Sectoral Investment Opportunity For 2020
Sectoral Investment Opportunity For 2020
One question that is constantly asked by many investors is where is a good investment opportunity in the current market? With BSE SENSEX trading at its all-time high, the answer to this question is not so simple and straight forward. To identify an investment opportunity, one needs to see where the price-value gap is.
In this article, we would attempt to identify if there is any real investment opportunity in the already heated stock market by carrying out a sectoral study. We focus on sectors that contribute more to the overall profits but their market capitalisation is not correctly reflecting their contribution. We will also analyse Return on Equity (ROE) of all these sectors and focus on sectors which are still generating high ROE despite of all the troubles which the economy is currently facing. Our data sample is Top 250 companies as per their market capitalisation in 2019.
Overvaluation in a sector is generally caused by high expectations on the future profitability and cash-flows. Stocks of companies where the share prices have increased in anticipation of higher profitability, generally trade at higher PE multiples. However, if these expectations are not met, there would be a substantial correction in stock prices. Markets would appear to be patient for some time in the hope of improvement in profitability, but after waiting for some time, resources do get re-allocated to companies which are generating profits. Thus, it is important for companies to consistently generate higher ROE for shareholders. Investors should always be on a lookout for sectors which are likely to do well and are reasonably priced.
In this study, we focussed on Top 250 companies in 2019 and gathered data for them since 2010. We obtained market capitalisation for all these companies segregating them industry-wise. Further, we calculated the sector-wise market capitalisation and its percentage share in the overall market capitalisation of all 250 companies. This methodology ensures that each sector market capitalisation is indicated as a percentage share of 100 (overall sample).
Chart-1 Relative Share of Market Capitalization of each Sector
Studying chart-1, we can observe that in 2010, energy sector (21 per cent) had the largest share by market capitalisation; closely followed by financial sector (20 per cent), followed by basic material, industrial and technology each at ~10 per cent. In 2019, these ratios have significantly changed as the financial sector contributes 28 per cent followed by energy sector at 13 per cent. There is a huge gap between the leading two sectors in 2019, which was very insignificant in 2010. This strongly suggests that there is a very significant overvaluation in the financial sector as compared to other sectors. Now let’s analyse the contribution to profits by each of these sectors. We obtained profitability of all the companies and calculated percentage profitability of each sector as a proportion to the overall profitability.
Chart-2 Relative Share of Profitability of each Sector
In 2010, the highest contribution to profits was from energy sector (27 per cent) followed by the financial sector (22 per cent). These exactly were the two sectors which had the highest contribution to market capitalisation in 2010 indicating that the market capitalisation was in sync with the profit numbers. Now let’s focus on the year 2019. Energy sector contributes 30 per cent to the profits but the contribution to market capitalisation is merely 13 per cent. Further, the financial sector which contributes merely 11 per cent to profitability of the Top 250 companies is contributing almost 28 per cent to market capitalisation. This is really contrasting and suggests a huge overvaluation in the financial sector as compared to its profitability; the data points also suggest undervaluation of energy sector.
Technology sector contributed 8 per cent to overall profits and had market capitalisation of 10 per cent in 2010. Whereas in 2019, technology sector contributes 17 per cent to profits and has a 12 per cent share of market capitalisation. This is also an indicator of relative undervaluation of technology sector. Similar observation can be made for sectors like basic material and utilities. Profitability of sectors like consumer discretionary, real estate and telecommunication have eroded over the past few years and are unlikely to recover soon.
Now let’s analyse these industries by using the Return on Equity as this ratio matter a lot to shareholders. We obtained the ROE of all the companies and calculated the average ROE for each sector from 2010 onwards.
Chart-3 Return on Equity from 2010 to 2019
Average ROE for most of the sectors has shown a decreasing trend over the period, except for technology, utilities and consumer staples. Average ROE for telecommunication sector has been negative and shows great amount of variation.
After studying the three parameters, Market capitalization, Profitability and ROE, we can expect that stocks prices in the following three sectors (technology, energy and utilities) should appreciate more as compared to other sectors as these sectors are relatively undervalued. Increase in return on equity and profitability over the period is a healthy indicator. Retail investors seeking an opportunity to invest in 2020 can look at shares within these three sectors for higher returns in the long term. Please remember the wise words of Peter Lynch, “My routine is always the same. I search for companies that are undervalued, and I usually find them in sectors or industries that are out of favour.”
Dr Ruzbeh Bodhanwala and Dr Shernaz Bodhanwala are faculty at FLAME University, Pune.