Fundamentals driving the Nifty and what to watch

The benchmark Nifty-50 index has risen by a stellar 136 per cent in less than two years. From a low of around 7,700 towards the end of March-2020, Nifty 50 is trading near its all-time high of 18,200 in January 2022. This included a few brief bouts of 5-10 per cent corrections but the momentum has been intact.

Usually, upside movements in markets are either driven by earnings growth, or multiple expansion (increase in PE multiple), or a combination of both. A good understanding of these drivers i.e.. factors driving earnings or multiple expansion, is imperative in assessing sustainability of stock returns and generate conviction in holding on to stocks. While estimating growth in stock prices based on next one- or 2-years earnings growth (measured by consensus estimates) is relatively simpler, assessing the jump in valuation multiple expansion is more hard work. It is impacted by long-term expectations, which include cyclicality, emerging trends, or perceptions, long-term competitive advantages or threats, etc.

An assessment of Nifty 50 sectors and companies indicates that multiple dynamics have played out while the stocks have moved up – both acceleration and deceleration in earnings growth versus historical trends and expansion as well as compression in multiples versus historical average.

Here we shortlist the top four sectors that contributed to the gains in the index. Using FY20 as the base, current estimated three-yearsearnings CAGR (FY20-23) based on Bloomberg consensus is compared to actual last 2-, 5- and 10-year earnings CAGR. The valuation multiple (Next Twelve month PE or NTM PE) is compared to 10-year average to calculate expansion/compression. *

IT Services

Indian IT punched significantly above its weight of 19 per cent in Nifty 50 in March ‘20, to account for close to 27 per cent of the index’s growth since then. Companies’ valuation multiple (NTM PE) has risen by 73 per cent above their 10-year average. Considering that the earnings outlook till FY23 is range-bound and closer to the higher growth phase of the last decade at 12-17 per cent CAGR, longer-term expectations would be the crucial link behind the leap in valuations.

Digital transformation

The pandemic has accelerated and brought forward technology adoption in the US and Europe as economies transform to tech-centred offerings across OEMs, finance, retail and services. Growth driven by clients’ digital transformation (DX) including data, cloud and customer experience, is the key expectation for the next two-three years in IT services.

Underlining the higher multiples is expectation of leveraging such contracts across other in-house verticals (IT companies are now far wider than in early decades) and sustaining the growth phase for a longer term. Companies that used the lean period of 2015-20 to reinforce their operations are now reporting strong and larger deal wins, reflecting a healthy demand environment.

While deal wins are an encouraging sign in the short term, sustaining the same is dependent on companies’ continued execution and the larger macro-trends. As the pandemic eases, so will the easy monetary policies of central banks; slowly affecting the buoyant tech-spends across companies. The high valuation premium may likely come under scanner if companies report any slowdown in the size or profitability of deals in future earnings.

While re-rating relative to historical levels may be justified for companies expected to report high double-digit earnings growth for sustained period of 7-8 years, IT companies’ ability to deliver on the same for extended period beyond FY23/24 is the key monitorable to be tracked. This would be a crucial factor in determining how much of rerating is justified. While the narrative has shown tangible results currently, the strength and duration of the same, dictated by macro trends and different players’ ability, will be the differentiating factor.

Financials

Financials are the largest sector in Nifty-50 with 35.6 per cent weight. Hence whenever the markets rally, it is highly likely that financials played their part. However, while financials were one of the largest contributors to the absolute upside in Nifty, they barely managed to match the broader market returns from March-2020. Currently the valuations of the sector remain largely within historical range, but for companies making a recovery in operations which have outperformed. ICICI Bank NTM PE improved by 70 per cent over 10-year average. Another company that saw expansion was Bajaj Finance (22 per cent expansion), as investors gave more weight for its quality, although its operations were impacted by the pandemic.

In general, the sector faced multiple headwinds starting from 2015-16 which is reflected in the largely range-bound valuation multiples in the sector. On a healthy exit from the pandemic, companies pursuing growth combined with conservatism and addressing the right credit portfolio mix may be able to shed legacy issues and be geared for higher growth.

The road so far

Starting from 2015 the industry was intermittently impacted by a spate of loan defaults, scams, and a consolidation phase. The industry faced either direct costs of bad credit or was impacted by tighter underwriting standards as a result. The companies walked into the pandemic while still in the process of balance-sheet clean up, IBC recoveries, and multiple rounds of recapitalisation (PSU banks). As a result, the metrics on asset quality and credit costs for the larger institutions were within expectations as of H1-FY22, even adjusted for restructured loans.

Growth levers available

Extrapolating the same and on a healthy exit from the current wave of the pandemic, lenders may most likely focus on growth drivers and look to attract credit share lost to NBFCs and CP/Bond markets. The probable turnaround in industrial credit demand can aid companies in book value growth, easing the burden from riskier segments. The excess liquidity on most large banks’ balance sheets is also a growth lever. These can be potential drivers, only on healthier grounds with wider recovery in economy; not resorting to price competition and sub-prime lending. The protracted time-correction in real estate market has made the housing market increasingly affordable, aiding retail growth. The asset base in place to leverage the secular shift (housing, personal, credit) to digital lending is an additional growth driver, possibly not yet reflected in range-bound valuations of most companies.

Metals

Accounting for a mere 3.3 per cent of Nifty 50, metals segment contributed close to 7 per cent of the index gains from March-2020. This was driven entirely by rally in metal prices including steel (135 per cent), aluminium and zinc (70 per cent each) from January-2020. The current rally finally saw the stock of industry bellwether Tata Steel comfortably zoom past its 2007-08 highs after over a decade in the doldrums. One interesting thing to note, though, is that the strong earnings growth of metal companies is accompanied by compression in valuation multiple . This indicates markets are adjusting for cyclicality in the sector.

Most metal prices dipped sharply by mid-CY20 due to the pandemic, expecting lower industrial production, construction, and automobile demand. But with the impetus of loose monetary and fiscal policies announced by central banks and governments around, and with return of demand, metal prices started increasing from May-June, 2020. The peaks this time were sharper and more intense compared to earlier metal rallies. While the raw materials, including energy costs, also went up matching the growth in realisations, operating leverage ensured expansion in EBITDA margins.

In recent months, while steel prices have shown correction from their peaks, aluminum and zinc are still at their peaks.

While last year has been excellent for investors in metal stocks, going forward, investors need to monitor a few trends. Weakness in Chinese real estate market and industrial production are immediate concerns for metal prices. The current calendar year will most likely witness softer prices, earnings and the resulting downward pressure on earnings estimates may lead to stock price corrections. But as a silver lining, structural factors of decarbonisation, demand growth and stronger balance sheets may support the companies, compared to earlier cycles.

International steel prices have corrected by 17 per cent from peaks by early January-2022, taking leads from China’s production cuts on weak demand and high energy prices. Although a correction in metal prices is expected in the second half of the current metal cycle, this may not entail a hard landing, with prices being supported above historical levels.

Decarbonisation, wherein economies across Europe, the US and China are lowering the use and production of coal, can translate to a higher demand or prices for Indian metal exports in the long run. A portion of the sharp cut in Chinese steel exports in CY21 can be traced to production cuts owing to environmental concerns. Also, ESG and associated costs for relatively modern Indian plants can be lower if implemented domestically. In domestic markets, return of high demand from automobile and housing construction will be a key monitorable in addition to export demand.

Companies deleveraging in the current cycle, for instance Tata Steel planning to stock lower than 2x Net Debt to EBITDA across steel cycles will be an improvement over previous cycle (recent peak of 8.8 times in FY16). While deleveraging is expected, so is strong capacity addition through brownfield or acquisitions in large Indian companies. Raw material prices following the eventual correction of metals prices can provide further cushion in the trailing period of the current cycle.

Automobiles

The Auto sector contributed to 7 per cent of growth in Nifty 50, decently above its weight in the index of 4.9 per cent. Its outperformance likely reflects expectations of cyclical recovery.

Auto sales started slowing in FY19, much before the onset of Covid. This was followed by demand further waning due to the pandemic initially and then, the semiconductor shortage putting spokes on a speedy recovery. However, considering the low base and the pent-up demand, expectations for earnings growth for large companies in the sector are in the high teens for FY20-23. Also, valuation multiples for leaders including Maruti and Mahindra & Mahindra have increased by an average 20 per cent over that of the last 10-year average. This expansion for a relatively cyclical industry (cyclicals involve valuation multiple contraction in up-cycles) implies a portion driven by long-term expectations included in valuations.

Low base entering the pandemic

Prior to pandemic hit in FY21 (-13 per cent volume growth), the domestic auto industry growth slowed in FY19 (5.2 per cent) and declined in FY20 (-17.9 per cent). The period saw a long list of issues impacting the industry, including migration to BS VI norms, decline in farm income, lack of availability of credit and higher axle load norms impacting CV sales. This low base, further deflated by the pandemic and expected turn in the cycle in the near term, is driving earnings growth expectations. 

Along with elongated recovery cycle, long-term expectations are also a factor in driving valuation multiple expansion. The lower penetration of automobile ownership in India, with tailwinds from preference for personalised commute post the pandemic, is a strong driver, for one. Secondly, the sector is also in the midst of EV disruption and any progress by auto manufacturers is being rewarded by the markets.

Tata Motors’ announcement a few months back of setting up a separate EV subsidiary for PVs at a $9-billion valuation is an example. Other players like Bajaj Auto and TVS too have announced setting up of separate subsidiaries for EVs.

With a lot of start-ups dominating the EV space, especially the two- and three-wheeler segments, the big auto manufacturers may not be the first movers in the EV game, though they do have a small presence in this segment currently. However, markets may consider their deep pockets and capacity to scale as an advantage which may stand them in good stead when the inflection point in terms of EV adoption is reached in India. That said, a speed bump in the expected recovery due to another wave of the pandemic may see some sluggishness in auto stocks and their earnings in the near term.

Investor takeaways

In conclusion, overall cyclical return of demand for metals and recovery from legacy issues in banking has driven strong expectations in respective sectors, while automobiles gained from a combination of the two – prolonged weakness and return of demand. Investors should be watchful of the trajectory that metal prices take, while financials growth will be dependent on how companies position themselves for credit growth while balancing conservatism. Automobiles need a structural visibility on demand development and a plan on EV, beyond the drawing board for further growth.

The IT rally, on the other hand, is built on both earnings growth and expectation centred on the narrative of digital transformation sustaining for a longer period. While cyclicality is a recurring theme in economies, the concurrent impact was felt across sectors in the last two years and may not necessarily be uniform in retreat. Investors can start assessing their holdings across sectors based on the above factors.

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