Best to enter 2024 with low return expectations, says Kotak Institutional Equities; lists 3 sectors to avoid
“There is very little value in the market across the capitalisation spectrum after the recent run-up in the mega-cap names, the last bastion of value in the market until recently. However, incremental news will likely be positive and may sustain market exuberance and frothy valuations”.
As per the brokerage, the conflict between fundamentals (value) and sentiment (price) is expected to be a defining feature of 2024. The coming year may witness either a convergence between price and value or a continuation of the pronounced disconnect seen over the past 6-9 months. While high ‘absolute’ valuations logically suggest eventual convergence, the impact of ‘positive’ incremental news, although already factored in, may sustain the divergence with sentiment exerting influence over fundamentals, noted Kotak.
Very little value in most parts of the market
The brokerage finds very little value in most parts of the market after the recent run-up in mega-cap stocks, the last bastion of value in the market until recently. Kotak has been quite cautious on the mid-cap and small-cap stocks for the past 3-4 months and positive on the large and mega-cap names. The Indian market is richly valued both on a top-down and bottom-up basis.
Despite this, certain factors may contribute to sustaining the market’s rich valuations. India’s stable macroeconomic fundamentals, expectations of lower global interest rates, and reduced election risk post the BJP’s strong state election performance could be catalysts.
However, it pointed out that the market may conveniently ignore the fact that the valuations of most stocks are well above their pre-pandemic levels when (1) interest rates will likely be higher versus pre-pandemic levels even after potential rate cuts in 2024-25, (2) global growth rates will be lower and weigh on certain export-oriented sectors, (3) fundamentals of several sectors and companies will weaken, especially in the consumption-related sectors and (4) excess industrial capacity in China may act as a limiting factor on the prices of commodities.
Expect decent earnings growth
In terms of earnings growth, Kotak forecasts that Nifty-50 is likely to witness a growth of 18 percent in FY2024 and 11 percent in FY2025. While there has been a recent upgrade in FY2024E EPS, primarily driven by OMCs, the scope for further earnings upgrades remains limited. This limitation is underscored by benign profitability and volume assumptions across various sectors, said the brokerage.
As investors navigate through the uncertainties of 2024, the interplay between market dynamics, economic factors, and corporate performance will undoubtedly shape the investment landscape in the coming year.
Sectors to avoid
The current market landscape presents a challenging scenario marked by a potential disconnect between price and value, and the difficulty in maintaining a rational investment stance. Since the brokerage finds very little value in the Indian markets, it noted that portfolio construction is clearly a challenge.
It further argued that constructing a robust portfolio is notably intricate due to two critical factors: an unfavorable reward-risk balance prevailing across sectors and stocks, and an unflinching exuberance among investors. This exuberance can be seen in the substantial positive inflows into the market from Foreign Portfolio Investors (FPIs) over the past two months and sustained domestic investor interest, driven notably by the enthusiasm of retail investors over several months.
The brokerage advises avoiding sectors and companies with the biggest distortion in price-value proposition irrespective of incremental developments.
“It would appear that investors are taking their cues from incremental developments and events and ignoring the fact that absolute valuations may already be pricing in the positive developments (real or even purported). We find this most prevalent in the automobiles and components, electric utilities, and IT services sectors,” argued the brokerage.
Automobile and Component: It noted that valuations of the automobiles and component companies are well above their pre-pandemic levels even as (1) volume growth has been fairly muted across segments for the past few years, (2) the 2W and 4W sectors are seeing tremendous changes given the ongoing transition to EVs from ICEVs and (3) profitability (EBITDA/unit) has expanded to all-time highs in the case of 2W and tyre companies. The market seems to be assuming that such high profitability will sustain despite the ongoing disruption in the 2W industry and competitive tyre industry, it pointed out.
It further stated that the absolute market capitalisation of the 2W companies and Maruti Suzuki discount unrealistic volumes and profitability assumptions. “The implied volumes are quite absurd despite our assumptions of current high profitability sustaining in the future. However, the market is simply unable to accept these anomalies being obsessed with incremental positives of near-term like recovery in (1) volumes; volumes will obviously grow in a country like India and especially from pandemic-year lows and (2) profitability; profitability has recovered from 1HFY23 lows margin but any assumption of sustenance of profitability at such high levels has to be viewed in the context of industry structure and returns,” it explained.
Electric Utilities: The brokerage opined that it struggles to understand the excitement around the electric utilities sector in India with the stocks having gone up sharply in the past six months.
“The underlying narrative seems to be a possible deficit in electricity generation capacity in India over the next few years. This may be true but we note several anomalies with the narrative—(1) the electricity generation roadmap is still unclear but we would assume that the longer-term focus will be on renewables and any addition of new thermal capacity will be of a limited quantum; the economics of solar electricity generation are not very good currently with RoE lower than CoE, (2) India has still not addressed the issue of distribution reforms and unremunerative electricity tariffs in several states, which raises questions about the viability (and value) of non-regulated electricity generation capacity and (3) the ‘deficit’ narrative should not apply to PowerGrid (although it was a preferred stock for us in the sector); PowerGrid is up 25% in the past six months,” it said.
Kotak further noted that it is most intrigued by the market’s approach to valuing BHEL and NTPC. It has used them as examples to demonstrate the exuberance among investors and the disconnect between perception (sentiment or price) and reality (fundamentals or value). Valuations may look reasonable on a cursory basis but a deeper look into the business models of the companies suggests that valuations may be on the higher side by a distance, it cautioned.
IT Services: The IT sector is a good case in point of the market’s focus on ‘incremental’ rather than ‘absolute’, noted Kotak. The IT sector has delivered very strong returns over the past one month with the market excited about the possibility of lower interest rates in the US. Kotak finds the argument quite hollow as (1) interest rates in the US are likely going to be higher than prepandemic levels and (2) revenue and volume growth rates of IT companies will be below pre-pandemic levels.
Portfolio changes
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The brokerage has added Embassy Office Parks REIT to the portfolio with a weight of 150 bps.
“The stock has been largely flat over the past 12 months and it offers decent downside protection in a market where many stocks could see flat-to-negative returns if the market focus was to shift to fundamentals from fiction. The stock offers a decent yield (6.7%/7.8% in FY2024E/FY2025E) currently and is also a possible play on reduction in interest rates in India. However, we would clarify that we do not expect any rate cut from the RBI for the next 3-4 quarters,” explained the brokerage.
Meanwhile, it reduced 40 bps from Adani Ports (150 bps), 60 bps from DLF (150 bps) and 50 bps from PowerGrid (170 bps) after the strong performance of these stocks over the past three months.
Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before taking any investment decision.
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Published: 29 Dec 2023, 12:13 PM IST
