Against inflation, equity valuations may hurt

Fast-moving consumer goods, paints, consumer durables and cement are some examples of sectors where companies saw severe gross and operating margin reduction in September quarter earnings, driven by strong volumes on a gradual recovery in demand.

The jury is still out on whether this rapid inflation is transient or not, but forms are passing the burden of increased costs on to customers to prevent further erosion of margins. However, while raising prices, companies are careful not to turn away potential customers and damage the nascent demand flow. Companies are trying to save margins, which is giving relief to investors in these sectors. Also, this risk is not unique to Indian firms. Analysts at fund-flow tracker EPFR Global reported that four out of five US firms reported third-quarter earnings that exceeded consensus expectations. However, three out of five US businesses reported that they raised prices in the past 90 days as headline inflation hit a 31-year high of 6.2% in October, according to the latest EPFR report.

Nevertheless, global equity investors are yet to fully understand the inflation threat on their portfolios. Lance Roberts, Chief Portfolio Strategist, US-based RIA Advisors has advised equity investors to be prepared for a correction. “It is probably unwise to ignore inflation risk. Past spikes in inflation tend to combine with weak economic growth, contraction of the stock market, or crashes,” he said in a note to clients on November 13. “However, for the time being, correction is the furthest thing from investors’ minds. So, while price inflation may be a problem, there is inflation in the recent ‘irrational enthusiasm’,” Roberts said.

In Indian equities, the downside risk arising from input cost inflation is more pronounced, given the sharp rally and rich valuations. According to data from Bloomberg, the MSCI India Index has risen 46% over the past year, comfortably outperforming MSCI Asia-Ex Japan’s 6% return. The former is trading at 22x the one-year forward price-to-earnings multiple while the latter is trading at 14x. The valuation gap between India and its emerging market (EM) peers has narrowed, but India remains a costly bet among Asian markets.

Analysts at overseas research house CLSA Ltd say that despite offering similar market profitability, investors are paying more than double the book multiple for Indian properties as compared to the rest of the EM group. Corporate earnings estimates still have to be revised significantly, adding to the trouble on valuations. “In most sectors, valuations trade at a premium to the average of the last 10 years. The earnings upgrade is missing due to concerns over the inflationary environment impacting margins for the year. Analysts at IDBI Capital Pvt Ltd in a recent report said, “Projecting Nifty-50 EPS for FY22E/23E year-on-year (YoY) at 43%/7%. ” EPS is short for earnings per share.

Therefore, according to CLSA, the biggest reason for profit-booking on India is the rise in inflation. “High energy costs, extreme margins, and stimulus withdrawal have been at the top of our list of concerns. For at least the past two decades, high energy prices have been closely associated with phases of underperforming Indian equities. are back in such an episode of energy pricing for the first time since the CLSA’s November 12 report.

While companies are raising prices to fight inflation, management comments suggest some of them expect margin pressure to persist for a few more quarters. “Prudential price hikes and efficiencies did not help offset the full impact of input cost inflation, resulting in a decline in gross margin in 2QFY22. As a result, coverage EBITDA margins saw a reduction of 210 basis points (FMCG -90bps, paint -910bps, and quick service restaurants -70bps), about 60bps lower than what we were building,” analysts at Nirmal Bang Securities Ltd. Said report good.