04 Jul 2016 14:46 IST

Up against a wall?

While there are pockets of growth across sectors, the Sensex appears to have priced in most of the positives, limiting the upside

What’s in a number? Plenty, if one were placing bets on the Sensex target. Not very long ago, during the bull market of 2014, Sensex targets of 35,000 and 40,000 were bandied about quite easily by market experts and brokerage houses.

But over the last two years, investors have not had much to cheer about. After a splendid run in 2014, the Sensex has lost ground and is still struggling to find its feet. Investors, who have always been nudged to park money in equities to earn inflation beating returns, have been looking at 8-odd per cent annual returns over the last five years.

The ten-year record is a tad higher at 10 per cent, but still short of the 14-15 per cent mark that financial advisers dangle in front of investors.

So where is the Sensex headed over the next two years?

Where we standGlobal risks lurking around the corner has become commonplace, be it the US Fed rate hike, China slowdown or the very recent Brexit vote. Our markets have also been quick to react to these global events, causing a lot of heartburn to investors over the recent years. The impact of Brexit in the near term will be manifold — sluggish exports to the UK, rise in stressed loans to companies that have exposure to the region, slower FDI or FPI flows into equities or debt market and increasing pressure on the rupee. These risks can limit the upside in the Sensex, unless domestic earnings play catch-up.

Before we delve into future earnings, let us understand how India Inc has fared last fiscal. A long spell of slowdown over the last three years and meltdown in global commodity prices have led earnings to play truant. After managing a marginal growth in FY15, net sales fell by about 3.5 per cent in FY16 for all listed companies. Some relief came in from lower input costs, which led to a 10 per cent growth in net profit.

But these gains have been whittled down if the performance of banks is taken into account.

However, if the latest March quarter results are any indication, demand can start to pick up in the current fiscal.

After de-growth of 4-5 per cent in the last three quarters, net sales inched up by 2.5 per cent (year-on-year) in the March quarter. Benign raw material prices have aided margins of companies in auto and auto ancillaries and the FMCG sector, in particular.

But the trend has not been broad-based, as is evident from the earnings. Only a few sectors can blow the recovery trumpet for now. Sectors and stocks linked to the capex cycle are yet to see a meaningful recovery, while consumer-related stocks have been upbeat. Companies that saw double-digit profit growth in the March quarter include those from auto, auto ancillaries, paints, cement and capital goods. Earnings of companies within the Sensex have also mirrored this trend, with auto and private bank stocks (barring ICICI Bank) putting up a good show but metals and mining, oil and gas and PSU banks (SBI) dragging the overall performance.

Whither Sensex?It is true that markets are seldom about fundamentals and more about expectations. Markets usually run up hoping that profits will catch up later. But the stock market has a way of correcting such anomalies. Take, for instance, the roaring bull markets of 1999-2000 or 2007-08: the Sensex halted its splendid run as earnings failed to catch up. After growing by over 30 per cent in FY07 and FY08, the Sensex EPS (earnings per share) plunged 18 per cent the following year. Trading at 20-22 times one year forward earnings, the Sensex could not hold its gains and cracked.

The Sensex EPS over the last two years has been nothing to write home about. While it fell 7.6 per cent in FY15, it grew by a modest 5.5 per cent in FY16. For the current fiscal, an already decimated earnings base in FY16 can act as a kicker.

Consumer-led themes will continue to drive earnings on the back of the Seventh Pay Commission payouts and possibly good monsoons.

While infrastructure-led sectors such as cement and capital goods can see some recovery in FY-17, much of the growth will get pushed into FY-18.

A look at the fundamentals of the stocks within the Sensex basket reveals that the market at current levels has priced in most of the positives. We have factored in a 16 per cent and 20 per cent growth in earnings for the Sensex for FY17 and FY18, respectively. Applying a 17 multiple (10-year average of one year forward) and 15 times to the Sensex EPS for FY17 and FY18 respectively, the Sensex target works out to 26,221 and 27,679 for FY17 and FY18, respectively.

(Since the Sensex is a weighted calculation of the companies it comprises, earnings have also been weighted in the same way to get the Sensex earnings).

Important to note, though, is that the Sensex target is essentially the ‘fair value’ of the bellwether index, considering the earnings prospects of stocks within the Sensex. Large inflows into or outflows from the market can take the Sensex far away from its ‘intrinsic value.’

Drivers and laggardsSensex companies have seen their profits grow by just 9.6 per cent annually in the last decade and 6 per cent in the last five years. In fact, the only occasion in recent memory when corporate profits did vault by over 30 per cent was in FY07 and FY08, when the economy was zipping along at 9 per cent plus and the global economy was in great shape too, before the global financial crisis hit.

So, is the assumption of 16-20 per cent growth in Sensex earnings for the next two fiscals, then, a tall order?

While there are pockets of growth in various sectors, we find that valuations for most sectors already price in growth expectations. We share a broad outlook for some key sectors and narrow it down to earnings expectations for stocks within the Sensex.

Auto/auto ancillaries — Gearing up

Auto stocks account for 11.5 per cent of the Sensex, by weight. Double-digit growth in sales and earnings of most auto/auto ancillaries companies, last fiscal, has been one of the bright spots in an otherwise lacklustre setting. Passenger car sales should continue to grow by lower double-digit, given the strong urban consumption boosted by Pay Commission dole-outs. The overall outlook on monsoons remains favourable despite some initial snags. The Centre’s various welfare measures announced for the rural and agriculture sectors are also expected to boost demand for two-wheelers and tractors.

Hence strong volumes and stable margins should keep this sector on a strong wicket. Company-specific concerns like the one 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 the heady growth rates seen post 2008, compounded earnings growth of 20-22 per cent for auto stocks within the Sensex over the next two years looks possible. But much of this growth expectation appears to have been priced in.

Over the last decade, including peak levels of over 40 times, the BSE Auto Index has traded at an average PE of 15.7 times one year forward earnings. The index currently trades at similar levels.

Banks — Not out of the woods yet

Banking stocks, which account for nearly 30 per cent of the Sensex, have been in the doldrums. Earnings of the BSE Bankex have plunged 24 per cent in FY16, after a tepid two-year performance (2-8 per cent growth). With credit growth still struggling to inch past decadal low levels of 8-9 per cent, the worst is not yet over.

The only solace is the very low earnings base in FY16 that can add some spark (at least optically) to the FY17 earnings. Over the last decade, the BSE Bankex has traded at an average PE of 13 times one year forward earnings and 2 times one year forward book. It is impossible to assign a broad sector multiple due to the wide divergence in performance of private banks and PSU banks. Within the Sensex basket, we expect stocks to deliver 16-18 per cent (annual) earnings growth over the next two years. HDFC Bank and HDFC will continue to post strong earnings. Private banks such as ICICI Bank and Axis Bank, which felt some heat last year, are likely to bounce back in FY18.

Defensives — An expensive lot

Let’s not forget the defensive sectors — IT (16.5 per cent weight) pharma (7.7 per cent weight) and FMCG (11 per cent weight). The growth in revenues of IT companies has moderated in the past year. Brexit can cause volatility in the interim, with slower pace of projects from the region. With earnings growth expectation of 11-12 per cent annually for the next two years from players such as Infosys, TCS and Wipro (within the Sensex), valuations of about 17 and 15 times FY17 and FY18 look justified. The BSE IT Index is trading close to its 10-year average of 16.9 times PE multiple.

Within the pharma space, companies’ earnings in FY16 were impacted due to the regulatory tangle. However, over the long run, these issues are likely to get resolved. Overall, we expect 24-26 per cent annual growth in earnings over the next two years for pharma stocks within the Sensex. But these stocks, trading at stiffish 22-25 times one year forward earnings, offer limited scope for large upsides.

Earnings growth of consumer companies has been aided by benign prices of raw materials. Going ahead, it will be important to see if these players are able to sustain margins as raw material prices go up. High multiples of 30-odd times (in line with 10-year average) limit sharp rallies. Within the Sensex, we expect ITC and HUL to post a 13 per cent annual growth in earnings in the next two years, for which valuations are already steep.

Industrials — Long-drawn recovery

The fortunes of the stocks in the cement or the capital goods sector are linked to the state of the economy and pace of investments. Forecast of better monsoon and some of the Centre’s structural reforms yielding results can provide impetus to demand. However, steep valuation of stocks can be a risk. The BSE Capital Goods Index is trading at about 26 times one year forward earnings, a tad lower than its ten-year average. It has already priced much of the positives and poses a risk if earnings disappoint.

The outlook for L&T, the only player within the Sensex basket, looks sanguine.

Metals — Can play spoilsport

Oil & Gas (9 per cent weight) and metals (2.5 per cent) continue to be laggards. But the Centre’s pricing reforms in the oil sector have offered some relief to oil marketing companies. The recently unveiled Hydrocarbon Exploration Licensing Policy should also help increase the domestic oil and gas output over the long run. Within the Sensex pack, ONGC and GAIL should witness healthy growth in earnings, over the next two years. Reliance Industries, whose FY16 earnings were driven by strong refining margins, should benefit from capital expenditure in the refining and petrochemicals segments. For metal companies, while the global commodity downturn has played truant, there was some recovery in the March quarter.

Within the Sensex pack, Tata Steel can be adversely impacted by Brexit. But for Coal India, prospects are good, given the expected increase in output and ample coal reserves.

In the power sector (2.7 per cent weight), the Centre has undertaken various reforms. But most of these will play out only in the long run. Power Grid and NTPC are among the better placed.

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