31 Dec 2017 15:54 IST

Brace yourself for turbulence

Hold on to large-caps, which may navigate the badlands better, while offloading mid- and small-cap stocks

As we begin the New Year, there are some positives that can help corporate earnings, going ahead — recovery in global growth, waning effect of GST rollout on companies’ profitability, normal monsoon and higher MSPs driving rural demand, and lower interest rates bringing down finance costs. Many companies have been improving their profitability through cost-cutting measures in the second quarter of FY18.

The negatives are in the form of declining private investment, mammoth problems of the banking sector, the tight fiscal situation and slowing consumption.

The bigger problem facing the equity market is that stock prices have run up without the backing of an improvement in earnings in 2017. This has taken valuations, especially of mid- and small-cap stocks, to near-bubble territory. Other signals show that a correction is imminent, at least in the smaller stocks.

Hallmark of a market top

In the stock market classic, the Dow Theory, derived from a series of Wall Street Journal editorials, written between 1899 and 1902, Charles H Dow (1851-1902) illustrated some tell-tale signs through which stock market tops can be identified. These indicators have proven right many times in the past and are now telling us that the Indian stock market could be near a peak.

One, in the last stage of a stock market uptrend, smaller stocks — called cats and dogs — rally higher even as large-caps slow down. A casual glance down the top gainers’ list on the BSE will reveal many stocks with prices less than ₹10 and some with a market price under ₹1, too. Small-cap stocks in India were on a tear in 2017, with the Nifty small-cap 100 index rallying 48 per cent, even as the Nifty gained 27 per cent.

Two, the primary market witnesses frenzied activity close to a stock market peak as investors search for new investment avenues in stocks. This too proved true in 2017 with primary issuances among the highest in recent years and increased speculative activity in this segment.

Three, the number of new investors increases sharply close to market tops as the rally attracts shoe-shine boys, house-wives, et al. Around 93 lakh new mutual fund folios were added up to November 2017 and the number of demat accounts with CDSL and NSDL crossed 3 crore last year.

Valuation is discomforting

Aside from the disconcerting investor behaviour, the current valuation of the market is far from comforting. The Nifty currently trades at a trailing price earning multiple of 23.7, far beyond its five-year average of 19.5. The valuation is also slightly above 22.5 — the PE at which the Nifty was trading in December 2007.

The froth is, however, more in the mid- and small-cap stocks. The NSE midcap 100 index is currently trading at a trailing PE multiple of 50.3 while the Nifty Smallcap 100 trades at a PE of 188.

The earnings growth that the market is factoring in appears out of sync with reality. According to Bloomberg’s consensus estimates, Nifty and Nifty Midcap 100 Index’ earnings for 2017 are expected to grow 23 per cent and 19 per cent year-on-year, respectively. This is a tough ask, given the performance in the first half of FY18.

Earning expectations from small-cap stocks are even crazier, with the consensus estimate pointing to expectations of a nine-fold increase in earnings of the Nifty Small-cap Index in 2017.

While the larger stocks could perform well, driven by consumption-oriented sectors and the slow resolution of the woes of financial stocks, smaller stocks are in bubble territory. While a broad-based market correction can drag large-cap stocks lower by 10-15 per cent, the recovery here will be faster. But for many smaller companies, this peak might not be surpassed for many years to come.

Liquidity at risk

The other factor that could roil the market’s up-move is reduction in liquidity. Foreign portfolio investors net purchased ₹49,835 crore worth of stocks in 2017, twice the amount they bought in 2016. But they turned net sellers in December 2017.

Monetary tightening by global central banks, including the Federal Reserve, European Central Bank and the Bank of England, appears to have been priced in. But there are fears that the tax break given to US companies to repatriate funds held overseas by paying 15.5 per cent tax on cash, against the 35 per cent otherwise payable, can cause some disruption in the currency market, shoring up the dollar. This can cause emerging market currencies to weaken, destabilising global equity markets as well.

The domestic money that has been coming into the equity market received an impetus in 2017 due to demonetisation. This impact will ebb. Inflows could, moreover, dry up if a market correction begins.

Course of action

Turbulence is expected in equity market in 2018 but large-cap stocks could navigate this patch much better. It is best to hold on to these stocks and reduce your holdings in mid- and small-cap stocks that have witnessed a steep rally.

You can, however, keep your shopping list ready to pick up bluechips if there is a correction.

Five themes for the equity market:

It is common for investors to draw up a strategy for equity investments at the beginning of every New Year. This year, however, finding value buys in the market will be an uphill task as stock prices of most high-growth businesses have rallied sharply over the last two years. Still, there are certain themes that can influence stock price movements over the next few years. You can keep these on your radar to help you identify stock picks when the market corrects.

The GST driver

1. The landmark Goods and Services Tax rollout was among the most significant events of 2017. The expansion of the tax net under GST was expected to help listed companies, as tax incidence was expected to render companies in the informal sector uncompetitive. Sectors where the unorganised segment has a share of over 70 per cent, such as apparel, dairy industry, gold jewellery, plywoods, diagnostics, some consumer durables and textiles, were expected to gain from this shift. Many stocks in these segments, including Whirlpool, Bajaj Electricals, Symphony, have been moving up since July in anticipation of this shift. Some segments, such as tiles, plywood flooring, sanitary ware and apparel, were initially unhappy with the higher GST rates, but they got a reprieve in November when the rates on 178 items were moved lower from the 28 per cent slab.

But these are early days and the shift from unorganised segment has not really taken place due to various concessions given by the GST Council to smaller businesses such as postponing the implementation of the reverse charge mechanism and increasing the threshold limit for those filing GST under the composition scheme. It might be a year or so before the above sectors begin receiving more business due to the unorganised segment becoming uncompetitive. You can put on your radar stocks such as Kajaria Ceramics, Greenply Industries, Titan, PC Jeweller and Havells. These stocks have seen a sharp expansion in their PE multiples, making them too pricey at this juncture. Wait for a dip before buying them.

Logistics is another segment that stands to benefit from GST. Some companies in the sector, such as Container Corporation, Navkar Corporation and VRL Logistics recorded a good improvement in revenue and profitability in the September quarter. With the abolishing of octroi, entry tax and other local taxes, the running time of transport fleets is expected to fall by at least 30 per cent, improving profitability. The need for larger warehouses and container freight stations will benefit companies such as Navkar Corp. The run-up in these stock prices, however, calls for some caution.

Higher input tax credit is expected to help margins of most companies, going ahead.

Infrastructure spends

2. Low plant utilisation makes revival of private capex unlikely in the next few quarters. The RBI’s OBICUS Survey shows that capacity utilisation in Indian factories was 71.2 per cent in the June quarter of 2017, the lowest level in the last five quarters.

But government spending on infrastructure can benefit listed companies. A report from Edelweiss shows that 32 per cent of government capex spending is on roads while 43 per cent is targeted towards railways. The Union Budget had an outlay of ₹3,96,135 crore for upgrading infrastructure in FY18, of which the spending on rail infrastructure is expected to be ₹1,31,000 crore. The Bharatmala project announced recently plans to set aside ₹7 lakh crore to construct 80,000 km of highway over the next five years.

These spell opportunities for players in road construction, such as Sadbhav Engineering, Ashoka Buildcon, IRB Infra, ITD Cementation and NBCC, over the next five years, at least.

Larger companies, such as Larsen and Toubro, ABB and Siemens are long-term plays on infrastructure spends on roads and railways, and can be accumulated on corrections.

Similarly, government spending on electrification through construction of power transmission and distribution infrastructure is expected to be around ₹2,60,000 crore between FY17 to 22. This will help the order books of companies such as KEC International and Techno Electric Corporation.

Aspirational spending

3. Private consumption expenditure accounts for the largest portion of the GDP, at 53.9 per cent, and has been the key theme for investment in Indian stocks too, for many years now. While growth has been slowing in this segment over the last four quarters, the slowdown is expected to be transient and most market gurus believe that the consumption theme will hold sway for many more years.

There is, however, a slight twist to the story. As consumption of articles such as toothpastes, soaps, shampoos, 2-wheelers, mobile phones, and so on, reaches saturation point, growth in these segments will slow.

However, growing awareness due to increased smartphone penetration, along with higher purchasing power, will lead to a higher demand for aspirational goods and services.

Travel is an area that is likely to account for a larger share of consumer wallets in the years ahead. Airline company Interglobe Aviation is witnessing good growth of late, as more Indians take to the skies. Thomas Cook stands to gain as travel spends increase.

Jubilant Food, that runs Domino’s Pizza, will benefit as Indians are eating out more. Stocks of Trent and Avenue Supermart are already witnessing traction as the shopping bug bites.

Media and entertainment companies such as Zee Entertainment will also see good growth in the coming years for the same reason.

Focus on agri-business

4. According to the World Bank, nearly 67 per cent of the population lives in the villages. This translates to nearly 18 crore households of which 64 per cent depend upon agriculture for a living. The problems in the agri sector — among which are smaller farm sizes, inability to sell produce at viable prices in the market, faulty government procurement system and muddled policy decisions on importing agri-inputs — are beginning to hurt farmers greatly, as witnessed in increased protests across the country in 2017.

The Union Budget of 2018-19 is likely to focus on agri reforms and alleviating farmer distress as the Centre cannot afford to ignore this segment ahead of the Lok Sabha elections.

Companies involved in agri-business — UPL, Chambal Fertilizers, Coromandel International, Kaveri Seeds and PI Industries — will benefit from the increasing focus on this segment.

Opportunities in housing

5. Even as real estate developers grapple with excess inventory in the premium segment, the demand for affordable housing in urban areas is increasing constantly. The shortage of housing for the Economically Weaker Segment and Lower Income Group is estimated at 10 million units, and is being addressed through the Pradhan Mantri Awas Yojana. Also, ₹81,975 crore is expected to be spent on the rural housing scheme PMAY (Grameen) between 2016-17 and 2018-19.

The migration of population from rural to urban areas is a theme that will unfold in the coming decades, creating demand for housing for middle- and high-income groups as well.

Higher disposable income and greater number of nuclear families will aid this trend.

While real-estate developers struggle under a high debt burden, excess supply, crackdown on black money and falling demand, allied industries such as paints, tiles, plywood, cement, steel, electricals and cables stand to benefit in the years to come. Lowering of the GST rate on many building products in November will provide a further boost.

Paint manufacturers Asian Paints and Kansai Nerolac will be a good addition to your portfolio, on corrections in their stock prices. Similarly Kajaria Ceramics and Greenply Industries can be added at the right time.

Wait before you leap

The stock market has been in a strong rally for over four years now and smaller stocks have gained the most in this period. Since most of the stocks discussed above belong to the mid- and small-cap segment, it would be best to stagger your purchases and accumulate such stocks over a period.

(The article first appeared in The Hindu BusinessLine.)