In a recently published interview, Prashant Jain, chief investment officer, HDFC Mutual Fund, said the Indian market had a six-to-eight year cycle. Stocks and sectors which fall out of favour in one cycle become leaders in the next. Looking at the third quarter (Q3) results (the interview happened before the fourth quarter or Q4 results), Jain said the earnings trends fitted, with laggards becoming leaders in the next cycle.
Profit growth in Q3 was largely contributed by financials, energy, industrials and materials. The perennials — fast-moving consumer goods and pharmaceuticals — had negative or minimal contribution. The Q4 results might confirm the growth patterns. If HDFC Mutual Fund is focused on these four sectors, the expectations of higher returns could, to some extent, be self-fulfilling. Certainly, given the high respect for Jain, there will be plenty of people following his lead in picking stocks.
Jain made another interesting point, which goes some way in addressing the glaring problem with very high valuations across the market. He is looking at the long-term averages for market-wide valuations. For example, he says operating profit margins (OPM) are lower than the historical long-term averages and hence, these could expand. If OPM does go up, price to earnings (P/E) ratios will come down, in a market where interest rates are stable or headed down.
The hope of higher OPM is one rationale for expecting an upside. There are huge natural variations in margins between sectors and there can be big changes for the same company between a cyclical low and a high. Deriving average values for OPM is therefore, an art rather than a science. But, since many sectors are rising from cyclical lows, OPMs must have an upside in logical terms.
The market capitalisation (m-cap) to gross domestic product (GDP) ratio is also low. Many large stock markets often have m-cap-to-GDP ratios above one. India generally doesn’t have a very high m-cap-to-GDP ratio. At bear market bottoms, it drops below 50 per cent. The current m-cap-to-GDP ratio is around 80 per cent. At the top of the bull run in 2007-08, it was 145 per cent. At the top of other bull runs, the ratio has also been above 100 per cent.
If history does repeat, this implies a great deal of upside even at current levels. This can be backed up by looking at historical PE values, which indicates the Nifty hit a PE of 28-29 at the previous market peak. The Nifty is at a PE of 23 now and smaller stocks have outperformed the giants. So, the Nifty could have 20 per cent upside, while smaller stocks could move up more.
A look at the m-cap to GDP suggests there could be an upside, and higher OPMs are also a reasonable expectation. Nevertheless, valuations do seem very high and it’s possible the OPM growth expectations have been largely discounted. History suggests investments at valuations such as a PE of 23 can take three years or more to start offering decent returns. Even if the market zooms to a PE of 28, it’s unlikely to stay there very long. Timing an exit would not be desired by long-term investors. If the market does go up through this financial year, smaller stocks will surely outperform. As of now, the top 100 stocks (by market cap) contribute about 60 per cent of total m-cap. If smaller stocks outperform, the weights could well change.
Financials, energy, industrials and materials are slated to do well, according to Jain (and others). Three of these sectors are driven by domestic growth. Analysts can make calls purely based on India-specific factors. Material and industrials are suffering from lack of demand, which means over-capacity and no investment. If demand does pick up, these sectors will do much better. Financials are in deep trouble. If banks cannot clean up existing bad non-performing assets (NPA), credit disbursal cannot expand. However, faster growth would also make it much easier to recover bad loans. Profitability could jump across the financial sector if the NPA situation improves, and turnaround stocks and turnaround sectors can receive huge discounts. Energy prices, on the other hand, are almost exclusively driven by global factors. Domestic coal, gas and crude oil prices are directly linked to global prices. So long as global energy prices stay down, the Indian energy sector should do well. Reliance’s results are a pointer.