We favor ‘value’ stocks in banking, metals & mining, oil & gas and regulated utilities going into CY2017 as we find their valuations inexpensive despite their solid performance in CY2016. We see scope for further re-rating of their multiples on the back of improved fundamentals and lower domestic yields. ‘Growth’ stocks may see further de-rating as their valuations are still rich (despite the recent correction). Also, higher DM yields and high gross margins may act as headwinds.
Useful to know ‘macro’ drivers but useless to invest based on consensus views of outcomes
We see a fair degree of uncertainty emanating from economic and political developments in CY2017. The pace of economic recovery in the US and Europe will be the dominant ‘macro’ variable as it will determine the level of DM bond yields. Recent economic data suggest strong economic recovery in the US and moderate recovery in Europe, which has shaped consensus views about higher DM bond yields in CY2017. Additionally, China’s response to continued large outflows, Europe’s national elections and US’s fiscal, foreign and trade policies can cause mild shocks if their outcomes are different from consensus views.
Earnings: Strong growth (again and hopefully finally) off a low base
We project FY2018 and FY2019 net profits of the Nifty-50 Index to grow 20% and 16% driven by normalization of profits in sectors such as PSU banks, metals & mining and pharmaceuticals. However, our thesis on consumption-led demand recovery has got punctuated with the recent demonetization measure. Also, we see some uncertainty in the earnings of sectors such as cement, consumer discretionary and industrials from weaker-than-expected demand and profitability; weakness in demand will hurt profitability disproportionately.
Overall valuations reasonable on FY2018E basis; prefer ‘value’ over ‘growth’
We find valuations of the market (Nifty-50 Index) reasonable at 15.5X FY2018E ‘EPS’ after the recent correction. Valuations of ‘value’ stocks are inexpensive despite their strong performance in CY2016. We see their (1) earnings improving due to better fundamentals (banks) and lower interest rates (leveraged metal stocks, downstream oil & gas) and (2) valuations benefiting from lower domestic yields (banks, regulated utilities). However, valuations of the ‘growth’ stocks, especially consumption stocks, are still quite rich despite the recent corrections and their high multiples and EBITDA margins preclude further expansion in multiples and margins.
Economy: No major improvement in key parameters barring interest rates
We forecast FY2018 GVA growth at 6.8%, less than potential output level of around 7.5%. We do not see any scope for a meaningful improvement in India’s fiscal or current account deficits. We model GFD/GDP (central government only) at 3.3%, unchanged from FY2017E’s 3.5%. Also, we expect CAD/GDP to rise to 1.2% from 0.8% in FY2017. However, we expect a 50-75 bps rate cut in CY2017 on the back of lower inflation (average inflation of 4.1% for FY2018) subject to (1) normal monsoons and (2) moderate levels of global crude oil prices (US$55/bbl average in FY2018).
This is an excerpt from Kotak Institutional Equities Strategy note dated December 16, 2016. Copyright 2016 Kotak Institutional Equities (Kotak Securities Limited). All rights reserved