Epidemic! – This would be a good way to describe the current state of the markets. Since January, the S&P 500 is down 18%, while the Nifty 50 has corrected 8.5%. While there is a strong urge to sell everything and buy only fixed deposits, we would advise you to be tight-lipped and do nothing for your equity portfolio. The villain of this case is inflation. To make matters worse, these changes have happened too quickly, without giving the markets time to adjust smoothly. High inflation is bad for equity markets in two ways – earnings are hit and valuation multiples shrink. While the fears are real, we think the markets are over-reacting for a number of reasons.
Earnings and Valuations
With markets anticipating a moderation in earnings growth, there is mistrust in forecasting earnings per share (EPS) growth of 15% over Bloomberg consensus estimates. However, we broadly agree with these estimates as a large proportion of India’s index companies are resilient to inflation. The heavy-duty sectors in the Nifty 100 index are either not directly affected by inflation, or have the pricing power to pass on the inflationary effect. As part of our research, we have studied the past performance of FMCG stocks. During the period of high inflation from 2009 to 2014, FMCG companies managed margins well, leading to a strong performance against the index. Such flexible companies account for 77% of the index (see table). As such, only 23% of the Nifty 100 companies are exposed to inflation risk.
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The second reason for the correction is a change in the valuation multiple. Higher inflation means a lower price-to-earnings multiplier, which explains the sharp drop in share prices. As per Bloomberg estimates, Nifty 50 earnings are expected to see 15% annual growth in FY22-24. Nifty 50 is trading at around 15.5 times its FY24 estimated earnings. Assuming that market levels remain unchanged, and projected EPS is achieved, this would be 15.5X trailing-twelve-month (TTM) valuation in March ’24. When we look at the average TTM valuation over the last 15 years, it has become 20 times. If the valuation metric falls back to the average value of the 20X TTM, investors entering now stand to earn approximately 14% annualized returns over the next two years. It is at the index level; Better stock picking can potentially give higher returns.
what is watching
Investors should keep a few fundamentals in mind. The industrial sector is returning to good health. The real estate cycle has just started again, the capital expenditure cycle is also just beginning. Textiles and telecommunications have also become active again. Mining and defense are two industries whose contribution to corporate income is set to increase substantially. All these industries will provide better earnings growth than in the past, which should lead to valuation upgrades. The ‘China Plus One’ dynamic will continue for many years, increasing the income of companies that replace Chinese exports with Indian exports. The global super power rivalry is indeed beneficial to India, with many sensitive technology production potentially shifting from China to India. There are early signs of cooperation among the Quad countries for chip making, an important industry on India’s strategic wish-list. All this should boost Indian corporate earnings growth, which will lead to better equity market outcomes. With China taking a favorable market action, the Indian equity market looks relatively more attractive. This should be implemented in the coming quarters as inflation and war worries gradually go away. Once this happens, the flow of FIIs will resume.
From the Indian market perspective, we see this decline as a bull market correction. Our advice is to stay invested.
Anil Sarin is the CIO at Centrum PMS. The views expressed here are for informational purposes only.