Margins hold the key: Morgan Stanley

Equity returns correlate strongly with profit margins. What happens to margins is material to medium-term equity returns.

Corporate net profit margins (for a sample of 1,200 companies) have declined 490 basis points since fiscal 2008. This was on account of an overvalued currency, a rise in the external deficit, a drop in investments and a sharp fall in capital productivity. A rise in the public deficit has somewhat tempered the fall.

At the sector level, save for financials, margins have fallen everywhere, led by telecoms, materials and utilities.

Looking forward, the big change is on the external side — the rupee is no longer overvalued on a real effective basis and global demand seems to be rising. This may provide reason to believe that the worst for margins is over.

But, a new cycle hinges on the balance between restoration of public savings and policy action, which will roll out after the elections. Even that is not straightforward, given how deep the cycle issues have become. However, the market is already getting sanguine about a new cycle, as evident in valuations.It has already started to get priced in, as suggested by earnings yield gap, real equity yields and investment styles. That said, there are still portfolio calls to be made.

We see downside risk to margins in consumer staples and financials and upside risk in technology, telecom and consumer discretionary. We are overweight on telecom (trimming financials) and are already overweight on technology and consumer discretionary — sectors with possibly the most predictable margin upside.

For cyclical sectors such as industrials and materials, a margin recovery is linked to macro outcomes. Bottom line: the reward for making a prescient call on a new margin cycle is declining.

Excerpts from Morgan Stanley’s India Equity Strategy report