The curious case of the Indian market.
The valuations of the Indian market look reasonable on a top-down basis but the valuations of individual stocks are super-expensive or fairly valued in most cases. The high weightage of 'low' P/E PSU banks, commodity stocks and utilities in the broader market indices pulls down the overall valuations. It may be tempting to derive solace from top-down market valuations but it would be more rewarding to disregard indices and focus on bottom-up challenges.
Market valuation may have lost its relevance some time back
We note that very few sectors trade near the market valuations and the range of valuations has widened sharply over the past few years (Exhibit 1 in the original report, which shows the 12-month forward P/E of individual sectors in the Nifty-50 Index over the past seven years on year-end basis). The range is quite high currently. At the same time, the constant changes to the composition of the Index in the past few years may preclude meaningful historical comparisons and compel investors to look at bottom-up valuations. For example, the recent inclusion of IHFL and IOCL in the Nifty-50 Index has optically reduced the valuation of the market.
Earnings increasingly dominated by 'low' P/E sectors
We note that 'high' P/E sectors account for a low share of overall profits of the Nifty-50 Index while 'low' P/E sectors account for 46% of overall FY2017 profits. More interestingly, a large share of incremental profits over FY2016-19E comes from 'low' P/E sectors. The energy sector accounts for 49% of incremental profits for FY2017E and AXSB, ICICIBC, PSU banks, metals & mining & TTMT for 54% of incremental profits for FY2018E and 33% for FY2019E.
Overall market valuations look optically reasonable but hide several disturbing facts
The overall market valuations look palatable at 15.2X FY2019E Nifty-50 Index 'EPS' but hide (1) super-rich valuations of 'growth' stocks and (2) expensive valuations of companies with mediocre business models. It seems to us that the market has largely accepted the high valuations of 'growth' stocks as 'normal' valuations without questioning the sustainability of the factors that have supported the (1) re-rating of multiples (low global bond yields; the cycle has already turned) and (2) expansion in gross and EBITDA margins (sharp decline in commodity prices).
Valuations of mid-cap. stocks in 'bubble' phase
We find valuations of several mid-cap. stocks in our coverage universe very high. In fact, it would not be wrong to say that some are in the 'bubble' phase with the market extrapolating strong growth and high returns in perpetuity. While some of the companies do have certain strengths, we find valuations at over 5X book for several semi-branded (semi-commodity) businesses absurdly high in the context of their business models and limited competitive advantages. We had covered this issue in greater detail in our April 3, 2017 report titled The curious case of investment and investment reforms and our November 1, 2016 report titled No 'easy' business.
Model Portfolio changes
Model Portfolio. We reduce weight on HDFC and LICHF by 100 bps each to 700 bps and 200 bps noting their strong performance over the past 3-4 months (following the collapse post demonetization) and full valuations. We like the medium-term growth prospects of the housing and housing finance market in India but (1) high valuations and (2) growing competition with likely pressure on NIMs reduce the reward-risk balance of the stocks at current levels.
We increase weight on IOCL and PWGR by 100 bps each to 400 bps each. We find their valuations quite reasonable at 10.6X FY2018E EPS and 10.1X FY2019E EPS for IOCL and 12.5X FY2018E EPS and 11X FY2019E EPS for PWGR. We note that both these stocks have been very strong performers over the past 12 months. Nonetheless, we still see reward-risk balance as being favorable.
In the case of IOCL, we would highlight that refining margins can surprise on the upside given growing supply-demand balance for refined products led by (1) continued strong global oil demand and (2) limited new refining capacity additions in most parts of the world given concerns about the long-term future of fossil fuels. The report also gives details of global oil demand, refining capacity additions and capacity utilization over the next few years.
For PWGR, we note that growth will likely continue beyond the current phase of ongoing capacity addition, which will increase the regulated equity base and drive earnings (see Exhibit 14 for key details of capital expenditure, capitalization, regulated equity base and earnings). We acknowledge the risk to earnings from a potential downward review to regulated returns for the five-year period FY2020-24 (starting April 1, 2019). However, we believe valuations adequately capture the risk. Lastly, we expect India's requirement of transmission network to accelerate as it focuses more on renewables and thermal power plants at pitheads (to reduce the burden on India's creaking railway infrastructure), which would entail (1) production of power in remote locations and (2) distribution of power to other parts of the country through a large transmission network.
We also take a small position (or 'punt') on TPWR (200 bps) noting its exposure to Tata Group companies and potential removal of the overhang with respect to its Mundra power project in the case of a favorable decision on compensatory tariffs. Any unwinding of cross-holding within the Tata Group or a favorable final decision on the issue of compensatory tariff will result in significant value unlocking. The Supreme Court will take a final decision on the latter issue as the distribution companies are still objecting to the decision of the Central Electricity Regulatory Commission (CERC) and the Appellate Tribunal of Electricity (APTEL) to award compensatory tariffs to the Mundra-based power plants of ADANI and TPWR.
We reduce 100 bps each on Maruti to 300 bps and TTMT to 500 bps noting (1) the limited upside to our fair valuation in the case of MSIL and (2) growing concerns about potential earnings disappointment in the case of TTMT from unexpected factors despite reasonably strong volume growth.