Morningstar shifts to debt, says valuations for Indian equities stretched

Valuations of Indian equities appear stretched at this point, given their sharp run-up from March lows, observed a report by Morningstar Investment Adviser India, a subsidiary of the independent investment research provider Mornin-gstar. The advisory firm said return expectations from Indian equities are lower than what they were at the start of 2020, with all three market-cap segments — large-, mid- and small-cap — offering low real returns. 

Morningstar Investment Adviser India has cut its allocation to Indian equities across all its four PMS portfolios. The allocation has shifted to the medium- to long- term debt segment, which ranks relatively better and offers attractive real-term spreads. At a market-cap level, the advisory firm continues to favour large-caps over mid- and small-caps.

“Indian mid- and small-cap stocks have traded at a lofty price-to-earnings multiple (P/E). The current valuations indicate a significant premium to our fair value assumption. On the other hand, the current margin and return on equity (ROE) are lower than the fair (long-term) assumption. Our valuation implied that return framework factors a higher long-term margin and ROE estimate as compared to the current low margin and ROE that Indian equities offer — indicating a positive reversion impact on return expectations,” said Morningstar. 

The firm believes that investors are relying on the benefits of future growth opportunities to stoke returns, which may not be good investor behaviour. 

 

 
The firm says it prefers assets that are priced below their intrinsic value and offer attractive margins of safety.

A fundamental driver for equities to rally in the current cycle could be low interest rates or cost of equity, observed Morningstar. 

This could be partially justified with record-low interest rates, which have a positive impact on discounted cash flows of corporates. 

“This is an unusual market cycle, where on one side, the global economy is contracting by double digits, corporates are reporting losses, job cuts, low or no capex, and weak private consumption. On the other hand, stock markets are seeing a strong recovery from recent lows and continue to look robust. Risk-averse investor behaviour during times like these would avoid equities and prefer assets such as debt and gold, which tend to do well in terms of protecting investor wealth,” it said. 

Some of the high-frequency lead indicators suggest growth improvement over the past couple of months as lockdown restrictions were eased. 

Over the short-term, government expenditure is likely to support growth, with expectations of another round of front-end fiscal measures, although fiscal room is limited, observed Morningstar.


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