Stocks could yield healthy returns over 3 years if earnings growth revives

Those who have become heavily overweight on equities should do some profit booking. But cashing out altogether will be a mistake

The Nifty 50 index touched the 13,000 level this week. Since its March 23 low, this benchmark is up 70.7 per cent. After such a steep run-up, many investors are worried today that a correction could take away the gains they have made in the markets so far this year.

High global liquidity

A few fundamental factors are responsible for the sharp turnaround in the equity markets. Central banks across the world have kept interest rates low and liquidity levels high. This has supported the growth outlook for companies and sectors and helped sustain equity valuations.

Foreign institutional investor (FII) flows into Indian equities have been strong. They have invested Rs 58,710 crore into Indian equities in November so far. Emerging markets (EMs) have been significant underperformers vis-à-vis developed markets (like the US) over the past 7-10 years, due to the local issues they have faced. Now there is a belief this trend could reverse over the medium-term. A weakening dollar tends to support EM flows. India is expected to benefit from these flows.

Rebound in earnings

Corporate results in Q2FY21 were better than anticipated. “Listed companies have coped better with the crisis than was expected and have reported higher bottom-line numbers than anticipated,” says Sailesh Raj Bhan, deputy chief investment officer (CIO)-equity investments, Nippon India Mutual Fund.

Based on management commentary, the earnings rebound may sustain for a couple more quarters. For next year, it remains to be seen how strong it will be. The weak base effect will help from the April-June quarter. The pace and strength of earnings recovery will depend on a variety of factors, including interest rates, whether there is another big wave of Covid, and so on.

One key factor that drove the improvement in earnings in Q2 was cost savings. About 50-70 per cent of this could be temporary. For instance, consumer companies have cut down sharply on advertising, sales promotion, discounts to retailers, etc. Due to supply disruptions, the bigger players are able to sell what they are producing and hence don’t need to offer these. But they may have to restore these spendings after a couple of quarters as things normalise and supply chains get restored.

Positive news flow on vaccines

Prior to November, there was no expectation that vaccines would become available anytime soon. But now there is data to show that some players have been able to meet the efficacy thresholds. Regulators are willing to give emergency authorisation and players are going in for advance production (even before the approval comes in). Emergency authorisation could come in by December-end. Supply for the most vulnerable segments of the population could start around February, and within two-three months after that for the rest of the population. The expectation that a vaccine may become available earlier than previously expected has fuelled optimism among market participants.

Another Covid wave is the biggest risk

Today the market does not expect inflation to go up. While there is some inflation in India, it is low across the world because of depressed commodity prices and weak demand. Inflation in India is more the result of supply-side issues. Nonetheless, in the unlikely scenario that inflation comes back more strongly than expected, central banks in India and abroad will be forced to increase rates. This could affect equity-market valuations adversely.  

A second uncontrollable wave of Covid could also result in localised lockdowns, which would delay the recovery in economic activity.

Finally, the loss of jobs has been widespread. It remains to be seen how fast consumption spending picks up again. It will not unless people have faith in their economic prospects.

Valuations: Up but not exorbitant

Valuations have moved up owing to the run-up in the market. In select pockets, which have rallied substantially, stocks are trading at a premium. But many segments of the market remain ignored, especially those driven by domestic demand. These sectors still have the scope to do reasonably well.

Also, if earnings revive, valuations may not appear as exorbitant as they are currently.

Sectors investors should focus on

Bhan says he is positive on sectors driven by domestic demand, like steel, cement, metals, and select parts of the pharma sector. These segments of the market are witnessing a turnaround and are still available at attractive valuations. With growth expectations normalising, capex spending may revive, aiding the growth of many of these sectors.  

The government's Make in India initiative, and its efforts to make India an alternative to China in the global supply chains, could also benefit several sectors like engineering, capital goods, pharmaceuticals, chemicals, and electronics.

Do partial profit booking

Equity investors have to contend with the TINA (there is no alternative) factor today. With interest rates declining, returns from debt instruments have come down. Gold has already seen a large run-up. So, even if you book profits in equities, you may not find too many alternatives for parking money.  

If you have become heavily overweight on equities, you may reallocate part of your equity investments to other asset classes. But otherwise stay invested in equities. “Earnings could surprise positively over the next three-four years owing to the low base, especially if interest rates remain low,” says Bhan.

While the opportunities to invest may not be as attractive today as they were when the markets were at the 8,000-10,000 level, many pockets remain attractively valued. Instead of worrying about the valuations of major indices, focus on identifying market segments that are expected to outperform over the next three years and try to ride stocks belonging to them.

Themes mutual fund investors should focus on

According to S Naren, executive director and chief investment officer, ICICI Prudential Mutual Fund, mutual fund investors can negotiate these markets effectively by focusing on a few themes and fund types: value, special situations, and dynamically managed asset allocation schemes.    

Naren says the divergence between value and growth stocks continues to prevail. “Barring a handful of growth stocks, markets have broadly underperformed. This makes value as a theme attractive relative to growth,” he says. According to him, fundamentally sound value stocks are available at inexpensive valuations. They are providing good dividend yield and have better earnings visibility.

Furthermore, the US dollar may depreciate further due to ample liquidity. Going by historic trends, emerging markets tend to do well when the US dollar depreciates. And historically, the value theme has performed in tandem with emerging markets.

Naren is also bullish on the special situations theme. The pandemic, according to him, has thrown up special situations across multiple sectors. “Many companies have been affected by short-term disruptions but offer value from a long-term perspective,” he says.

The markets are expected to remain volatile as the world comes to terms with the Covid-19 situation and its economic fallout. Hence, Naren recommends dynamic asset allocation schemes which stand to gain from market volatility.