Earnings Growth Will Propel Nifty To 10,000 In FY18, Says CLSA’s Mahesh Nandurkar
Nandurkar expects at least 13-15 percent earnings growth in FY18.
Brokerage house CLSA has pegged its Nifty target for financial year 2017-18 at 10,000. And its India strategist Mahesh Nandurkar is betting on earnings growth to propel the index to that level.
He expects at least 13-15 percent earnings growth in FY18, Nandurkar said on BloombergQuint’s weekly series Thank God It’s Friday.
Here are edited excerpts from that conversation.
Earnings Driver
CLSA’s Nifty target for March 2018 stands at 10,000. What are the triggers that will get us there?
Over the last couple of years, what we have seen is that corporate earnings growth has generally been weak. We have barely seen single-digit earnings growth in financial years 2016-17 and 2015-16 and there are reasons as to why that happened. But we believe in FY18, earnings growth will be much better. We are expecting at least 13-15 percent earnings growth. So I take the point that the valuations are at a premium but I think earnings growth will be the key driver. That should be able to drive 10-percent plus returns over the next 12 months.
The Valuation Picture
How do you value the index stocks and the relatively smaller stocks in the mid-cap space. Based on your earnings expectations, where would you place your bets for the coming year?
If we look at the overall Nifty, valuations at the index level we are probably at 17.5 times 1-year forward earnings. Which roughly puts us 10-15 percent higher than what the last 10 years average has been in the large-cap index Nifty. Even if you look at some of the mid-cap and small-cap names most of these companies are trading well above their historical averages. In fact, if you look at the long-term analysis we usually find that mid- and small-cap stocks, on an average, usually trade at 15-20 percent discount to the large caps. That discount doesn’t exist anymore. Not only do we have large caps trading at above-average levels, mid caps are trading in line with large caps. To that extent, one can easily argue that valuations in the mid-cap space are much more expensive relative to history than the large-cap space.
I would not make the judgement just on the basis of where current valuations are vis-a-vis history because then there are other factors as well. One big factor that you have to keep in mind when you talk about price-to-equity multiple analysis is where we are in terms of the corporate earnings cycle, in terms of the overall profitability. Currently the average corporate ROEs are not that high; we are in the 15-16 percent range which is well below their historical averages. If you look at these numbers in a slightly different way, say corporate profits as a share of GDP, something that a lot of people track in the develop markets, which I haven’t seen a lot of people talk about here in India, but that is also an important indicator. In India when we look at the corporate profit as a share of GDP, we are close to an all-time low.
While PE multiples are on the higher side, corporate profitability is on the lower side. That’s why I believe, over the next few years, earnings growth will be significantly better, which justifies current valuations.
Monsoon Themes
Based on initial estimates from Skymet and IMD, we have an expectation of normal monsoon for the second year in a row. What are the best monsoon-related investment themes, according to you?
It is a very important factor. Not only do we have a second consecutive year of normal monsoon, most likely, but also if you look at the strategies and the target of the government, both at the central and state levels, the focus is more towards the social sector and rural development such as social housing, irrigation, rural roads etc. I think it is a combination of the both, the government trying to increase its spend on the rural side at the bottom-end of the pyramid, and also the second consecutive year of normal monsoon. This will aid rural wage growth. For the last two years we have seen rural wage growth in the 5-6 percent range. That should move higher.
Consumption sectors such as staples, consumer discretionary such as auto, media, branded apparel, the building material segment not only derive demand from rising rural incomes but fit in nicely with the social housing scheme which the government is clearly focusing on.
So I would be focus on the social housing scheme which would be at the intersection of both rural incomes as well as what the government is trying to achieve. Stocks such as housing finance companies, building material companies would be the ones to look at. The staples, while it looks as an obvious beneficiary, at some point valuations will begin to be a constraint for some of these names. I would play it through autos and media and some of the names that I have mentioned.
‘Betting On Housing Finance Companies’
Will housing finance companies see further expansion in their multiples or stock prices given the government’s continued thrust on affordable housing? What’s a better way to play the affordable housing scheme – housing finance or real estate?
The housing finance sector is nicely poised at this point. There are two factors which will help the housing market going forward. One is government support for the affordable housing scheme and the fact that they are offering housing loan subsidies, explicit cash subsidies for houses in the rural and urban areas etc. Secondly, the affordability in itself – over the last 4-5 years, property prices have not really gone anywhere; they have been more or less stable or moved up in single digits over the last 4-5 years. At the same time the per capita income grown almost 8-9 percent over the last 5-6 years which has been the trend in India for the last several years. Plus we have seen mortgage rates have come down from the peak by almost 200 basis points and plus this housing loan subsidy etc.
If you look at the affordability chart, a typical household would look at buying houses in the price range of Rs 20-50 lakh – I would call that an affordable segment – that affordability ratio today is probably at the best levels that we have seen in the last two decades. So the combination of affordability and government support is an ideal combination for the housing market to start reviving.
At this point, is the housing market is booming? The answer is no. Because we are recovering from demonetisation and so on. So it’s going to take some time. But if we take a 3-5 year view, I think this is one segment that will benefit a lot and what better way to play that other than that housing finance companies.
Real Estate Vs Housing Finance Companies
The real estate sector which was considered to be the worst hit by demonetisation has been outperforming. Reports suggest companies are looking to unlock value from their commercial assets. Are you looking at stocks in this sector right now?
I will not comment on specific stocks. The real estate development space, in general, has seen several years of subdued stock prices and the fundamental performance has not been great either. The housing finance and the building materials segments are better ways to play a revival in the housing market, if it were to come through over the next 3-5 years. If you look at the listed space, the number of companies operating in the affordable segment are not that many or the proportion of income that comes from that segment is not that high. Most listed companies are targeting the premium and luxury segments which will take longer to recover. So there will be some select companies, but as a category, I would still prefer the housing finance and building material companies.
‘Prefer Private Sector Banks’
Is the worst not over yet for the banking sector and the balance sheet clean-up? Could we be headed for an earnings shock, especially with respect to PSU banks?
AQR2 (asset quality review 2) was a bit of a surprise. Having said that, I would say that the NPA cycle is close to peaking. Currently we have 11.5 percent of the total outstanding credit which is classified as non-performing loans (NPLs). That number may go up by a few percentage points. I don’t think we are in for anything even remotely close to an AQR kind of shock that we saw a year ago. I would say that AQR in itself was not really a shock because the market has already anticipated that the actual asset quality is not as good as it is made out to be and investors are already factoring in the incremental level of NPLs.
PSU banks will still be more vulnerable if this actually doesn’t turn out to be the case and is worse than anticipated. So a much better way to play the banking sector is still through the private sector banks. Within the private sector banks, we have the retail-oriented banks and the corporate-oriented banks. In times to come, as NPLs come under more pressure, corporate-oriented banks might get some relief. Some of the smaller private sector banks where we still see enough growth opportunities - the credit growth might be struggling in 5-10 percent kind of range - but some of the smaller private sector banks will still continue to grow in the range of 15-20 percent easily.
We are working in an environment where, of the total outstanding credit, the private sector has only 25 percent market share and the government-owned banks have 75 percent. So there is still a lot of room for the private sector to grow and gain market share and now that we look at an AQR2 kind of situation, some of the smaller government-owned banks will struggle to grow in line with the industry because they don’t have enough capital.
Sectors To Avoid
Anything you would absolutely avoid right now?
There are two types of stocks, one which is doing well - the fundamentals are good, growth is reasonable, and then there is appropriately higher valuation as well - and the other is stocks or sectors which haven’t done well that includes IT, pharma, industrials, real estate. Although real estate has moved up a little up over a last few months. You have valuation comfort on the second side. Within that, IT looks bit more promising because there is lot of pessimism around that space.
We remain underweight on healthcare. There will be select companies where things will look up, but by and large, I would keep an underweight on sector. From a 3-5 year view, I would be a little-cautious on staples as well. This is because over the next 3-5 years, I’m expecting a kind of a trend reversal. In the last 5 years we’ve seen the capex cycle, the property cycle generally being weak. I believe things will reverse and you will see better infrastructure spending, better capex spending. So some of these sectors will look better over the next 3-5 year period. And at the same time, there’s something like staples – which was used by investors as a place to hide – the money will start to flow out of these sectors into some other sectors over the next 3-5 year period. I’m not saying it’s going to happen tomorrow or in the next 3 months or so but if one takes a longer-term view, then even staples also look on the more expensive side where returns will be subdued.
Interest In Financial Services?
Do you see some play in the financial services companies especially given the increased traction that we’re seeing in terms of retail inflows into equities?
It surely will. Indian households are slowly shifting away from savings in physical assets to financial assets - in the form of equities, insurance products etc. And that’s an encouraging trend. It’s also good for the economy because if you lock up a large part of your savings in some land parcel somewhere or even in gold for that matter, it doesn’t really help the economy. If it’s gold, then money is actually going out of the country, if it’s a land parcel, it’s just dead money which doesn’t create any jobs. So the fact that money is coming into financial markets is a welcome thing from the overall economic perspective. And what is driving that is also the government’s focus on inflation. After a very long time, financial assets are giving real returns adjusted for inflation which wasn’t really the case in the late 2000s or the earlier part of this decade. The focus on inflation is really a key in that aspect.
So long as inflation remains under control and so long as investors get real returns from financial savings, the money will continue to flow in. Whether it comes in the form of equities, debt, corporate bond, whatever it is – it’s all good.
We now have a reasonably growing financial services sector in India. There are some financial services conglomerates, the local/domestic financial conglomerates. They are well-positioned to tap into growth opportunities that this trend might throw up. Today it could be housing finance, tomorrow it could be equities or private wealth management and so on.
So these conglomerates could do fairly well?
Yes, I think so.
Investment Strategy
How do you strike a balance between intuition and calculated reasoning while investing?
A calculated reasoning probably has an upper hand, in my view. Especially in markets such as ours which is still not that well penetrated, where there is still some element of information asymmetry. And what is intuition? There’s some reasoning at the back of your mind. Intuition doesn’t just come like that. There’s something in the back of your mind which if you’re able to express clearly, you say it’s logical reasoning, and if you’re not able to express it very clearly, you call it a hunch or intuition. But there is some reasoning that always goes behind every intuition, in my view. So I would say that it’s always better to do some math, some analysis rather than jump into something.
If you look at the track record of Indian mutual fund industry, 80-90 percent of the mutual fund schemes have been able to outperform the benchmark Nifty. Why should one take that intuition-based decision when you have an established track record, when you have a reasonable chance of doing better than what the market has done?