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These Four Stocks Will Drive Nifty Earnings Growth In FY20, Says BofAML

Analysts’ consensus estimate suggests Nifty 50 earnings will grow 24 percent in the next financial year. According to Bank of America Merrill Lynch, bulk of that will be contributed by just four companies.

These are: State Bank of India Ltd., ICICI Bank Ltd., HDFC Bank Ltd. and Reliance Industries Ltd., BofA said in a report. Around 70 percent of the 24 percent growth in earnings per share will come from these four stocks, Sanjay Mookim, BofAML’s India equity strategist, said in an interview with BloombergQuint. “It is very concentrated growth forecast.”

“If those four were to miss, then the Nifty earnings number will be much lower than what people are forecasting today,” he said “So, there is significant risk to earnings.”

Liquidity injection by the Reserve Bank of India through bond purchases and reduction in corporate slippages will aid growth in banks, said Mookim. “Almost everybody has figured out that financial stocks are the only grape in town at the moment based on bottom-up catalysts like lending growth, (gaining) market share from NBFCs and reasonably better valuations.”

Mookim said there was a disparity between earnings growth and valuations of Indian stocks. “P/E differential between the top 10 percentile stocks and bottom 10 percentile continues to rise and it’s at an all-time high in India. Whereas, the difference of forward expected growth for the same stocks is falling,” he said.

This inequality prevented investors from buying stocks that had delivered returns earlier, he said.

Watch the full interview here:

Also read: UBS Says Investors Won’t Make Money on India Stocks in 2019

Below is the edited transcript of the interview

Looking forward, what are you anticipating for Indian equities?

We are concerned that equities might have downside at least in first half of calendar. Volatility will remain high for equities. We had exceptionally low periods of volatility, supported by central bank injecting liquidity all over the world. It is over. Unless banks blink, and start or stop withdrawing liquidity from world markets, this volatility will remain high.

Our concern on valuation of Indian equities remains. The expensive stocks continue to get relatively more expensive, even though they are not delivering better growth relative to rest. That is an environment which is unsustainable, especially now as growth globally is de-rating. India, despite a relatively bad 2018, continues to stand out as a market with high expectations and high multiples. Therefore, we are concerned that there might be some way down or some correction due in market.

What is disparity with regards to growth and price earnings multiples?

We have tried to look at PE differential between the top 10 percentile stocks and bottom 10 percentile stocks. PE inequality of market continues to rise and it is at an all-time high in India. The same phenomena were happening in EM, markets like Indonesia and it has stopped. So, PE inequality expansion in other comparable markets no longer happens. But in India continues to broaden.

The growth inequality, which is difference of forward expected growth in top 10 percentile and bottom 10 percentile stocks, is falling. It is close to multi-year low. Hurdling of people’s investment is happening in stocks that have worked. It is at risk as now there is enough evidence that re-rating of growth globally has stopped. Can India de-couple the way down when it had benefited the way up? I am suspicious that it will happen.

What is the indicator? Does it mean the over inflating valuations of stocks which are not delivering growth? Or bottom 10 percentile is still there but they are not getting valuations that they should be getting?

We have made the argument of premium for stability. We have argued that companies, which have got stable earnings growth have seen expansion of multiples. Even in consumer sector, the company has not delivered stable growth and there is volatility in its earnings which has not benefited from re-rating of multiples. It is across sectors. Industrial companies have delivered stable growth. Paints companies are considered globally as chemical businesses and they get single-digit multiples. Only in India, they get significant premiums. But the characteristics are the same. Whatever business they might be in, if it is delivering stable growth, it has benefited from an expansion of multiples.

The growth levels may differ and therefore end PE will differ. If you are at a low level of growth, you may have 20 times PE. If you are at the high end of growth, you end up with 50 times PE. The two things which are argued is that the confusion around which you are re-rating growth whereas I am trying to suggest that you might be re-rating stability instead. That makes sense because global walls were very low and in low-wall environment stability gets premium and this has happened everywhere. You take a staple company in India and its counterpart in Asia or in developed country, the PE charts for all these companies are the same.

Ever since QE started in U.S., you will not be able to distinguish the PE charts of the Indian staples company from its Indonesian counterpart or global counterpart. So, evidence to my argument is it is not you but something else which has led to re-rating. Whenever you have a dislocation in stability, if you have a company which delivers a disappointing quarter, then it gets penalised on multiples dramatically. So, high P/E expensive companies are on knife’s edge. They need to continue to deliver that growth or else they will be penalised on multiples.

Does the environment support the kind of expectations that everyone has in terms of earnings—the ones that have already been given higher multiples and now need to prove their worth for that higher multiple?

There are two layers. One is, whether these companies can continue with growth. Our argument is that there is more headroom to grow now. Principally, because the one variable which matters to economy i.e. oil price is in favour. There is a very strong correlation between corporate margins all across the country and oil prices. When oil prices fall, margins are supported. So, headroom has gone up. We were worried when oil prices were rising.

We have to be thankful that oil is fine.

The question is will these companies beat the consensus forecast which will have differing answers company by company. It is not necessary that every growing company ends up beating forecast.

What, according to you, are the first three important triggers that kick in for corporates once you see oil prices coming off?

On an aggregate perspective, every $10 move in oil adds up to 0.6 percent on GDP in consumption. Whether that consumption happens at government of India, in corporate balance sheets or at a consumer level, it is an internal distribution affair. You will see the effect and it is very big number. It is undeniable. Second is, you will see the margin support.

Charts show the correlation very well that as oil prices go up, corporate margins fall and visa versa. If companies choose to pass on their savings to customers through lower prices, then you will see volume support too. So, in all these aspects, volumes, margins and aggregate consumption, the lower oil price should support in earnings especially for the consumer facing pack in near-term.

Will it show up in Q3?

In December quarter, we are expecting reasonable numbers from consumer companies. I would expect, if the oil remains where it is, that phenomena will continue in the next one-two quarters.

What you are looking at in terms of relative market target for the index by the end of year? What are your reasons for classifying or putting out those targets?

This is first time that we have called little bit of upside on the index.

We think that Nifty will end up somewhere in 11,300 range by December.

It is caveated from our argument that there are no meaningful downgrades this year which unfortunately may not be the case. Since 2000 to now, Indian equities have always seen earnings downgrade. Other than from 2009—because post GFC we saw surprise rebound—consensus numbers have invariably been cut. Even if they were not, today consensus forecast a 24 percent growth in FY20 over FY19 for Nifty. It is high and it will be an achievement if we will get there. However, 70 percent of that 24 percent comes from four large stocks. It is very concentrated growth forecast. If those four were to miss, then the Nifty EPS number will be much lower than what people are forecasting today. So, there is significant risk to earnings. To get to 11,300 on average multiple only if that number doesn’t get downgraded.

And majority of that four names are from financials. Does it translate to fact that you are optimistic on financials?

Correct. There are bottom-up reasons to like financials. The liquidity injection should provide more ammunition for loan growth. Many of the corporates have resolved whatever management concerns people have on them. The large corporate slippages seem to be over. For two quarters, the addition to gross NPA in India has been negative. In that you have more reversals than slippages. You can get corporate slippage whenever the power plants are finally recognised by these packs. But NPA cycle is mostly a thing of the past. Valuation was relatively supportive. When I did a screen, which is Peter Lynch Growth Screen at reasonable price screen in India and I define reasonable price as any stock which is at and below its own average multiple. It was a very narrow set and only financial used to feature in, little bit of auto, auto ancillaries and so on. In large cap, the financials dominate a garb screen in India. So, combined with bottom up catalysts on the NPA, lending, market share from NPA, plus reasonably okay valuations, almost everybody has figured out that financial is only grape in town at the moment.

NBFC came into play because they started to lend to pockets where these banks could not make their reach felt. What changes things now for them to come back and be able to lend to those sectors which they earlier couldn’t?

It is not a geographical difference. It is not that NBFC were reaching tier-III town in middle of Maharashtra where the banks were not reaching. So, banks need to make a decision: do they want to get into that market place? That is the choice which banks needs to make. If banks don’t make noise, then fine. Then people will go to traditional ways of financing which they had previously. But wherever there was overlap of NBFC on bank, they will recede for the moment. They will have an opportunity to gain some market share from those pockets too.

What forms a contrarian view?

If we just go by the performance of the stocks, then the autos, auto ancillaries have gone down for a very long period of time. People are still wary of the stocks because you don’t see changing of demand in immediate term. The near-term looks weak in terms of volumes. If you get a little bit of confidence that the volume growth is restored, then you get contrarian trade coming back in auto space. We are argued that two-wheelers will not be poorly placed. We are not negative on rural demand. Even if the government does not have massive stimulus before election, we see higher demand. So, we prefer rural things like two-wheelers, tractors.

Will it show up in Q3?

In December quarter, we are expecting reasonable numbers from consumer companies, but I would expect, if the oil remains where it is, that phenomena will continue to next 1-2 quarters.

Is that pocket of interest even from foreign institutions?

By experience, no. There is possibility that it could be, but you need to surprise it with numbers for those companies beat expectations in terms of volumes before you see significant interest comeback.

On the contrary, banks have been left out so far. There are banks which have under-performed poorly for last several months. Even though the financial space may not outperform too much, there may be some banks to perform eventually and catch up under-performance for last three-four quarters.

Do you see FIIs still be cautious on India?

People are looking recovery from lows. You can pick cheaper stocks elsewhere in the region and that is become push back that we have recently started to receive from our clients too. In terms of interest, India is still the overweight market amongst foreign investors.

We have detailed math at Merill Lynch, where we look at individuals looking at a very large set of funds and compare to its own benchmark. It is a detailed analysis. We think that overweight position still stays but it has come off gradually from last several years. Recently, there is evidence of buy coming back in India and China. Though our side it is mostly passive buying.

Now that we see liquidity has moved out of the equation, the caution and risk has come in, you need to see deliverables before that money comes in.

If you take long term of equities, let’s say 1970s, value inevitably beats growth. In total return basis, MSCI value has outperformed MSCI growth. It is only in two extended periods, when the Asian bubble was formed in last 1990s and post GFC, has growth outperformed value for a noticeable period of years. Post GFC, we saw re-rating of post multiples. That has stopped. Since August or September last year, value has outperformed growth simply by not falling as growth is falling globally. In India, the hindrance is there is no convincing value basket. Names which show in value screens are the names which investors don’t like. Therefore, there is still hoarding which was traditionally considered growth stocks in the country but everywhere else is falling. When globally people are not incrementally looking for growth, there is not much to do in India. You come here with long-term promise. We have said that India is the land of compounders. Unless you start with a price which is reasonable then, the interest levels are low.

Have FIIs changed their stance on India?

India rarely de-couples from emerging market direction. From 1990s to now, the only de-coupling was where EM was flat, and India went up was in 2013-14 around the elections. Lot of people, rightly or wrongly, again focusing on election coming in. While we can debate whether it matters to business cycle or it will change the direction of the economy whatever there is government in Delhi.

Second is, central government is diminishing in size. State governments put together are far bigger than central government. They were not 10 years ago. So, economically you can make arguments which don’t matter. But from the market perspective, almost everybody that we are speaking to the election is on top of mind. Because naturally, the uncertainty will increase until the elections happen, people are not aggressively buying in India.

Did it surprise to see the reaction of the market? Post the recent five state elections, we have seen market move up. Also, of RBI governor stepping down. These are big events and tend to weigh on market sentiment. But it looks like we have taken it in our stride.

If on Monday, I could have told you that RBI governor is going to resign on Tuesday and the BJP would lose three states, you would have aggressively shorted the market and you would have lost money. A lot of that depends on what is happening outside the country.

Yes, it is strange. Take demonetisation. You had it in November and December and then you have seen a very big rally after that. But the day India market inflected, 26 Dec. 2016 was the day the global market inflected. India bounced because Indian investors took a view that demonetisation is not going to have such an impact on Indian equities. Then the answer is no. It is the global rally which lasted in 2017.