Leading brokerage house Kotak Securities expects the total earnings of the Nifty 50 companies to grow 10% in FY20, and 27% in FY21. “Much of FY21 earnings growth of the Nifty 50 hinges on the profit growth of banks,” says Rusmik Oza, senior vice president and head of fundamental research, Kotak Securities, in an interview with Fortune India. However, considering the earnings mix and slowdown in many sectors, “we do not rule out the possibility of FY21 earnings getting cut in future,” Oza adds. He believes the ‘disconnect’ between equity markets and the economy may continue until the Union Budget in February. Edited excerpts:

Nominal growth has slowed to a record low of 6.1% and the outlook for consumer spending, credit supply, risk appetite remains subdued. Do you see the possibility of an earnings cut in FY21?
We are estimating earnings of the Nifty 50 to grow 10% in FY20 and 27% in FY21. The earnings growth in FY20 will be led by banks, consumer staples, diversified financials/non-banking financial companies (NBFCs), and Reliance Industries. And in FY21, it will be led by banks, metals & mining, automobiles and Reliance Industries. Much of FY21 earnings growth hinges on the profit growth of banks. The lower base of FY20 for many old economy sectors could lead to higher growth in FY21. On the contrary, many full taxpaying companies will see a jump in FY20 profits, which will prove to be a hindrance for FY21 earnings growth. Considering the earnings mix and acknowledging the slowdown in many sectors we do not rule out the possibility of FY21 earnings getting cut in future.

Consumer spending has nearly halved to 5.1% and investment is down to 1% from 11.8% last year. In fact, manufacturing has contracted by 1% in the September quarter against 6.9% expansion a year ago. How deep is the slump and when do you expect the economy to turn the corner?
Our thesis is that the current slowdown is more structural in nature than cyclical as visible from lead indicators and the degree of slowdown. Even as part of the banking and corporate sectors’ balance sheets have seen some improvement, the potential threat of a higher fiscal deficit indicates the deterioration in government finances. Pushing growth under these circumstances will be difficult and hence the possibility of a sharp growth recovery, beyond base effects, may be difficult. We expect GDP growth in FY20 to be 4.7%, and on this favourable base we expect GDP growth in FY21 to move up to 5.5%. Few cyclical tailwinds will aid growth but the structural impediments will keep growth weak in FY21. Cyclically, consumption growth numbers will likely revive in FY21 due to lower base, better rabi output and small-ticket items seeing some buoyancy. Investment growth is unlikely to pick up soon. Going by this year’s monthly lead indicators and quarterly GDP numbers we can expect improved numbers from the first quarter of FY21.

Given the underlying weakness in the economy, what is lifting the market to scale record highs? How long can this momentum continue?
Market mood is more positive than what is reflected in the real economy, mainly due to jump in earnings, led by a reduction in corporate tax rate and strong FPI flows supported by steady local SIP flows. Developed markets have performed exceptionally well in this calendar year with returns in the range of 20-25%. The Nifty 50 return in this calendar year to date has been 11%, which is even lower than other emerging markets. The disconnect between equity markets and economy could continue until the Union Budget and take future shape based on the outcome of the Budget. On valuations, the Nifty 50 forward price-to-earnings (P/E) ratio is trading closer to its previous peaks of ~19x leaving a very little scope of any further re-rating. Within the Nifty-50 a handful of leading stocks have seen huge outperformance in this calendar year, taking valuations closer to the previous peak. If one excludes these handfuls of stocks, then most of the other stocks are trading at or below their 10-year average valuations. We expect the Nifty-50 to still deliver double-digit returns in CY20, on the back of strong earnings growth and rotation in stock performance.

What potential upside do you see for the S&P BSE Sensex and Nifty 50 from the current levels in the next year?
Our one-year target of the Nifty 50 and the Sensex is 13,400 and 45,500, respectively. This works to an upside of 11% from current levels. The 10-year average forward P/E of the Nifty 50 works to 15.5x. We have used a benchmark of 17.5x forward P/E, which is one standard deviation above the 10-year average to derive at our one-year Nifty target. The current Bond P/E stands at 14.7x and the 10-year average premium of equity P/E over bond P/E has been 260 bps. Hence a 17-18x forward P/E benchmark for equities is justified. The annualised inflows by way of SIPs is now closer to $14 billion, which seems to be quite sticky in nature. Keeping all these factors in mind like earnings growth, flows and valuation benchmark we derive at our one-year target for the Nifty 50 and the Sensex.

From the 2008-2009 cycle, we know good opportunity can be found in the backdrop of economic gloom. Currently where do you see attractive opportunities in terms of valuation?
In the current slowdown, we have seen most old economy sectors witnessing erosion in market cap. At the same time, most of the high-growth sectors and defensives like consumer staples and consumer durables have seen good accretion in market cap. In terms of valuations, we see most consumer stocks trading at price to perfection levels. Even though most of the consumer companies have seen a steep slowdown in volume growth, they continue to be a safe harbour for large FPIs and fund managers. They may continue to trade at rich valuations till the time we don’t see a broad recovery in the economy. We see attractive valuations in sectors like capital goods, utilities, oil & gas, construction, healthcare, metals & mining, and auto ancillaries. Certain sectors like automobiles and cement are beaten down but they are still expensive in terms of valuations.

Share prices of some auto companies are down nearly 50%. Is there a buying opportunity?
Within auto, we think recovery could first come in the two-wheelers [segment] followed by passenger vehicles. Recovery in commercial vehicles could take some time due to the economy slowdown and idle inventory of trucks in the system. Another two quarters could see disruptive sales volume trend due to the shift from Euro IV to Euro VI emission norms. The third quarter of FY20 could still see muted sales growth but the fourth quarter could see higher sales due to pre-buying by potential buyers. From earnings growth and valuations perspective, we are more bullish on Mahindra & Mahindra (M&M) and Tata Motors. We are negative on Maruti even though earnings growth could be ~25% in FY20 and FY21E, because RoE, which was at 25%, is likely to hover at around 15% in the next two years. In the backdrop of lower RoEs, Maruti trades richly at 25x on Sep’21E, even after factoring 25% growth in earnings for the next two years (i.e. FY20-22E). We see buying opportunity in select auto ancillary companies that have a presence in non-engine-related businesses.

After many quarters telecom companies have raised tariffs. Will this have a meaningful impact on the debt-laden balance sheets? Should investors increase exposure to telecom?
The recent developments in the Indian wireless space offer the promise of strong multi-year Ebitda growth phase driving return to healthy return ratios. We expect strong earnings jump in earnings of Bharti Airtel and Reliance Jio in the next two years, led by 24-28% revision in Ebitda forecasts. For players like Vodafone Idea, if Ebitida has to meet its cash outflow obligations, then it needs ARPU of ~Rs 200. Bharti Airtel offers a good margin of safety in most plausible outcomes. We expect Bharti Airtel to report free cash flows in FY21 and FY22E after reporting negative free cash flows in FY19 and FY20E. Investors can look to increase exposure in Bharti Airtel at current price and every decline. Investors can also look to accumulate Reliance Industries, as there is a steep upward revision in the value ascribed to the Jio business.

What’s your outlook for the information technology (IT) sector in the backdrop of a strong dollar and global uncertainties?
The outlook of the IT sector is a function of outlook on global financial services, U.S. retail vertical, large deal wins and digital deals. We expect earnings of the big five players in the sector to report muted earnings growth of ~6% in FY20, which is likely to improve to ~10-12% in the next two years. We factor in average depreciation of ~2.1% for the rupee against the dollar in FY21E, with the rupee likely to be in a range of 70-73 (average of 72.1) against the dollar in CY20. The sector seems fairly valued at 17x FY21E, considering the high RoEs of ~25% and likely double-digit earnings growth potential. Within the larger names, we see Infosys, Tech Mahindra, and HCL Tech offering growth at reasonably attractive valuations.

While several banks beat Street estimates in the second quarter, NBFCs continue to be a soft spot. Liquidity concerns have not eased and most economists expect the economic slump to deepen in the coming months. Where do you see pockets of value in the BFSI sector?
Within the BFSI space, we are more bullish on the corporate-led banks and larger NBFCs with strong parentage. In the case of corporate-led banks, expect earnings to go up in multiples between FY19 and FY22E, led by loan recoveries and decline in slippage ratio. Return on equity of corporate-led banks, which had collapsed in the last three years, is expected to move up to 15-16% in the next two years. Strong earnings growth and better RoEs could lead to re-rating in corporate-led banks. We like State Bank of India (SBI) and ICICI Bank in the corporate bank space. We also like some of the old private banks like Federal Bank, Karur Vysya Bank, and DCB Bank, as valuations range between 1x and 1.7x book value for potential RoEs of 13-15%. Post the NBFC liquidity crisis, larger NBFCs and housing finance companies with strong parentage are expected to garner higher market share. Valuations of larger housing finance companies are way below their 10-year averages. We like HDFC and LIC Housing Finance in the NBFC space.

Managements of leading FMCG companies have been fairly cautious in their outlook for demand in the coming months. Do you expect a sharp dip in earnings going forward?
The volume growth of most FMCG companies has come down to mid-single-digit. At the same time, they have got the benefit of softer raw material cost, thereby maintaining Ebitda margins. On the earnings side, most FMCG companies were paying full tax rates. Hence most of them will see a good jump in FY20 earnings on account of the cut in corporate tax rates. We expect our universe of 15 FMCG companies to report earnings growth of ~20% in FY20. Going forward, we expect earnings CAGR to slightly moderate to ~15% between FY21 and FY22E. In case demand does not recover, then there could earnings disappointment for a few FMCG companies who will have a higher base in FY20 due to a reduction in the tax rate.

In the face of current economic challenges and volatility, what’s the ideal portfolio mix of large-, medium- and small-cap stocks for an average investor?
For an average investor, it is ideal to have a mix of 50:25:25 in large-caps, mid-caps, and small-caps, respectively. On valuations the Nifty 50 is trading closer to its previous peak valuations, hence upside could be in the 10-11% range in this Index. One needs to be selective even in the large-caps and go for stocks whose earnings are likely to improve in FY21 and FY22, and valuations are below the 10-year average. Mid-caps are reasonably valued in relation to large-caps but one needs to be bottom-up in this segment. We find huge value and upside in the small-caps as the Nifty Smallcap Index is trading at the lower end of its underperformance with the Nifty 50 since its inception in 2004. In the past 16 years, this is the fourth time the Nifty Smallcap Index underperformance has come closer to its lower end.

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