our favourite infra plays – industrials, metals and cement – have moved up strongly, but are slightly lower than peaks seen in 2010-15.

·         IT is currently below pre-covid levels.

·         Staples lost 200-250bps from its peak in 2020, but gained c.150bps since 2022.

·         Discretionary (ex-auto) is nearing its highs of 2020.

·         Automobiles’ weight up from covid lows, but still quite low vs. pre-covid levels.

·         Pharmaceuticals gained weight in 2019-21; currently stagnant at 2022 levels.

·         Oil & gas down c.200bps from its 2022 peak.

Financials – gains due to financial penetration

In N-50, financials have been leaders with banks being major contributors, gaining c.7% in the last 10 years (between March 2013 and 2023), plus c.4% in FYTD24 (due to the HDFC merger). Since 2014, in N-500, the sector’s weight increased by 5% to touch 22.4%.

Banks: The sector’s weight increased steadily in the past decade, especially in the N-50, to 31% from 20%; excluding HDFC Ltd’s merger impact, to 25.4%, up c.5%. Banks’ weight decreased during the onset of covid in 2020, while it has risen in the N-50 but is now stagnating at around 26%.

NBFCs: The sector has remained in focus in the last decade, gaining due to greater financial penetration and expanding economy, up almost 3-4% in terms of Nifty weight. Its weight increased consistently till 2021 from 2016, and declined gradually after that, seeing the highest drop in July 2023 due to the HDFC merger, excluding which, the segment’s weight is near all-time highs.

Investment-oriented sectors – highest gainers post covid

The weight of investment-oriented stocks in N-50 and N-500 was declining since 2014, but increased gradually yoy post covid. Their weight in the N-500 grew to 13% in FY23 from 9% in FY20 while in N-50, it increased to 10% from 7.5%, with a major rise coming from the industrials and metals & mining sectors.

Industrials: Its N-500 weight almost halved by 2020 (from 2014) to 3.6%, but doubled to 6.0% from FY20; it increased substantially post FY22 due to capex, infrastructure, and economic expansion. In the N-50, the sector saw its weight falling to 2.7% in FY21 from 7.7% in FY11 (led by change in constituents – then, BHEL, Suzlon, ABB, Siemens were a part of N-50 while at present it is only L&T). Weights rebounded by 110bps to 3.8% in FYTD24 from FY21, with major increase taking place after FY22.

Metals & Mining: Just like industrials, its N-500 weight declined to 2.3% in FY20 from 4.9% in FY14; then, spiked to 4.4% in FY22 due to a significant rise in demand after covid and sharp surge in prices. As prices corrected, so did the sector’s performance in FY23, losing weight by 40-100bps. In the last few months, it has picked up (in line with our expectations). In N-50, the trend and weight have remained almost same. In FYTD 24, the sector’s weight almost doubled to 4.3% in FYTD24 from a low of 2.2% in 2020.

Cement: Its N-500 and N-50 weights have been stable, at 2-3% since 2014 (after a slight dip in 2018-20). In the last two years, the weight has been stable near 2%, and we see an upside.

Consumption oriented – higher discretionary spend driving share

The weight of consumption-oriented stocks in the N-50 / N-500 was in the 15-21% /18-23% range since 2015. The sector gained momentum during the onset of covid, slowed over the next two years, but weights have increased lately, in 2023. Consumption’s weight in the N-50 / N-500 fell to 15% / 18% in FY22 from 21%/ 22% in FY14, but increased to 19% / 21% in FYTD24 due to staples and auto & ancillary.

Staples: The sector saw mixed sentiment in different periods, resulting in many swings in the last decade. Overall, its weight in the N-500 / N-50 declined to 6.4% / 7.2% in 2022 from 9.6% / 10.6% in 2014. It increased FTYD24 by 140/210bps for N-500 / N-50 from 2022 levels, led by price hikes amid softening commodity prices, downsizing product packets, and slight demand recovery – driven by increasing disposable income and emerging channels such as modern trade and e-commerce.

Discretionary: In the past decade, the sector attracted investor attention, resulting in an increase in weight by c.300 (also led by new listings) in N-500 and 100bps in N-50 during 2014-20. During the onset of the pandemic, it remained in focus, but after April 2020, its weight stayed mostly flat. The weight has increased in N-500/ N-50 to 6.2%/ 3.2% in FYTD24 from 3.4%/ 2.0% in 2014.

Autos & Ancillary: The sector’s weight has reduced from 2017 to 2022, halving since 2017. N-500 / N-50 weights reduced to 5.2% / 4.8% in 2022 from 9.9%/11.0% in 2017. However, recently (in the past 8 months), its weight increased by almost 100bps due to the rising standard of living and disposable income, robust demand for PVs/ CVs/EVs, government PLIs, and increasing government focus on infrastructure development.

IT and other services – global economy dragging the sector

Nifty weight of ‘IT and Other Services’ grew drastically from 2017 to 2022, gaining 450bps in N-500/N-50. During the same period, while the IT sector gained, Telecom and Services sector remained flat.

IT: The sector saw enormous growth in index weight during 2017-22; N-500/N-50 at 14.7%/18.2% from 9.8%/13.0%. A strong bounce in IT came after covid, as more businesses rushed to adopt digitization, enhancing demand for IT software and solutions. However, weight started falling in the second half of 2022 due to the global economic slowdown.

Telecom & Media: The sectors’ weight consistently declined since 2015, but increased slightly during the onset of the pandemic in 2020. It has been inching marginally higher since FY22.

Services: The sector’s weight remained flat for N-500 / N-50 at c.2%/1% since 2017.

Pharma & Chemicals – a mixed bag

The Pharma & Chemicals’ N-500 / N-50 weight was flat at c.7% / 3% between FY18-19. In N-500, its weight increased mostly after the pandemic until 2022, and stagnated thereafter. However, within this, the pharma sector’s weight grew majorly in 2020, while the chemicals sector’s weight grew majorly in 2021 and 2022. Currently, both sectors’ weights are below their all-time highs.

Pharma and Healthcare: The pharma sector’s N-500 weight remained flat at c.4.7% in FY18 and FY19. During the pandemic, in N-500, it increased by 90bps in 2020 from 2019 levels, while N-50 weight increased by 160bps in 2022 from 2019 levels. Currently, the sector’s weight in both indices is near its highest since covid, as it gained momentum recently due to improvement in business and earnings.

Chemicals and fertilizers: The sector’s weight in the index was stagnant during 2018-20, before rising in FY21. Its N-500 weight remained flat at 2% from FY17 to FY20. But in 2021, a sharp increase in global demand for speciality chemicals and a rise in prices propelled its weight. Currently, the sector’s weight in both indices is down (from 2022 highs) due to weak domestic demand, subdued global economies, and declining commodity prices.

Energy sector – almost flat!!

The energy sector’s weight has remained almost flat since 2017 with a sharp increase in 2022 due to high demand and low production. In the N-500, its weight increased slightly to 13.5% in FY22 from 11%.5 in FY17 and is currently at 10.8% in FYTD24, while in the N-50 its weight increased slightly to 14.9% in FY22 from 13.7% in FY17 and is currently at 12.9% in FYTD24.

Oil & Gas: The sector saw a slight increase in index weight majorly in FY16 and FY17. Its N-500 weight increased to 8.6% in FY17 from 6.8% in FY15, while in the N-50 it increased to 10.8% from 8.2% in the same period. Current weight is 8.2% and 10.7% in N-500 and N-50 respectively.

Power: The sector has seen a consistent decline in weight from FY17 to FY21, with negligible growth in recent months. Current weight is 2.7% and 2.2% in N-500 and N-50 respectively.

Corporate profit cycle enters value-creation zone (ICICI Securities)

RoE of NIFTY50 index is rising above the 15% mark after a decade and we expect it to expand to ~17% by FY25E, thereby clearly entering the value-creation zone, driven by improving demand environment for capital-intensive and cyclical stocks. P/B ratio of NIFTY50 index is at the long-term average mark of ~3x and a rising RoE is likely to boost it driven by the aforementioned stocks. A similar trajectory was observed between 2002-07 when cyclical recovery in the economy driven by the capex cycle boosted RoE to >25% and P/B >5x. Currently, as capacity utilisation is moving above the 76% mark, we believe the benefits of operating leverage have started to creep in, although corporate re-leveraging cycle is yet to begin. High-frequency indicators corroborate rising utilisation levels.

NIFTY50 index enters value-creation zone after a decade

Stocks that are likely to improve their RoEs over FY23 to FY25E and transition into value-creation zone include capital intensive and cyclical sectors such as auto, capital goods & infrastructure, utilities, telecom, commodities and financials. The RoE trajectory provides a sense of ‘déjà vu’ of what happened in the pre-GFC era between 2003-2007 when stocks within capital-intensive and cyclical sectors like L&T, BHEL, Bharti, NTPC, Hindalco, M&M,ACC, Reliance and DLF transitioned from sub-14% level RoE to value-creation zone of RoE >15%. Most of the aforementioned stocks further touched the high quality zone of RoE >25% at the peak of the investment and credit cycle.

Expansion in RoE could boost P/B ratio which is around long-term average

As capital intensive and cyclical sectors expanded their RoEs above the 20% range in pre-GFC era, their P/B ratio was also boosted and by the peak of the profit cycle, P/B ratio expanded well above 5x. A similar behaviour cannot be ruled out going ahead. Relatively less capital-intensive sectors such as FMCG, IT, pharma etc. are largely in value-creation zone (RoE >15- 20%) and do not provide any major driver of boosting RoE from current levels.

High frequency data indicates demand is robust and being largely driven by rising ‘investment rate’

Capacity utilisation improved to ~76% in the economy, as per RBI’s OBICUS survey, and high frequency indicators like PMI, GST collections, infra orders, and real estate construction indicate demand overall remains robust driven by the investment side of the economy.

Agri output and IT hiring slowdown are key risks to consumption demand

However, severe weather conditions pose risk to agriculture output and income growth for rural economy with ~46% of the working population involved in agriculture. Also, within the formal segment, IT hiring has been slow along with a weak outlook. Its enormous share of ~42% to the private corporate sector wage bill remains a key risk.

Refining Margin of Indian Players to Stay at $9-10/bbl (CARE Ratings)

After a period of almost nine months, Brent crude again breached the $90/bbl mark at the start of September 2023. With this, the gap between international benchmark Brent crude prices vis-à-vis Urals, the flagship Russian crude, has widened for Indian refiners as Russian crude can be sourced within the G-7 price cap of $60/bbl.

The Urals had mostly traded below the G-7 imposed price cap of $60/bbl but have breached the cap in recent weeks whereby it is trading at around $69/bbl. Upon the rise in prices of the Urals, the share of Russian crude in India’s total crude oil sourcing basket declined to 34% in August 2023 from nearly 40% since the outbreak of the Russia-Ukraine war.

With Saudi Arabia and Russia deciding to reduce their daily crude oil production by 10 lakh barrels till December 2023, any major softening in crude prices is unlikely in the near term on the back of stable demand prospects.

In this backdrop, Indian refiners which are the key beneficiaries of cheaper Russian crude should still be able to clock Gross Refining Margins (GRMs) of around $9-10/bbl in FY24 as the likely decline in their margins on processing Brent crude is expected to be offset by the significant expansion in margins on processing Russian crude which can even balance out the potential decline in supply of Russian crude in the near term. Also, with the onset of winter in Western countries, cracks for refined products are expected to improve from the existing levels, further helping the GRMs of Indian refiners.

FMCG: A crude spike and an uneven monsoon could spoil margin gains (Anand Rathi)

Spotty monsoon could drive food inflation higher, drag rural demand. August saw a sharp monsoon deficit after a flurry of rain in July. At present, the all-India monsoon (till 6th Sep) is 11% deficient with uneven rainfall distribution across the country. While sowing area rose 0.4% over the last year, less area sown in pulses, cotton, jute, etc was seen till 1st Sep. This could drive food prices up as was seen with select vegetable prices shooting up recently.

Palm oil, soda ash, packaging prices soft. Barring prices of milk, wheat and sugar prices of most other commodities have been down. Palm oil prices fell ~40% in FY23 and fallen another ~11% so far in FY24. The steep fall in palm oil prices benefits soap (~60% of input cost), snack (~30%) and biscuit (10-20%) manufacturers.

We expect the drop in palm oil prices to be favourable to HUL (~25% soaps portfolio) and GCP (~25%). Further, prices of many crude-linked inputs have fallen (soda ash down 14% y/y in the last six months,p olyethylene down 12% y/y). Soda ash accounts for about 20-25% of the input cost in the manufacture of detergents. Packaging costs constitute 15-30% of FMCG companies’ input costs. HUL (~25% of the portfolio) and Jyothy Labs (~30% of the portfolio) are expected to benefit from lower soda ash prices.

Gross-margin gains could shrink on crude-oil price spikes. The recent spike in crude oil (~17% over 3m) could mar gross-margin gains for FMCG manufacturers. In Q1 FY24, lower input costs (primarily crude-linked derivatives) for them had led to 100-800bp gross-margin gains. However, the spike in crude-oil prices drove prices of packaging, soda ash, LAB, titanium dioxide higher, which could shrink gross-margin gains.