By Chirag Setalvad, Senior Fund Manager, HDFC Mutual Fund
Post the recent rally, market valuations have become more demanding, particularly of mid caps. However, large cap valuations remain in line with long term averages. Even for mid caps, while challenging valuations may impact near term returns, the excess valuation is not so much as to materially compromise long term return expectations. The market valuation, if seen, on a market cap to GDP basis, is still attractive as the market cap has lagged the rise in the country’s GDP over a period of time. The liquidity flows into the equity market, primarily from the domestic mutual funds have been strong. On the economic fundamentals, the overall economy expected to grow at around 7%– 8% in real terms with inflation of 4% – 6%, the nominal GDP could grow at 11% – 12% over the next few years. Most other important macro indicators including inflation, fiscal deficit, current account deficit, FDI, etc. are showing an encouraging trend.
The momentum of reforms by the government is also expected to revive growth from a medium to long term perspective. The impact of GST on economic growth is expected to be positive. Revenue growth over the long term for corporates should reflect nominal GDP growth. At the same time margins are today at cyclical lows and as capacity utilization improves there should be an upswing in profitability levels. In addition, with interest rates falling there will be some benefit to interest costs as well. Thus, earnings should do reasonably well over the medium term and this should get captured in equity market returns.
As in the past, we continue to emphasize that profits drive stock prices in the long run and it is on this front that there has been a marked change in fortunes across sectors. In the earlier cycle, sectors including pharma and FMCG were the leaders of earnings growth which also reflected in their stock prices. In the current cycle, the earnings growth is expected to be driven by metal, corporate banks and capital goods primarily and we have started witnessing telling signs of the same.
As an investment team, our broad focus is on stock specific portfolio creation with an emphasis on quality and understandability and an effort to restrict large losses. At the same time, we are extremely mindful of valuation in order to deliver capital appreciation on a consistent basis.
In equities, we strongly believe that patience gets rewarded over a period of time. Especially, at a time when valuations are not very attractive, one has to have a longer time horizon. Secondly, trying to time the market amid volatility would be a futile exercise. Systematic Investment Plans are a great way of participating in the market as they help tide over short term volatility inherent in the equity markets.
To summarize, equity market have lagged nominal GDP growth for several years now. Markets are trading at FY20E PE of ~16.1x and FY20E PE of ~14.2x, which are reasonable, especially given the low interest rates. Earnings outlook is improving with improvement in operating margins, lower interest rates, peaking NPA’s and higher metal prices. Any volatility in the short term driven by bunching of new issuances in September / October or by international events should be used to their advantage by long term investors. In our opinion therefore, there is merit in increasing allocation to equities (for those with a medium to long term view) and to stay invested.