Is the current euphoria in equity markets justified?

March 10, 2014

(Any opinions expressed here are those of the author and not of Thomson Reuters)

The third-quarter results season corroborates my view that 2014 will be a year of fragile recovery for the Indian economy. Fragile, I reiterate.

The market, however, has run up to an all-time high, with the Nifty breaching the psychological barrier of 6,500. Is the euphoria justified?

At an aggregate level, the results indicate a typical bottoming out – though revenue growth is muted, the margins have improved. This shows companies are becoming leaner and meaner.

An analysis of 997 public companies (excluding financial and oil companies) shows a revenue growth of 11.6 percent and an EBITDA margin expansion of nearly 121 basis points or bps (100 bps make a percentage point) year on year.

Like it usually happens in a recovery cycle, larger companies have put in a much stronger performance. Revenues of the Nifty 50 lot are up 20.3 percent and their EBITDA margin has swelled by 224 bps.

Export-linked sectors such as IT and pharma have expectedly fared well, helped in no small measure by a depreciated rupee, while the revenues and margins of investment and capex-linked sectors such as capital goods, construction and commercial vehicles remain under pressure.

IT companies have seen revenues grow a healthy 24.1 percent and EBITDA margins improve by 153 bps, driven by improving utilization rates. Similarly, the pharmaceutical sector’s revenues have risen 21 percent and EBITDA margins (excluding outliers) improved by 160 bps on year.

In sharp contrast, the capital goods sector has seen revenues decline 6 percent on year due to slower project execution with EBITDA margins shrinking 208 bps due to lower capacity utilization. The construction sector has seen a muted revenue growth of 2 percent and 200 bps shrinkage in EBITDA margins (excluding outliers). Commercial vehicle makers have also seen revenues shrink 31.2 percent and have posted losses at the EBITDA level, highlighting the plight of companies linked to the investment cycle.

The performance of other sectors broadly ranges between these two extremes. Results in the readymade garments, steel, FMCG and media sectors have been encouraging, while automobile makers, airlines, and sugar companies remain under pressure.

Within the financial space, the gap between public sector and private sector banks has widened on several counts.

I have earlier written about stress building up for public sector banks. In the third quarter, a slowdown across sectors exerted further pressure on their asset quality. The result was a 16 bps quarter-on-quarter deterioration in gross non-performing assets (GNPAs) to 4.63 percent of advances. With a high proportion of non-earning assets in their books, the growth in these banks’ net interest income (NII) — net of interest earned on advances and paid on deposits — was a tepid 11 percent on year. Net profit dropped a whopping 41 percent under the blow of higher provisioning requirements and lower treasury income.

However, private banks continued their good performance, with GNPAs improving further quarter-on-quarter to 1.82 percent of advances. NII and net profits also witnessed healthy growth rates of 19 percent and 17 percent, respectively.

There were no major surprises otherwise. The recently concluded summit of G20 finance ministers and central bank governors in February laid emphasis on carefully calibrated and clearly communicated decisions regarding monetary policy. In the backdrop of tapering by the U.S. Federal Reserve and its implication for the global markets, such a move would provide a welcome breeze of predictability. Back home, the vote-on-account budget was largely a non-event as far as equity markets go.

The key question then becomes — is the current euphoria in equity markets justified? I believe that expectations from the April-May general elections are swaying valuations in the Indian equity markets. As earnings are in a soft recovery mode, a stable political outcome can speed up recovery, whereas an unstable outcome can delay the process (or in the worst case, stall it).

Investors may expect volatility in markets until election results are announced and a new government is formed. In such a scenario, committing to high-beta sectors may be a bit too risky right now. A good idea, if I can say at the cost of repetition, would be to stick to growth sectors and good fundamentals.

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