Indian markets: Earnings in focus, better to stick to fundamentals

June 2, 2014

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

It’s reasonable to ask whether the Indian stock market has lost steam after the blistering run-up seen over the past couple of months. Since August, the markets have rallied about 40 percent, with many stocks in high-beta sectors such as infrastructure generating a return of more than 100 percent. At a one-year forward price-to-earnings (P/E) multiple of 15x, the Nifty isn’t exactly cheap for retail investors right now.

The Narendra Modi-led government, which contested and won the elections on the development plank, is expected to push for reforms in no time, taking on knotty issues related to taxation and infrastructure.

Of course, there is much it must do before the improvements begin to show — from fast-tracking older projects and resolving mining issues to longer-term imperatives such as keeping inflation under control and achieving fiscal consolidation. But there is no gainsaying that all this will improve the earnings outlook of companies and mark the beginning of a structural bull run for the market.

So what must be the strategy of retail investors now? Calculations suggest that in the current scenario, the Nifty will go into overbought territory beyond 7,400 points. Hence, a fundamentals-driven equity strategy, with an investment horizon of between three and five years, can generate better returns.

In the next one year, markets should continue to exhibit a positive bias, driven by improvement in earnings outlook across sectors. Even over the long term, positive momentum is expected to continue and pave the way for the index to scale new heights.

However, there are several challenges in the short term, including the possibility of the climatic condition called El Nino causing drought in large parts of the country. These can lead to intermittent volatility and minor corrections in the index. Any correction will be a good opportunity for long-term investors to build equity exposure.

The run-up to the elections has ensured that valuations in cyclical and investment-linked sectors such as materials and industrials are already rich. We see the next rise coming from earnings re-rating across sectors.

Financial sector companies are expected to deliver the best returns over the next three or four years, clocking a compounded annual growth rate of over 20 percent. The returns will be driven by the expected resolution of policy-related issues, which should result in superior earnings growth and improvement in the asset quality of banks. For cyclicals, however, earnings re-ratings are expected only after the current issues dogging them get addressed over the next 12-18 months.

Further, in the next one year, export-oriented sectors such as information technology and pharma should continue their growth momentum (this is without incorporating a significant appreciation of rupee in projections). As mentioned in my previous column, the rupee is not expected to appreciate significantly, at least in the next one year.

Overall, all sectors should start participating in economic growth over the next few years if we are to get into the 6.5 percent growth zone from the current sub-5 percent. Companies with strong fundamentals would be better poised to reap benefits of the improving economic scenario. In the longer run, investors will be better off sticking to fundamentals.

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