What the Future Holds
Earnings recovery is still uncertain, but good investment opportunities can always be found in buoyant markets
The Nifty has traversed a full circle in two years – from approximately 9,000 in March 2015 to back to 9,000-plus. In April, the first month of financial year (FY) 2018, the markets retained the momentum built in FY17. Valuations for the Nifty, based on both one-year forward earnings and trailing earnings, are rich. But the underlying near-term operating backdrop for India Inc. remains hazy. There are no visible signs of an immediate recovery in earnings although the fourth quarter performance of FY17 may be boosted by the depressed base for some cyclicals.
FY17 started with hopes of an earnings recovery, backed by expectations of good monsoon, the seventh Pay Commission awards and macro buoyancy. However, continued weakness in private capex cycle, absence of broader consumption pick-up and sluggish asset quality trends in financials played spoilsport. Additionally, events such as demonetisation changed the setting mid-way, leading to flattish earnings. But the Nifty gained an impressive 19 per cent in FY17 to end at a record high of 9,174. The benchmark delivered three quarters of positive returns in FY17, with the March quarter delivering the highest quarter-on-quarter returns since June 2014. The result: We stand at a great divide now – buoyant markets but stagnant earnings.
The Nifty’s earnings performance has been flat over the past three years. Between FY15 and FY17, earnings were impacted by several factors, including asset quality review of banks, correction in commodity prices, slowdown in discretionary consumption and demonetisation. The earnings composition has also changed. The share of public sector banks has declined from 8 per cent to 2.9 per cent while the shares of oil and gas, technology and healthcare have increased. Our research team estimates 21 per cent earnings CAGR over the next three years, aided by a low base in the second half of FY17 and recovery in metals, public sector banks, and oil and gas.
After reaching 9,000 in March 2015, the Nifty could not sustain the momentum in FY16 due to absence of earnings growth and several macro as well as sector-specific headwinds. Back to 9,000-plus in March 2017 after a sharp 15 per cent rally, the markets have largely shrugged the impact of demonetisation.
Also, the macro backdrop is conducive now – inflation is under control; twin deficits are within tolerance limits; the government is sticking to the fiscal consolidation path and currency is stable.
Even then, valuations at about 18x FY18E earnings on a projected 23 per cent earnings growth do not leave much room for error. Delivery of projected earnings growth is crucial for valuations to sustain and expand. While FY18 will benefit from a low base in the second half of FY17 (demonetisation impact), there are two near-term earnings headwinds. First, inflation in commodity prices, which may erode margins for B2C sectors. Second, GST implementation, which may impact earnings for a quarter or two (due to inventory adjustment in trade and implementation hurdles). The pace, frequency and magnitude of policy changes are precluding earnings predictability.
So, how will the great divide be bridged? Will earnings recover or will there be a tempering of valuation multiples? From a long-term investor’s perspective, I believe pursuing these answers will be far less rewarding than identifying stocks to invest in despite the fluid environment. Good investment opportunities can be found at any time, in any situation. I would rather invest my time in identifying such opportunities.
THE PACE AND MAGNITUDE OF POLICY CHANGES ARE PRECLUDING EARNINGS PREDICTABILITY