Theres Value In LARGE-CAP STOCKS

The ongoing market correction has pushed most of the large-cap stocks lower into a range that would but naturally excite long-term investors. In fact, this correction has pushed the broader market into an attractive zone as well.Yogesh Supekar highlights why large-caps should be preferred at this point of time in the context of emerging volatility 

There is never a dull moment when it comes to the equity market. However, ever since the corona virus pandemic hit the world unexpectedly, the markets have turned extremely slippery. As if the pandemic was not enough, the equity market now has to deal with a geopolitical situation that has stirred the commodity prices in such a way that we have already witnessed some record-breaking moves in metal prices, such as those of nickel. Owing to a massive short squeeze, nickel prices jumped to USD 1,00,000 a tonne and the London Metal Exchange had to halt trading.

Meanwhile, crude oil price is seen trading comfortably above USD 100 per barrel. Exactly a year before, crude oil was trading at USD 60 per barrel. India being one of the largest importers of crude oil, it goes without saying that any rise in crude oil prices is most detrimental to the Indian economy. We can only hope that the crude oil prices do not sustain over USD 100 per barrel for a long time. And with the prices of steel, copper and aluminium also caught in an upward spiral, the price rise trend is seen to be gaining momentum in 2022 as well. As such, inflation is the biggest casualty of the emerging ground reality. One of the most important objectives and goals of the Reserve Bank of India (RBI) is to manage the inflation rate. 

INTERVIEW

Ashutosh Bhargava Fund Manager and Head Equity Research, Nippon India Mutual Fund

Investors Need To Diversify And Focus On Right Allocation Mix

What is your overall assessment of the current equity market scenario?

The current market scenario is a bit confusing. The news flow is overwhelming. On the one hand we are seeing proper opening up of the economy while the domestic demand is strong at an aggregate level. We are likely to see a shift in growth leadership from manufacturing to services going into FY23. At the same time, inflation is a genuine concern both globally as well as locally. So, this is not a usual cyclical environment as the supply side is dominating the demand side and investors are struggling to ascertain where we are standing from a typical cycle stand- point. Despite cost pressure, at an aggregate level, corporate profit to GDP may continue to rise in the next two years.

That’s because sectors like financials, commodities, technology and telecom are least impacted by rising inflation. Therefore, despite many sectors facing the risk of earnings’ downgrades, overall profitability at the headline index level is limited. We acknowledge that while the breadth of earnings’ revision may be on the downside, the current environment of decent growth with elevated cost pressure is where the mix of earnings is changing and investors will see new sectors taking the growth leadership. On the valuations front, rise in interest rates and reduced capital market liquidity is a dampener. To sum it up, the environment of strong earnings’ growth with deteriorating breadth of earnings’ revision along with rising interest rates would mean the returns per se may be much more measured versus what we have seen in the last two years.

What is your outlook on large-cap stocks for 2022? Will they outperform mid-cap stocks?

This debate of small-cap versus large-caps is a bit overrated. Over time, index composition changes. All other things being equal, which kind of portfolio or index should get what kind of multiple is a function of a) extent of cyclical companies, b) leverage of stocks, c) terminal growth risk of the businesses, d) pricing power, and d) quality of corporate governance in the index companies, and so on. In the past, small-caps used to be inferior on most of these counts and therefore deserved lower multiples versus large-caps. However, things are different now and small-caps’ index composition quality has improved over time.

So, maybe some narrowing of valuations discount of small-caps may have some structural underpinnings. That said, there has been massive outperformance of the broader market in the last two years. Small-cap and mid-cap indices are trading at a slight premium to large-caps. Given that the broader market earnings’ revisions are no more positive and valuations are higher for the broader market, the overall risk reward is relatively favourable for large-caps. As such, opportunities are available across the size spectrum and there are many profit pools which are only available in the broader market. It may be prudent to prefer a multi-cap approach with a slight tilt in favour of large-caps.

Which three sectors you would bet on for the long term?

I would bet on the following sectors: 1. Financials: India’s credit to GDP ratio has broadly stagnated for the last 10 years at around 50 per cent. As the economy develops and matures, we will see a rise in credit to GDP and maybe move towards 100 per cent. At this point, the NPA cycle is largely behind, banks and corporates’ balance- sheets are very strong and we are at the bottom of the credit cycle. Further, banks are not only about lending as their profit pools are diverse and allied services like insurance or mutual funds offer tremendous value. Pricing power is returning and valuations versus the rest of the market are undemanding. 2. IT Services: The sector has delivered above estimate earnings over the last 18 months. The management commentary remains extremely buoyant as many expect multiyear demand acceleration. We remain confident on growth as Indian companies are set to gain market-share versus captives and global peers. Within defensive sectors, IT services remain our preferred sector. Valuations have also corrected in the sector despite earnings’ upgrades. During periods of rupee weakness, IT services fall less and thus provide meaningful diversification advantage to investors. 3. Capital Goods: There is a need for capital expansion and capacity creation at a global level. In the near term we will see certain growth in government capex and then private sector capex will follow. Strong national infrastructure pipeline, focus on localisation and coordinated execution of infrastructure projects will propel the government capex. Improved capacity utilisation, strong commodities’ cycle, strong corporate and banks’ balance-sheets and reforms like production-linked incentives would aid corporate capex revival. While the valuations are not very cheap, there are good long-term risk-reward opportunities available in the sector.

This crucial responsibility implies allowing the inflation level to increase only to the point where it does not start impacting economic growth. The volatile situation can be accounted for by the current geopolitical situation. A huge spike in inflation can only be tamed with an increase in interest rates. But if the interest rates are increased, this may impact economic growth negatively. From the perspective of the equity market, rise in interest rates can be one of the most negative developments.

However, it is interesting to note here that the market was anyway expecting a rise in interest rate since a low interest rate environment becomes unsustainable over a long period. In fact, global economy never has witnessed such a prolonged, historic low interest rate environment. The US Federal Reserve has already announced a rise in interest rate for the first time in its March 2022 meeting. In its first rise in interest rate since 2018, the event is seen as a significant decisive move by the central bank in the US, the largest economy of the world. There is also an indication of a further rise in interest rates through the year.

The equity markets so far have reacted positively to the development on the interest rate front as the move by the central bank was on expected lines and there was no negative surprise there. The biggest unknown is about how the conflict between Russia and Ukraine will play out. In such times, playing it safe in equity markets via large-cap stocks would seem to be a good idea. One cannot and should not detach volatility while studying the equity markets. Risk and returns are the two sides of the same coin when it comes to equity investing. The Indian VIX is clearly at the upper range when we consider the levels for one year. During such volatile times it makes sense to bank on high-quality, blue-chip stocks that promise to deliver as against the projected growth and are also available at a reasonable price.

Advantage Large-Cap

There are several advantages of betting on large-caps such as availability of historical data that makes research feasible, higher standards of corporate governance, higher liquidity, efficient pricing of stocks that makes it relatively cheaper to buy and sell (spreads) and proven management quality. Large-cap stocks are also the ones with better fundamental parameters such as higher return on equity (ROE). The table below reflects the higher average ROE for Sensex constituents when compared to the BSE Mid-Cap index and the BSE Small-Cap index constituents. 

"In most countries, excess demand is driven mostly by constrained supply, not strong demand, resulting in the dominance of cost-push inflation – the bad type of inflation that squeezes profit margins, erodes real household income and tends to self-correct when demand is weak "  - Nomura Holdings 

Conclusion

It is always interesting to research price behaviour of stocks in order to understand what set of stocks may or may not outperform in the foreseeable future. It is also important to figure out the sectors that may outperform in CY 2022. What we know is that the metals outperformed and financials and pharmaceuticals underperformed in CY 2021. Several large-cap financials are seen outperforming the markets so far on YTD basis. It is likely that financials may stage a comeback and so would the pharmaceutical stocks. We already have Sun Pharmaceuticals representing the pharmaceutical sector, it being one of the top performing Sensex stocks on YTD basis.

Sun Pharmaceuticals is also making multi-year highs while several Nifty stocks are struggling to remain in the positive territory. Large-caps no doubt provide much required safety and liquidity in turbulent times such as now. However, sector identification will always remain the key to market outperformance. Apart from financials, IT and sugar stocks could create some alpha-generating possibilities for investors in 2022. The much talked about renewable energy sector may create wealth for investors even if there are very few opportunities in the large-cap space for the investors. Another important aspect that investors will need clarity on is whether to bet on value or growth.

The question is important because we have witnessed a sharp correction and hence there is a good chance to spot value in the large-cap space. That said, the markets these days are highly growth-sensitive. Investors are willing to pay a premium wherever growth is visible. The preference is definitely tilted towards high-growth stocks. However, investors with a long-term horizon can expect to identify some highly lucrative opportunities in the current market where growth is available at reasonable price owing to the steep correction in stock prices. As the market is highly sensitive to growth, investors must be cautious on buying growth stocks that fail to deliver on growth. Market punishment is severe for growth stocks that fail to live up to the promise.

CY 2022 could belong to those investors who are skilled enough to identify growth opportunities without ignoring the valuations. Indian key benchmark indices have outperformed most of the key markets globally on YTD basis even after staging an outperformance in CY 2021. At this point of time, the conflux of events has no historical parallel and hence the job of predicting market direction has become even more difficult. Meanwhile, we have a further wave of Omicron round the corner, which may derail any swift recovery in the markets. Investors also have to be aware of the US Federal Reserve’s willingness to go aggressive on managing ‘too high’ inflation levels. This is not good news for equity investors. Hence, only quality large-cap stocks or growth stocks with value from promising sectors should be shortlisted.

Methodology

To come up with a list of performing large-cap stocks, we took into consideration five crucial parameters. The first includes market capitalization. The second and third parameters obtained from the Profit & Loss Account include Sales, Operating Profit and Net Profit. We have also taken into consideration the efficiency of the companies by analyzing profit margins. Lastly, we factored in the returns earned by investors by means of dividends. This is because we want investor- friendly companies to be featured on our list. Each parameter was then ranked by awarding it a carefully determined weightage based on its significance. We then segregated the companies into three categories as follows: Turnaround Performance: These companies include those that successfully managed to turnaround the losses incurred in FY20 into profits in FY21. Improving Financials: Although these companies still reported losses in FY21 as they did in FY20, they succeeded in reducing these losses by a notable amount. This indicates that they are on the road to recovery. Thriving Companies: This list includes all those companies that have seen their profits increasing on yearly basis for FY21. All the raw financial data is sourced from Ace Equity and price-related information is as of March 17, 2022.

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