10 Apr 2017 15:58 IST

What charged the bulls?

PC: Pixabay

The Sensex is just short of the 30,000 mark

Not very long ago, during the bull market of 2014, Sensex targets of 30,000 and 40,000 were bandied about quite easily by market experts and brokerage houses.

The Sensex managed to surge past this ‘dream’ target last week, when it briefly crossed the 30,000 mark. Bears, fretting over stocks heading into bubble territory, have had to throw in the towel. So, what led the Indian stock market on an elevator ride to scale new highs since the lows of February 2016?

Flows, and more flows

Be it the US Fed rate hike, Trump’s unexpected victory or the historic exit of Britain from the Euro Zone, Indian markets have shrugged off global risks with aplomb, over the past year.

The BJP’s victory in recent Assembly elections, the passage of the GST Bill in Parliament and improving macros, such as sharp reduction in current account deficit and narrowing trade balance, have been a big draw for foreign investors.

The recent rally in the Indian equity market, from the February 2016 low, has been led by strong foreign portfolio investor (FPI) inflows. Up until the Union Budget 2016, FPIs had been net sellers in Indian equities for five consecutive months. The euphoria that began thereafter lasted for seven consecutive months, the longest streak since September 2014. Inflows between March and September 2016, totalling $10 billion, drove the market rally.

But the party ended abruptly, after the surprise victory by Donald Trump in the US Presidential election. FPIs turned net sellers. Between November and December 2016, FPIs pulled out $3.89 billion, putting bulls on the backfoot.

But FPIs are now back in action. After bringing in $1.47 billion of money in February, FPI buying only intensified in March. The resounding victory by the BJP in State Assembly elections has drawn FPIs into Indian markets once again.

The month of March saw an inflow of $4.75 billion in the equity segment, the highest for a single month since February 2012. Also, the $6 billion inflow in the first quarter of this calendar year 2017 has been the best since the June quarter of 2014.

Overall, foreign flows have begun on a strong footing so far this year. So far in 2017, foreign inflows into equities have touched $6.75 billion, which is double the $3.19 billion and $3.18 billion of flows seen in 2015 and 2016, respectively.

Foreign money flows have always been a major driver for Indian equity markets. The multi-year bull run after the US sub-prime crisis is a case in point. The three-year period between 2012 and 2014 saw a whopping inflow of $60 billion into Indian equities from FPIs.

What hangs as the sword of Damocles over strong foreign flows is the threat of the US Fed hiking rates more aggressively than anticipated.

For now, though, this risk looks unlikely to play out. The US Fed, playing by the script and hiking rates by 25 basis points in March, has kept Indian markets in good stead. The Fed also stuck with its policy of gradually raising rates, pencilling in two more quarter-point increases in 2017 and three more in 2018.

So, unless the US Fed reverses its stance in the coming months and rides the rate hike bandwagon more furiously, foreign flows will likely keep flowing. Also, domestic fund flows have been strong and kept the market going, often offsetting slowdown in foreign flows. With mutual fund and insurance inflows continuing to grow at a robust pace, local money should also support the market, going forward.

Of course, the joker in the pack — domestic corporate earnings — can throw a spanner in the works.

So, will earnings play spoilsport or take the market to new highs? Let’s break the rally down into sectors and themes to gauge the bigger picture on earnings.

Small scores big

The greater the risk, the better the return. This market axiom has played out to the letter over the last three years.

The bull party in mid- and small-cap stocks that has been on for the last three years has failed to sway investors away from these pricey stocks.

In fact, domestic investors continue to pump money into this segment. Large inflows chasing a few stocks has kept the cash register ringing for the mid- and small-cap segment.

Since last February’s low, while the Sensex has delivered a return of 30 per cent, the BSE Small Cap index has raced past, delivering 55 per cent return. This is despite the index having a spectacular run in the preceding two years as well. Of the 733 stocks within the index, 80 have delivered a return of over 100 per cent.

The top performer was Tata Metaliks (a subsidiary of Tata Steel), a player in the ductile iron pipe industry. This stock has moved from ₹87 to ₹621, giving a whopping return of over 600 per cent.

Sudarshan Chemical Industries, a pigment and agro chemical maker, delivered the second highest return, gaining 360 per cent. The list of outperformers from the BSE Smallcap index includes names from sectors such as financials, cement, oil and consumer space largely.

Some of the top performing stocks from the BSE Small Cap index trade at trailing PE multiples of 90-100 times. However, it’s important to note that many of the mid and small-cap companies have depressed earnings. Hence, price-to-earnings (PE) multiples may seem out of whack and not accurately represent the entire space.

The overall BSE Small Cap Index valuation, though, is still not very expensive compared to historical averages — an indication that earnings of a good number of companies have kept pace with the rally in their stock price.

The index’s valuation stands at about 58 times on trailing earnings of one year. The five-year average valuation is 67 times.

The returns of mid-cap stocks have also been stellar. The BSE Mid Cap index has rallied 50 per cent since the lows in February 2016. The performance of many stocks within the index has been even more spectacular.

The stock of Indian Bank, for instance, has rallied 255 per cent. The other outperformers from the index have given a return of over 100 per cent during this period. The 85-member BSE Mid Cap index trades now at a valuation of 30 times (on trailing basis).

Should investors continue to ride the rally in mid- and small-caps?

The mid- and small-cap stocks have always caught the fancy of investors. With the earnings growth of some of these stocks steadily beating expectations, chances of them turning multi-baggers have been high.

Investors should tread this segment with caution as valuations have sky-rocketed over the past three years. A typical case of more money chasing few stocks.

But given that these stocks have delivered mouth-watering returns for investors, it may not be advisable to shun them altogether.

Investing through the mutual fund route can add spice to returns, with lower volatility.

Whither sectors, earnings?

At a little short of the enviable 30,000 mark, the Sensex trades at around 17 times its one-year forward estimated earnings. This is mostly in line with the long-term average PE at which Indian markets have traded over a five or ten-year period.

While this offers some comfort, the recent euphoria in the stock market leaves very little headroom for a slip-up in corporate earnings.

The meagre 2 per cent compounded annual growth in Sensex earnings over the last three years begs the question: is the growth in earnings of over 20 per cent pegged by market consensus for the next two fiscals a tall order?

Breaking down the broader market rally across sectors can help narrow down earnings expectations.

The rally since last February low has been led by metals, which gained a whopping 78 per cent during this period. Base metals, which were in a multi-year down-trend, witnessed a strong comeback in 2016, giving fillip to metal stocks.

Demand stabilising in China and Trump talking of a big push to improving infrastructure in the US saw large-cap metal stocks pick up steam.

Analysts are still sanguine about the fortunes of metal stocks, despite the robust rally over the past year.

After earnings of companies within the BSE Metal Index plunged into the red in calendar 2015, and losses shrank somewhat in 2016, consensus estimates, according to Bloomberg, show a strong earnings reversal in 2017.

The rally in metal stocks is unlikely to lose steam in a hurry. But given that a lot depends on global demand and prices, investors can bet on companies with strong cash flows and avoid those with high debt concerns.

The other heavyweight sector that has propelled the market to new highs is Oil and Gas, rallying 71 per cent between February 2016 and now. The Centre’s pricing reforms in the oil sector have brought good tidings for stocks in the sector.

Reliance Industries, which has been scaling new highs, still has a lot to ride on. Aside from benefiting from its capital expenditure in the refining and petrochemicals segments, the company’s big foray into the telecom sector through Jio has already led to a big shake-out within the sector.

For the oil sector as a whole, a lot hinges, however, on crude prices, which could impact earnings of companies.

Banking stocks have also been making tidy gains for investors, with the BSE Bankex rallying 56 per cent over the past year or so.

The euphoria has been on account of hopes of a possible pick-up in economic growth leading to investments and capex.

But the earnings of the BSE Bankex, which plunged 30 per cent in 2016, leave very little upside for investors. In fact, the recent rally and euphoria precariously hinges on the assumption of a sharp earnings revival.

With credit growth hovering at multi-year lows of 4 per cent, the worst is not yet over. Risks in earnings remain, as a sharp increase in loan delinquencies cannot be ruled out.

The only solace, if any, is the very low earnings base that can result in a strong growth in earnings (at least optically) in the coming year. Also, the Centre putting NPA resolution on fast track can offer respite to State-owned banks.

Over the last decade, the BSE Bankex has traded at an average PE of 13 times one-year forward earnings and 1.9 times one-year forward book. After the rally over the past year, the index trades at 16 times one-year forward earnings and a little over 2 times book.

The right way to gauge the performance of the sector is to look at individual stocks as there is a wide divergence in performance and valuations of private banks and PSU banks.

Private banks such as HDFC Bank, YES Bank and IndusInd are still good bets. ICICI Bank and Axis Bank, which have some lingering concerns over asset quality, can be good picks for the long term. SBI remains a better bet among PSU banks.

The fortunes of the stocks in the capital goods sector are also linked to the state of the economy and pace of investments. Earnings of companies within the BSE Capital Goods Index have made a strong comeback in 2016.

With the index rallying by over 50 per cent since last February, valuations are still a tad lower than the long-term historical average of about 28 times. This sector, which essentially supplies equipment and services to other industries, can see order flows revive if companies begin to invest in new projects. But with most positives priced in, there is the risk of earnings disappointing.

The BSE Auto Index has gained 41 per cent over the past year or so. The performance of this sector has been led by a bitter-sweet medley of events.

After the sharp revival in the medium and heavy commercial vehicles (MHCV) segment in FY15 and FY16, volumes moderated. Passenger car sales volumes, though not stellar, were healthy, on the back of strong urban consumption. The favourable outlook on monsoons boosted demand for two-wheelers and tractors. But demonetisation led to a temporary blip in these segments.

Overall, the outlook for the auto sector remains sanguine. Though commercial vehicle (CV) manufacturers may see some impact on earnings for a quarter or so post the ban on sale of BS-III vehicles, the prospects seem healthy.

A revival in economic activity, particularly in the mining sector, is expected to keep volumes in good stead. While car volumes may not grow in double digits, earnings of companies such as Maruti and Mahindra & Mahindra look promising.

After a short blip, two-wheeler volumes are already witnessing a revival. Hence, good volumes and stable margins should keep this sector on a sound wicket.

Company-specific concerns like the ones surrounding Tata Motors or Motherson Sumi having presence in the UK and Europe region will remain, though, until the full impact of Brexit unfolds.

While the sector is unlikely to get back to heady growth rates, compounded earnings growth of 20-25 per cent for stocks within the BSE Auto Index, over the next two years, looks possible.

Over the last decade, the BSE Auto Index has traded at an average PE of 16 times one year forward earnings — the index is currently trading at similar levels.


In short, the trend in earnings, as evident, has not been broad-based. Only a few sectors have been able to showcase a sustainable recovery. But then, markets are seldom about fundamentals and PEs usually run up, hoping that profits will catch up later.

On this count, there could certainly be some room for the Sensex to soar a bit more. Looking back at the roaring bull markets of 1999-2000 and 2007-08, they halted only after the Sensex PE shot up to 20-22 times or thereabouts. The barometer now trades at about 17 times.

(The article first appeared in The Hindu BusinessLine.)