AN AMAZING MONTH
There is only one way to describe the resilience of the Indian Stock Markets. Its Extraordinary. While most other markets sold off in the earlier part of this year, actually till last month the Indian Markets held up very well. However as other markets saw a good rally in October we participated well on the upside. The Nifty gained 5.4% and Midcaps underperformed with a 2.3% gain. At the end of this month Nifty is up around 4% for the year which is huge given that most other markets are down 15-25%.
So the key is to evaluate what actually changed which led to the US Markets rallying the most in nearly 50 years in October for a single month. As we evaluate nothing much changed except for the fact that potentially markets became extremely oversold and in today’s day of Hedge Funds and Options trading moves on all sides are extremely exaggerated. On the macro front inflationary concerns have not subsided and as such most central banks are on course to raise rates further atleast over the next three to six months. The base case after that is likely to be a period of prolonged hold at higher levels till inflation falls back into the comfort zone.
India to that extent is better placed as our inflation issues are relatively lesser as compared to the Western Economies. We were used to double digit inflation till just about 15 years back and inflation was slowly tamed in India. As such a 7-8% inflation is not felt so much here as an 8% inflation is felt in developed economies.
The results season started this month and as I expected results form most technology companies have turned soft which is also reflected in their underperformance. However Indian Technology companies are doing much better than large US Technology companies which have sold off much more severely post pre and post results. Banking sector has held up the markets with huge outperformance in both the stock markets and results. The good part about financials in India today are that most are well capitalized with low NPA’s. Smaller banks and NBFC’s will face challenges as deposit rates move up but larger banks will do better. Consumer companies have seen stress in results with most talking of subdued growth driven by high inflation. Cement company results have also been muted driven by lower prices and higher costs though the long term prospects are better. Capital Goods companies continue to do well driven by higher order book and execution while commodity stock earnings have seen a severe downturn with could remain for some time. Automobile company results are encouraging and this could be an outperforming sector. Overall earnings growth of companies that have reported till now is just around 4% which is much lower than analyst expectations.
Indian markets as I have written earlier too have been in a zone of their own relative to whats happening around us. A leftist/socialist turn in China combined with their zero covid policies have created huge wealth destruction for domestic as well as foreign investors in that country. Diversification of sourcing out of China has got more pronounced as frequent shutdowns and lockdowns have shaken the confidence of foreign companies. Many countries will benefit due to this and India will be one of them.
Overall valuations of Indian Markets are now nearly 20% higher than historical valuations which indicated muted returns overall from the broader indices over the next one year. However sector and stock specific opportunities will remain as sectoral rotation create opportunities. For example the fancied sector of the last two years i.e. Chemicals could see severe margin compression over the next two years as capacities increase and demand slows down. Similarly many commodity consumers like Automobile and Durable companies as well as plastics etc consumers will see strong margin uptick over the next 1-2 years driven by lower input prices which could more than compensate for higher interest rates which is usually negative for these sectors. A static investment strategy is unlikely to work in these kind of conditions and we have to be ready to shuffle portfolios as opportunities come.
As another example the hotels sector which did not perform for nearly a decade or more are into a sweet spot now. Total star rated rooms in India are just around 150000 at this stage and due to Covid disruptions and previous low profits planned additions are just around 35000 for the next 5 years giving a CAGR growth of 4%. With domestic tourism growing strongly and international tourism expected to return this provides and excellent platform for operating leverage as many costs of hotels are fixed and every extra rupee of revenue has high profitability and there should be continued strong profit growth over 3-5 years. Hardly any investors own these stocks thus creating opportunities.
Market valuations have a direct linkage to the risk free rate i.e. rate on government bonds. These rates have gone up substantially this year as such any market upmove cannot get support from rerating on the upside. In this situation only earnings growth can drive the markets which also is moderating giving slowing economies. As such the next one year will be tough for investing.
The thinking process has to be contrarian to perform in the kind of markets we are entering where interest rates are higher, growth slower and as such valuations could come under pressure. Companies that are at very high valuations based on unrealistic expectations of growth might see sub normal returns for the next 2-3 years.
Overall we will continue to look for opportunities as we have done in the past and outperform the markets.