Vijay Kumar Gaba

The latest earnings season (2QFY23) ended, leaving the markets with “glass half full or glass empty” feelings. The aggregate results were mostly in line with the already moderated expectations; though granular details indicate a wide divergence within sectors. Overall, the management commentary sounded optimistic about easing raw material, logistic and wage cost pressures; though the companies did not sound particularly sanguine about the demand environment, especially the rural demand and export demand.

The earnings for 2QFY23 were also mostly driven by financials; while IT, FMCG and Pharma also put up a good show. Oil & Gas, capital goods, consumer durables, telecom, automobiles and cement were notable underperformers. Post the results, FY23 Nifty EPS estimates have seen marginal changes, while FY24e earnings estimates have been moderated further. The long term (5yr CAGR) earnings trajectory is now flattening after a sharp growth witnessed during FY19-FY22. This flattening of long term earnings trajectory may jeopardize any chance of a PE re-rating of Indian markets, in my view.

As I suggested yesterday (see A perfect storm), “the best strategy under the present circumstances would be to (a) hold nerves and not panic; (b) review the portfolio for any corrective action that may be needed once the storm passes and the sea becomes calmer.”

To add further to that, I may suggest that the following points may be pertinent to note while reviewing the portfolios:

1.    The higher cost of capital (interest rates) would result in lower fair valuation for equities in general. The growth companies that have debt on balance sheet or need to borrow for capex; and/or where the free cash flows are mostly back ended may see much sharper cut in their target multiples. In fact we have already seen 20% derating in Nifty PE Ratio over the past eight months.

2.    The market consensus was working around 18% CAGR for Nifty earnings over FY23-FY24. The realized earnings growth may be much lower than this. My personal assessment is that we may end up with ~10% CAGR over FY23-FY24.

3.    The popular trades of the previous market cycle (2018-2021) may continue to see sharper valuation rationalization over the next couple of years. Many of these stocks may therefore not participate in the next market cycle.

4.    Monetary tightening, growth slowdown and consumption demand destruction shall essentially result in deflationary conditions in 2023-24. The strong earnings cycle for most non-food commodities may therefore not last much longer. The metal and energy stocks may therefore see sharper correction in multiples and fair value targets.

5.    A new market cycle is mostly led by the market leaders, till a new theme(s) emerges and the stocks from that theme(s) catch the fancy of the market participants. It is therefore always better to be positioned in a large cap basket during the twilights of a market cycle.

In my base case assessment, the risk reward in Nifty from one year perspective is positive at the current levels.

 The latest result season (3QFY22) has ended on a mixed note. While aggregate numbers look on expected lines, the internals however show a different picture. There is significant divergence in performance of various sectors. In fact, the number of companies that did not meet market expectations is higher than the number of companies beating the expectations. Raw material inflation hurt most of the manufacturing sectors. Lack of pricing power in view of poor demand thus resulted in margin compression for most of the manufacturing sector. Financial sector was the brightest spot with credit demand accelerating, and asset quality, recoveries & profit margins improving. IT Services and Real Estate were other sectors that witnessed better performance on better demand environment. Metals and mining had another great quarter as prices remained elevated, with non-ferrous performing better than the ferrous metals. Oil & Gas sector performance however was below expectation. Though the headline Nifty EPS did not see any noticeable change post results, in broader markets earnings downgrades outnumbered the upgrades.

The most notable features of 3QFY22 results were (i) continued deleveraging of corporate balance sheets; (ii) material decline in rural demand and (iii) significant disappointment by small cap stocks.

Some of the key highlights of 3QFY22 results could be noted as follows:

Nifty EPS

Nifty EPS for FY22E has been reduced by ~1% to INR735 (earlier: INR743) largely due to a big downgrade in TTMT earnings. FY23E EPS has been broadly unchanged at INR874 (earlier: INR872) as downgrades in Autos, Metals and Consumer sectors were offset by upgrades in O&G and BFSI sectors. (MOFSL)

NIFTY EEPS has seen only minor tweaks in the current quarter with 15.6% EPS CAGR over FY22-24 with FY22/23/24 EPS of Rs691, 807.5 and 924.4. Our estimates are higher by 1.6/0.8/0.3% for FY22/23/24. NIFTY is currently trading at 21.8x 1-year forward EPS which shows 6.3% premium to 10 year average of 20.6x. Past 3 dips show that NIFTY has bottomed out around 10 year average PE except in March 20, when it bottomed out at 23% discount to 10 year average. (Prabhudas Liladhar)

Margins Compression

3QFY22 net profits of the Nifty-50 Index increased 24% yoy versus our expectation of 20% increase and EBITDA of the Nifty-50 Index increased 17.5% yoy versus our expectation of 15.5% increase. All the consumption sectors saw further compression in gross and EBITDA margins due to continued high raw material prices and limited ability of companies to raise prices fully. (Kotak Securities)

EBITDA margins (excl financials & commodities) compressed significantly on YoY basis, by 236bps. Major compression was seen in Paints (753bps), Tyres (913bps), Utilities (712bps, mainly from the gas price increase), Pharma (535bps) and Cement (756bps). However, on a sequential basis, significant margin improvement was seen in Chemicals (194bps) and Paints (288bps).

Notable sectors below the 5-yr peak are Travel (by 11pps), Tyres (7ppt), Media (9ppt), Paints (5ppt), and Automobiles (5ppt). Notable companies below 5yr peak are Eicher, Godrej, Welspun, Mahanagar Gas, MRF and Torrent Pharma. As for the EBITDA margin above the 5-yr peak, some notable names are IRCTC, Cyient, TVS, Jubilant FoodWorks, and ACC. (IIFL Securities)

Upgrade vs Downgrade

The biggest downgrades happened in Cement and Tyres (7ppst each), Financial services (6ppt) and Business services (5ppt). Some notable companies with the biggest downgrades are MRF, Whirlpool, Dalmia Bharat, JK Cement, Lupin and Dixon. The highest upgrades were seen in Paints, Real Estate, Telecom and Discretionary − all in the 2-3% range. Some notable companies with the highest upgrades are Blue Dart, Canara Bank, SRF, and Titan. (IIFL Securities)

Deleveraging

Aggregate interest/Ebitda is broadly stable, at 10% levels, led by both, improved Ebitda and cash flows, down from 24% in the Mar-2020 quarter. Significant deleveraging during the pandemic, coupled with low interest rates, has helped in reducing the interest burden on companies. On an aggregate level, interest costs are down by 8% on a 2Y CAGR basis. Going forward, though, interest rates may rise again on the back of acceleration in credit. The current corporate bond yields have cut the gap to their prepandemic levels to some extent and central banks across the globe too are looking at rate hikes, to initiate normalisation.  (IIFL Securities)

Rural Demand

Recent commentaries by several corporates indicate to slowdown in rural demand. The slowdown has been observed in select FMCG categories, 2 Wheelers, cement and post Diwali durables demand has also been tepid. Rural slowdown has many reasons- Rural slowdown has been triggered by 1) higher increase in the cost of Agri inputs than the outputs potentially impacting farm incomes which are roughly 30% of rural income 2) Poor spatial distribution of monsoons 3) Lower remittances from urban workers to their families as labor is yet to fully migrate to cities for work 4) High Inflation in essential commodities like fuel, edible oil, tea and other daily essentials due to global disruption in supply chains. However we believe bumper wheat harvest and rising job/work opportunities led by Infra development, housing, artisans, carpenters, painters, truck drivers, factory workers etc. will boost income and demand. However given high inflation the earliest a rural seems likely is from the middle of 1Q23, with 4Q demand being also under pressure. (Prabhudas Liladhar)

Key sector trends

Private Banks, NBFC, Logistics, Retail and Utilities reported higher-than-estimated PAT growth, while Autos, Cement, Consumer Durables, Healthcare and Metals reported PAT below our estimates in 3QFY22.

Technology – 3QFY22 was a good quarter for Indian IT Services as companies under our coverage reported an overall QoQ topline growth of 4.6% (in USD), despite seasonality due to furloughs. The demand remains strong in the medium term.

Private Banks and NBFCs – asset quality trends improved. Most of the banks posted a decline in their NPL ratios, led by controlled slippages as well as healthy recovery and upgrades. NBFCs saw sharp improvements in disbursements and collection efficiencies.

Consumer – discretionary companies (Paints, QSR, Titan, Liquor, etc.) delivered strong double-digit topline growth while staples’ performance was muted as rural showed visible slowdown and margins were hurt by RM prices.

Cement – the sector was adversely impacted by weak volumes owing to unseasonal rains while high energy costs took a severe toll on margins and profitability.

Healthcare – after 12 quarters of growth, 3QFY22 marked the first decline in profits as rise in raw material costs due to supply disruption in China and continued price erosion ins US depressed profitability. (MOFSL)

Conclusion

Overall 3QFY22 earnings were encouraging, given the context of inflationary pressures, tightening liquidity, supply chain bottlenecks, adverse weather conditions; fiscal constraints impacting cash payouts in rural areas and fresh Covid breakout.

The management commentary post earnings have been mostly optimistic; though some companies have raised concerns over consumer demand. So far most analysts appear to be sticking with their FY23 earnings estimates. The geopolitical concerns, energy prices and impact of interest rate hikes on global commodity inflation are some of the key variables to be watched in the next 3-4 months. Most important among these would be easing of global inflation without hurting the growth materially.

 Wishing all readers on the auspicious occasion of Lohri, Makar Sankranti, Maghi, Poush Sankranti, Pongal, Surya Uttarayan, Bhogi, Tusu, Bihu, Pedda Panduga and much more. 

May this auspicious transition of Sun God may empower the universe with divine energy and light and protect humanity from all demonic forces.

Happy Earning Season

Technically the quarterly result season starts from first day of every calendar quarter. However, the formal festivities begin with the IT Services major announcing their quarterly performance 10-13 days later. This season, perhaps for the first time in history, the top three IT service players chose to kick start the festivities together on 12^th January. Obviously it was an auspicious start to what is popularly anticipated to be an extremely fruitful earnings season.

Near consensus on corporate performance

There is near consensus on corporate performance during 3QFY22 in particular and FY22 as a whole in general. Post 2QFY22 a majority of brokerages have upgraded their earnings estimates for Nifty for FY22 and FY23.

Sector wise also, there is near unanimity on (a) continuing strong earnings momentum in IT Services and chemical sectors; (b) compression of spreads and decline in profitability for metal companies; (c) strong growth in BFSI segment with further improvement in asset quality and NIMs; (d) sequential improvement in auto numbers even though overall performance may be weak; (e) lackluster performance of pharma and consumer staples and (f) sequential improvement in consumer discretionary.

The following excerpts from brokerage commentary on quarterly performance are noteworthy:

Nifty PAT to grow 20% yoy (Kotak Institutional Equities)

We expect net profits of the Nifty-50 Index to increase 20% yoy and 3% qoq; and estimate EPS of the Nifty-50 Index at Rs726 for FY2022 and Rs844 for FY2023.

Sector wise - (1) banks (steady sequential decline in slippages, lower provisions, better performance of large banks), (2) metals and mining (higher realizations and volumes on a yoy basis, but weaker sequentially), (3) oil, gas and consumable fuels (higher qoq and yoy realizations for upstream companies, improved marketing and refining margins for downstream companies sequentially) and (4) retailing (strong volume growth led by increase in footfall and operating leverage-led margin expansion).

Expect decline in the net income of (1) automobiles (production issues, RM headwinds) and (2) construction materials (weak demand environment, higher fuel and power costs) sectors.

Earnings strong but breadth weak (MOFSL)

After two strong quarters of earnings growth, we expect MOFSL Universe to register another healthy quarter of 22% YoY growth in 3QFY22 on a high base of 33% YoY growth in 3QFY21. While the aggregate growth is impressive, it is narrow and driven by just four sectors – Metals, BFSI, O&G and IT. Two-thirds of the incremental growth is steered by Metals and Oil & Gas (O&G) sectors, with the Financials sector driving the remainder. However, the breadth of earnings remains weak with 42% of companies likely to post YoY decline in earnings while 38% are expected to post>15% earnings growth. The key 3QFY22 drivers are: a) Metals – likely to post 60% YoY profit growth and contribute 35%/35% to incremental MOFSL/Nifty earnings growth for 3Q, respectively; b) O&G – high Brent crude prices and demand led to higher GRM’s and volumes for OMCs; c) BFSI – higher loan growth due to improved economic activity and lower slippages leading to asset quality improvement and d) IT – strong demand backed by multi-year growth tailwinds on Cloud migration to drive topline growth. The key inhibitor is Autos – likely to drag down the earnings aggregate as it is impacted by semiconductor shortages for PVs amid demand concerns for 2W and tractors.

Nifty FY22E EPS has seen an upgrade of 2% to INR743 (v/s INR730), while Nifty FY23E EPS has remained almost unchanged at INR872 (v/s INR873). We introduce FY24E earnings and estimate Nifty FY24 EPS to be at INR993.

IT Services – growth to defy seasonality and remain strong (MOFSL)

The strong demand environment is expected to continue in 3QFY22, with Tier II players again outgrowing Tier I companies within our coverage universe.

Despite adverse seasonality, Tier I companies should deliver revenue growth in the 3.2-4.8% QoQ CC range, while Tier II players will have a wider band of 3.6- 7.1% (excluding PSYS, which will benefit from inorganic growth).

We expect a strong initial outlook for FY23E, with companies maintaining their view of multi-year growth tailwinds on the back of Cloud migration. Guidance for 4QFY22 is also expected to be positive on the back of continuing deal wins.

We see margins for most companies (excluding company-specific factors) to be in a narrow range as supply pressures (attrition and hiring) are offset by operating leverage. Among Tier I players, EBIT margin will be in a tight (-20bp to +40bp QoQ) range, although they will see a steep decline v/s 3QFY21 profitability.

Critical quarter for BFSI sector (Axis Securities)

The Banking sector will continue to deliver growth driven by a growth in the retail segment. Moreover, asset quality is expected to remain under control and challenges should further moderate on a QoQ basis. NIMs are likely to remain stable and might even see marginal improvement on a sequential basis. Moving forward, key focus areas will be growth prospects and fueling the corporate segment which is currently seeing some sluggishness. We will watch the top four banks very closely for growth guidance. The smaller banks are expected to continue focusing on maintaining asset quality in light of significant deterioration seen during the last one year. NBFCs will also be closely watched for asset quality. At this juncture, we

believe Q3FY22 will be similar to Q2FY22 for NBFCs and funding costs will remain manageable. Overall, earnings prospects should improve for the BFSI sector during the quarter and management commentary on growth would be a key monitorable.

Cement – demand recovery and softening costs (Emkay Equity Research)

Industry EBITDA/ton declined 11% YoY in Q3CY21 and remained under pressure in Q4CY21 due to input cost inflation and soft demand. However, cost inflation should ease off from early CY22E with a softening in input prices (down 15-40% from recent peaks). After a ~50% increase in the past two years, industry EBITDA/ton is expected to remain flat in CY21 but is likely to increase by 4-5% in CY22E.

Expect demand to likely grow by 8-9% YoY in CY22E (vs. 6-7% long-term historical average), driven by higher infra spending, pick-up in the housing segment and revival in urban real estate activity. The South and West regions should see 8-9% growth on a low base, while the North regions may clock 6-7% growth. While demand has been impacted in the past few months by heavy rainfall, construction bans in North, sand mining issues in East and limited labor availability, it should pick up in the coming months with the onset of a busy construction season and easing inflation in construction costs.

Maintain our positive view on the sector based on robust earnings compounding and a structural RoIC reset, with medium-term demand growth visibility and calibrated supply additions.

Speciality Chemicals – strong underlying trend

Estimate our chemical coverage universe revenue to grow at 42% YoY (7% QoQ) during Q3FY22 on sharp rise in prices due to input cost inflation. However, gross profit is also expected to grow 29% YoY which indicates strong underlying trend.

Steel – Margins to normalize (Prabhudas Liladhar)

Expect EBITDA of steel companies under our coverage universe to fall sharply by 19% QoQ due to lower volumes and contraction in margins. Sales volume is expected to contract by 6.5% QoQ due to subdued domestic demand. Steel realisations would increase by 2.5% QoQ/Rs1,500/t, falling short of expected rise of 10% QoQ/Rs4,500/t in costs on account of higher coking coal cost. Owing to higher costs partially offset by increase in realisations, EBITDA margins would fall by 14% QoQ/Rs3,130 to Rs19,880.

Chinese steel demand is estimated to fall by 4.7% YoY in CY21e at ~955mnt due to weakness in housing and auto sector, compounded with little support from Govt’s spending.

Margins came off sharply QoQ in Q3FY22e due to 2x increase in coking coal cost and soft realisations coupled with weak demand in both domestic and exports market. Factoring US$50 drop in steel prices offset by US$15/t lower coking coal prices, we expect EBITDA/t to stabilise at normalised level of Rs15,000/20,000 for non-integrated/integrated producers in Q4FY22e. Even after the fall, normalized margins are 33% higher over the historical average.

Capital Goods – Mixed bag (IIFL Securities)

While short-cycle industrials continue to lead with healthy growth, the pace of rebound in the long-cycle portfolio has remained soft in 3QFY22, partially marred by headwinds in construction activities and by inflation. Recovery in government ordering has been muted, resulting in bunch-up for 4QFY22, with likelihood of slippages; yet, overall inflows have increased QoQ. Investment sentiment across private & infra projects remains positive and will not be deterred by Covid 3.0.

Inflationary headwinds and resultant delay in order finalisation from the govt. sector persisted in 3QFY22 too, adding risks of order slippages to 1HFY23. Ordering in Defence, Metro, O&G pipelines and the water segment was better, while remaining muted in rail, road and T&D. Private-sector ordering in both, short-cycle as well as projects in B&F, FGDs, WHR, data centres and manufacturing sectors, continued to show an uptick.

Real Estate – affordability remains high, demand robust (HDFC Securities)

3QFY22 seems to be promising for the Tier 1 developers. Despite an inauspicious period, holiday season toward Dec-21 second half and emergence of Omicron, 3QFY22 presales remained healthy. Whilst Jan-22 second half was expected to be launch heavy, we believe that Omicron driven COVID-19 wave three will push back the launches towards end of Q4FY22.

Our recent channel checks with leading real estate channel partners suggest that demand momentum remains strong and Tier 1 developers continue to gain market share. Affordability driven demand, rising income levels and near low mortgage rates are some of the factors contributing to the sales. Whilst globally interest rates are expected to harden, a 25-50bps increase may not result in demand destruction. Developers remain accommodative on pricing as most of them are holding historical land bank besides commodities prices are off highs. Whilst we expect property prices to re-rate it may be on the back of more sustained economic recovery and positive sentiments on consumption.

We expect the aggregate revenue/EBITDA/PAT for the coverage universe to grow sequentially by 2/2/5%. The impact of commodities’ prices will smoothen over the project completion period as companies will take the hit once projects complete. Overall, taking price hikes may derail recovery and developers may not go ahead with the same.

Auto – Weak due to demand and raw material headwinds (Nirmal Bang Equities)

We expect 3QFY22 earnings of Auto & Auto Ancillary companies in our coverage universe to be relatively subdued due to sustained input cost headwinds and muted demand (weak festivals, supply chain constraints and moderating rural growth). We anticipate gross margin contraction of 10-40bps on a QoQ basis due to continued RM cost pressures. However, with major commodities showing signs of stabilizing/moderating prices at current levels, we note that further impact on gross margins could be limited. EBITDA margins should witness softer trends on YoY basis, but will be partially supported on a QoQ basis by positive operating leverage, price hikes and tight cost controls across most companies. We surmise that current issues of supply chain constraints and rising covid cases are dynamic, but we see them leading to subdued demand and weak profitability in 4QFY22 too. For 2Ws, narration on demand revival and electrification transition efforts would be a key monitorable while a sustained demand recovery in 4QFY22 is critical for CVs.

Chart for the day

 

Thought for the day

“Common sense is the collection of prejudices acquired by age eighteen.”

—Albert Einstein (German Physicist, 1879-1955)

Word for the day

Skookum (adj)

Large; powerful; impressive.

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The stock price of few top IT services companies in the country recently corrected sharply after declaration of 4QFY21 results. The explanation commonly offered and widely accepted for the fall in stock prices was that “the results were not as per the street expectations”. I find this little intriguing, especially in the current market environment.

It is well acknowledged that in recent times, the non-institutional investors (“retail investors” in common parlance) have been the dominant players in equity markets world over. In my past 30years of interacting frequently with this category of investors in India, I know that a large majority of these non-institutional investors are not well versed with financial analysis, especially related to the forecasting of financial performance and deriving fair price based on such forecasts.

Moreover, there is an insignificant minority in this category of investors which actually relies on the target prices forecasted for a security by “fundamental analysts”. This simply because they invest in a stock for much larger gains than an average analyst can possibly forecast.

Therefore, I find it little hard to accept the explanation that not meeting consensus forecast disappointed the “market”, even though the results are good and the forward guidance provided by the company is even better.

Another disturbing fact is the level of discussion on TV channels and social media about the future performance of reputable company. For example, I heard some young enthusiastic analysts having 6-8years of post qualification experience in equity analysis, questioning the guidance of the managements of companies like Tata Steel, Infosys, TCS, etc. I saw an analyst, who has spent just 5hours in a cement plant; has never purchased a bag of cement for himself; has always been a commerce student; learned the chemistry of cement from St Google, rejecting the demand forecast made by the management largest cement company in India.

Obviously, these analysts’ forecasts will eventually prove to be way of the mark. However, that is none of my problems. My problem is whether an investor should be relying on the forecast and guidance of the management, which has consistently delivered on its guidance; or go by the “street expectations”; particularly, when few are aware about the constituents of this “street”. It may be pertinent to note that in case of many mid and small cap stocks only 2-3 nondescript brokerages release their estimates. Thus the “street” in these cases may be extremely narrow, dark and stinking.

In this context, the following findings of a recent study by UBS Securities are also interesting to note:

(a)   In past one decade, the market consensus has overestimated one year forward Nifty EPS by an average of 20%, at the beginning of the relevant financial year. E.g., the earnings of FY22 are likely to be overestimated by 20% on 1 April 2021.

(b)   The analysts were so off the mark that even on the last day of the relevant financial year when only one quarter of earning was remaining to be declared, there was usually an overestimation by ~9%. In past year this error has ranged between 10% to 15%. Implying that even on 31 March 2021, the consensus Nifty EPS for FY21 could be overestimated by ~9%.

So before you call your broker to execute a trade based on what the anchor or analyst on TV is telling you about the earnings forecast, street expectations, forward guidance etc, please hold for a second and think “do you actually want the TV anchor or a random analyst to drive your investment decisions?”

In the context of India stock markets, I found the following two things worth noting on Tuesday:

(i)    A number of brokerages wrote strategy notes urging the clients to use the recent “lockdown fear” led correction in stock prices as a good opportunity to buy stocks. Apparently, the strategy appeared to be driven by (a) deep fall followed by a sharp recovery in 2020; and (b) belief that the abundant global and local liquidity and low interest artes will continue to support equity markets for couple of more years at least.

(ii)   The IT sector stocks corrected rather sharply after the bellwether TCS announced a decent set of number for 4QFY21 and encouraging commentary for FY22. This highlights, in my view, that markets expectations may be running rather high in terms of corporate performance and payouts. There is virtually no margin for any disappointment on earnings or payout front.

Some research reports have taken note of the intensifying second wave of Covid-19 infection cases, and cautioned against the likely adverse impact of the incremental restrictions on mobility due to this. For example-

“The Economic data released yesterday showed that the restrictions & sporadic lockdowns in response to the fresh wave of coronavirus infections started impacting the overall demand & growth. The IIP contracted 3.6% for February 2021, mainly on account of a steep contraction in the manufacturing output. Meanwhile, India's retail inflation rose to a 4 month high of 5.52% in Mar (5.03% in Feb & 5.91% in Mar 2020) as food prices soared.” (Aditya Birla Capital)

“The sporadic lockdowns/mobility curbs & night curfews put in place across key economic hubs in India in the past few days are likely to cost the nation $1.25 bn/wk. Taking into account rolling COVID curbs, if the current restrictions remain in place until the end of May, estimate is that the cumulative loss of activity could amount to around $10.5 bn, or ~0.34% of annual nominal GDP. However, the impact on the Q1FY22 nominal GDP is likely to be higher, shaving ~1.4% from the same.” (Barclays Bank)

The Nomura India Business Resumption Index (NIBRI) dropped sharply to 90.7 for the week ending 4 April from 94.6 the prior week, ~9.3pp below the pre-pandemic normal. This is its steepest weekly decline since mid-April last year. Accordingly, Nomura has cut the 2021 GDP forecast for India to 11.5% from the earlier 12.4%.” (Nomura Securities)

It is pertinent to note that currently, Nifty valuations (one year forward PER) are at 15% premium to the long term (10yr) average; and the market consensus is expecting ~32% earnings growth in FY22 followed by ~18% growth in FY23. Obviously, the expectations are running high, leaving little room for any disappointment.

Even after the recent episodes of sporadic mobility restrictions impacting the business and consumer sentiments, and downgrade of overall GDP growth for FY22, the consensus earnings estimates have been cut by less than 2% for FY22.

In my view, we may see further downgrades in both macroeconomic growth and earnings growth estimates for FY22. I am not sure if market may be forced to de-rate the equities’ valuation by these downgrades, but any rerating would certainly be difficult.

Currently, market consensus appears to be working with Nifty EPS of Rs640-650 for FY22 and Rs750-770 for FY23. I would prefer to be somewhat conservative and work with Rs590-610 for FY22 and 680-700 for FY23.

This means, I may be mostly ignoring the benchmark indices and focusing on businesses which I found (i) reasonably valued; and/or (ii) having very high visibility of growth, in spite of Covid-19 related obstructions. Because the Lord has commanded that “Blessed are the meek: for they shall inherit the earth” (Bible, Mathew 5:5)

The latest earning season (3QFY21) has been one of the best in recent times. Companies across sectors reported encouraging revenue growth. The margins also improved on the back of lower input cost and wage rationalization. Accumulated demand (due to two quarters of lockdown) and festive season may have a significant role to play in the demand growth during 3QFY21. It is anticipated that as the economy continues to open up further as vaccination drive accelerates and mobility restrictions are eased further, the demand growth may sustain for few more quarters. The demand environment is also supported by the counter cyclical fiscal policy and continued accommodative stance of monetary policy.

The quarterly earnings surprised many analysts on both EBIDTA and PAT level; while on top line the surprises were lesser in number. For Nifty companies, on aggregate basis, EBIDTA margins and PAT margins were flat. However, after adjusting for exceptional losses in Bharti Airtel and Tata Motors, picture does not looks that disappointing.

In 3QFY21, double digit top line growth in metals, mining, cement, construction and manufacturing also augurs well for the macro growth. In fact, the cement industry reported third consecutive quarter of good results with EBITDA/mt for the whole industry coming in at Rs1,000+. It was due to continuation of strong pricing and lower operating costs as witnessed during the first two quarters of FY21. The industry witnessed volume growth of 5.6% YoY after 2 quarters of decline. This these trends support the view that Indian economy may recover to a normalized 5%+ growth trajectory in FY23. Of course it is not something to celebrate, but it does provide a whiff of relief that the fears of a deeper recession have been alleviated completely.

The markets however appear to be discounting an all clear blue sky scenario, which might be little over optimistic. Cost advantages available in 3QFY21 are dissipating fast with sharp rise in raw material & energy prices and normalizing wages. Considering that EBIDTA margins in 3QFY21 may already have reached close to their all-time high in case of many large companies like Hindustan Lever, the earnings growth expectations from the current level may some room for disappointment.

After a spate of highly optimistic commentary oover past three months, some voices of caution have started to emerge. Analysts at BofA see rising commodity prices and bond yields as key risk for Indian equities in near term. A recent note from BofA research read, “With the Nifty already at our year-end target of 15,000, continuation of a broad-based market rally appears unlikely.” The research notes that steel, cement, crude, coal, copper, aluminium, iron ore, palm oil and caustic soda are the key commodities relevant for the Nifty companies and prices of these commodities are up by up to 75% since June 2020.

Similarly, Nomura analyst sees ‘rising number of Covid cases, higher commodity prices, rising in trade and current account deficit and rising bond yields as key risks to Nifty rally in the near term.

At CLSA, while earnings estimates for for over 2/3^rd of coverage stocks have been raised after 3QFY21 earnings, recommendation downgrades by analysts are about 3x the number of recommendation upgrades; with valuation.

A note from ICICI Securities also notes that “Margins largely augmented by ‘cost control’ and product mix even as input prices continued to put pressure on gross margins in general. This phenomenon is continuing in Q4FY21 as evidenced by further rise in ‘manufacturing inflation’ component within WPI to 5% largely driven by metal prices.”. The note also cautions that rise in credit cost may surprise negatively for some financials.

A note from IIFL Securities notes that, “The steady margin improvement up to the previous quarter, driven by aggressive cost-cutting measures and benign input costs, has paused for now. Normalising activity and rising input costs are putting pressure on EBITDA margins.”

After the upgrades, the Nifty earnings is now expected to grow @20% CAGR over FY20-FY23 period, with FY22 EPS growth estimated to be over 33% yoy. Obviously, the current earnings estimates do not leave any room for disappointment. 4QFY21 and 1QFY22 earnings seasons must therefore be keenly watched. Any sign of disappointment on either revenue growth or EBIDTA margins may cause significant volatility in the market.

The latest earnings season has started on a very buoyant note, led by some IT companies. In line with the high speed macro indicators, most brokerages have upgraded their earnings estimates in past one month. The present estimates are building in a very strong earnings recovery over FY22-FY23. The estimates for the current year FY21 have also been upgraded sharply from a contraction of 5% to 12% to a growth of 5% to 12%. Currently, the market is estimating an earnings growth of 24% to 38% in FY22 and another 18% to 22% growth in FY23.

It is important to note that these estimates assume GDP growth of -7% to -7.5% in FY21; 9% to10% in FY22 and 4 to 5.5% in FY23; interest rate bottoming in FY21 and elevated inflation of 5 to 6% over FY22 and FY23.

This implies less than 3% CAGR of GDP over three year period of FY20-FY23. Whereas, the present estimates imply ~19% CAGR in Nifty EPS over FY20-FY23. Apparently, there is disconnect between the macro forecast and earnings forecast. In past two decades at least, there is no precedence of such strong earnings growth with a dismal economic growth.

Furthermore, the estimates assume a strong recovery in earnings of financials and materials, from a very low base. Just to give a sense, Kotak Institutional Research estimates 473% (yoy) growth in Banks PAT and 860% rise in Metal’s PAT in Q3FY21. Construction Material (86%) is the third fastest growth forecasted. These three sectors probably have the strongest correlation with the macroeconomic growth and stability. Next 9months may be a case of low base effect, but with 3% economic growth, higher interest and inflation, it is tough to fathom these sector continue clocking sustainable high growth.

So in all likelihood the earnings estimates for FY22 and FY23 will fall in due course, as has been the case historically. Credit Suisse highlighted in one of their December report that EPS estimates fall 10 to35% from the level that is first estimated.

In my view, therefore, it would not be advisable to consider aggregate earnings as a key factor for investment decision. Better would be focus on the companies where sustainable earning growth visibility is very high. Of course these stocks will also fall in case of a broader market correction, but the chances of their bounce back would be much higher.

I shall therefore remain agnostic to sectors and size of companies. I would rather focus on individual companies for investment. Sustainability of growth would be my key consideration in selecting the company.

The year 2020 has been a period of extremes for markets. During past 12months, the equity markets have kept swinging between extreme fear and greed. The year began on a buoyant note. The benchmark indices scaled their all-time high levels on 24 January, after rallying for past 4 months. In the following 2 months the indices corrected ~40% from their January highs, refreshing the fading memories of 2008 crash. A sustained rally thereafter saw the benchmark indices scaling new highs in next 9 months. This rally was remarkably different from September 2019-January 2020 rally in terms of volumes, market breadth, and participation. Foreign investors and domestic household investor have been notable buyers in 2020 rally, while the domestic institutions have been net sellers.

In my view the top 10 highlights of the performance of Indian equities in 2020 were as follows:

1.    Though benchmark indices indicate that mid and small cap indices have done materially better than the benchmark Nifty; the market breadth has not been encouraging. Relatively less represented sectors IT and Pharma outperformed strongly, while the most represented financials and energy were massive underperformers.

2.    Market breadth was positive only for 5months, while in seven months market breadth was negative. March 2020 was the worst month and August 2020 was the best month in terms of market breadth.

3.    Indian equities were average performers, in comparison to the global peers. However, it underperformed its emerging market peers notably.

4.    A lot of discussion has taken place around the strong foreign flows into Indian equities. It is however worth noting that foreign investors have invested close to Rs48,000 crores in Indian equities during 2020. But most of this has come as switch from the Indian debt. The net foreign flows to India in 2020 are marginally negative.

5.    The long term Nifty return (5yr CAGR) is now consistent around 11-12% for past five year. Only 2019 was an exception with 8% long term return. This is the longest stretch of consistent returns. This highlights the maturity of Indian markets; and also lesser probability of exceptional gains in near future.

6.    Nifty averaged around 10985 in the year 2020. This is about 4% lower than 2019 average. During previous two crisis periods (2001-2002 and 20008-2009), the fall in yearly average traded value of Nifty lasted for two consecutive years. But the third year saw strong recovery in the average traded value. If the history repeats, the Nifty may average below 10985 in 2021.

7.    The market saw sharp rise in speculative trading activities during the year. The percentage of total shares traded to the shares delivered fell from 20.5% in March to 15.05% in June. However, it has again improved to 19.6% in November.

The net new money invested in equity trades (NSE net pay in) was highest in March 2020 when the market correctly sharply; implying that the first fall bought aggressively. May-June also witnessed higher new money.

The size of average trade increased to Rs32462 in November 2020 from the low of Rs22314 in March 2020; implying that the smaller investors are now less active in the market.

8.    After losing ~30% in 1Q2020; Nifty gained ~20% in 2Q2020; ~9% in 3Q2020 and ~20% in 4Q2020. The gains in last three quarters have come without any correction. Only the month of May2020 has yielded negative return of (-)2.8% since April 2020.

9.    Despite the crises and sharp correction in the market early in the year, the volatility has not spiked like the previous two crisis periods. Consequently, the arbitrage funds have sharply underperformed, yielding less than the liquid fund returns. Gold ETFs outperformed most of the equity fund categories.

10.  The Nifty earnings have seen a spate of upgrades in recent weeks. However, normalized for the base effect of FY21, the growth continues to remain anemic. Most of the appreciation in equity prices therefore could be purely due to PE rerating to factor in lower interest rates. This implies, interest is perhaps the single most critical factor to watch in 2021. Any sign of hike in rates could result in sharp correction in equity prices.