Markets nudge higher but fund managers have task cut out in assessing firms

'Disconnect between market and macro reality' makes all estimates about companies a risky business, say analysts.

Equity fund managers may have less to cheer even though Indian equities have staged a sharp comeback since their March lows. Market polarisation, uncertainty created by the pandemic, and a liquidity-driven rally have made their task of managing money more difficult.

Analysts and fund managers seem to have discounted the FY21 earnings entirely, and are betting on stocks based on the projected FY22 and FY23 numbers.

Consensus estimates peg the Nifty’s earnings per share (EPS) growth at 10 per cent and 39 per cent for FY21 and FY22, respectively, according to Credit Suisse Wealth Management, India. Local lockdowns, a surge in Covid-19 cases, and limited fiscal support could, however, pose significant downside risks.

“There’s a bit of disconnect between the market and macro reality. The former is driven by excess liquidity, and hopes of economic activity returning to normal along with a Robinhood effect in the form of huge retail participation,” says Navneet Munot, CIO of SBI Mutual Fund.

Getting a handle on earnings estimates will be a challenge. Price-to-earnings (P/E) multiples for FY21 have become almost irrelevant, given the dislocation of profits expected in several sectors.

“We are getting a better sense of how firms are managing their supply chain, logistics feed, and where the demand is coming from. Consumption in rural India, for instance, has been relatively less affected. But a clearer picture of the economy may emerge only in the December quarter,” says Jinesh Gopani, head (equity), Axis Mutual Fund.

Some managers say companies should be assessed on a normalised basis by considering their earnings 2-3 years from now. “Taking FY19 as the base, one could arrive at a normal growth trajectory for a particular sector over the next 3-4 years. Based on that, project the earnings for FY22-23 and value the firm on that basis. Also look at the price-to-book value and see where it is compared to historical averages,” says Mahesh Patil, co-CIO of Aditya Birla Sun Life MF.

Indeed, metrics such as price/book-value, market cap-to-GDP, and solvency ratios have gained relevance.

Market observers say companies with high debt and/or leverage may not be able to withstand the pressure on profitability and balance sheet. Those with a strong balance sheet, enough liquidity, robust risk management capabilities, focus on innovation, and healthy relationships with stakeholders will emerge winners.

“It’s not market capitalisation or size of physical assets that will determine resilience but how nimble and agile the management is,” says Munot, adding that the pandemic has necessitated tracking of high frequency data, as well as search, social media and mobility trends.

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Feroze Azeez, deputy CEO of Anand Rathi Private Wealth Management, says analysing Altman Z-scores could be a better way to predict impending defaults and bankruptcies, instead of credit ratings.

Another way to gauge resilience is to monitor the historical trend -- as far back as 10, 15, or 20 years -- to assess how firms have fared during different business cycles, past recessions, political uncertainties, and black swan events, according to Siddhartha Rastogi, COO and head (sales) at Ambit Asset Management.

Historical data, however, may not be relevant for sectors or businesses that will see a new normal because of the pandemic.

Taking cash calls won’t be easy. Setting aside 5-10 per cent of cash would be prudent given the limited upside for markets. Large cash calls could, however, backfire if the liquidity-driven rally continues.

 

Aditya Birla Sun Life MF, for instance, has decreased equity exposure in asset allocation funds to about 65 per cent from 75 per cent before the pandemic. Munot says SBI MF does not take large cash calls in equity funds, where the focus continues to be bottom-up stock picking. The fund, however, may take tactical calls to hold more cash in hybrid and asset allocation funds.

While valuations are not cheap like in March or April, fund managers insist there are enough opportunities for stock picking. “Selection was much easier 2-3 months back; we have to be more discerning now,” says Patil. "But we don't mind holding on to companies with a clear visibility of recovery and steady growth in the coming years, even if they are slightly expensive.”

Large cap funds or strategies, however, may find it difficult to beat the benchmarks given the polarization and years of weak earnings growth. Experts say investors should temper their returns expectations given the sharp run-up since May and spread out their investments to tide over market volatility.

Gopani does not rule out a 5, 10 or 15 per cent correction if the pandemic prolongs and economic recovery stalls. Patil says the market is still trading at 8-10 per cent below its long term averages on a P/B multiple. Which is why he is optimistic that investors can earn higher than the average long-term returns in equities over the next three years.