Mutual Funds

Where is value emerging in equity?

Mahesh Patil | Updated on September 15, 2019 Published on September 15, 2019

There is wide dispersion in valuation metrics across sectors and even within companies

We have seen high volatility in the market over the past few months, and the divergence seen in 2018 has continued into 2019. While headline indices such as the Nifty are holding up, the broader market has seen significant correction, and good value is emerging out of equity markets. It is an opportune time for investors to understand these pockets of value and position their portfolios appropriately, to capture the upside over a horizon of 3-5 years.

If we look at the large-cap Nifty 50 index, headline valuations seem reasonable, with the yield gap ratio close to its long-term average and the price to earnings (PE) ratio at a slight premium to its long-term average. However, there is an evident dichotomy with the top 10 highest-valued stocks in the Nifty trading at an average PE level of 30x, while the balance 40 stocks are trading at half that valuation (i.e., their average PE is 15x). These companies are not in favour currently due to concerns on short-term growth. But many of them have sound business models, strong balance sheets and good corporate governance, and should bounce back once we see initial signs of recovery in the economy.

For mid- and small-cap indices, valuations are attractive, with PE ratios close to, or below, their long-term average and at a 20-25 per cent discount to the large-cap index. Many mid- and small-cap companies have seen a fall of 40-50 per cent over the past 18 months, and in quite a few cases, this has occurred without any significant change in their business fundamentals. This segment is showing signs of having bottomed out, but in a market upturn, it can outperform the large-caps.

If we look at sectors, there is wide dispersion in valuation metrics across them and even in companies within a sector. NBFCs, PSUs (excluding banks) and utilities, pharma, auto, and infrastructure and capital goods offer good value.

NBFCs and PSUs

Over the past year, the NBFC space has been impacted by tight liquidity and higher credit costs, and has seen significant erosion in value. However, the market seems to have put all NBFCs in the same boat. Select NBFCs with a proven track record, good parentage and corporate governance practices, and reasonably strong balance sheets are now available at a price to book (PB) of 1.0-1.5x. As we see some resolution of the key stressed NBFCs, decline in interest rates and improvement in credit spreads, good-quality NBFCs should see a comeback.

PSUs (excluding banks) and utilities are currently at a 15-30 per cent discount to their long-term average on PE and PB basis. They have been impacted by the overhang of increased supply from the government in the form of the CPSE ETFs (Central Public Sector Enterprises Exchange Traded Funds). However, they offer a stable earnings profile and ROE, along with good, free cash flow yield and dividend yield, which are attractive in the current environment of falling interest rates. Some of them are currently available at a PB of 1.0-1.5x, and can be considered.

Pharma

The pharma sector looks attractive at this time as it is trading at 20-plus per cent discount to its long-term average on both PE and PB basis. Over the past three years, Indian generic pharmaceutical companies have corrected by more than 50 per cent from their peak, largely owing to issues on plant compliance and resultant impact on new product approvals and customer consolidation in the largest pharma market, the US.

Many plant issues have been resolved over the past 12-18 months. Price deflation in the US generics is stabilising, and increased product launches in the developed markets are expected to improve profitability. The negative impact due to these issues is already refelcted on the prices of pharma stocks and, the sector provides a good investment opportunity from a three to five-year perspective.

Auto

The auto sector has seen a slowdown across segments and is facing a host of issues which has ended up creating uncertainty regarding the demand outlook. With profitability being impacted due to short-term concerns, many companies in this sector are now quoting a PE of 8-15x.

However, we believe that these issues are cyclical and not structural in nature, and we should see revenue and earnings growth normalising. While it may still be a bit early to jump into them due to the uncertainty created by the upcoming BS VI transition in April 2020, they warrant a serious evaluation as long-term holdings.

Infrastructure and capital goods

Lastly, with the government reiterating its intent to invest ₹100 trillion in infrastructure over the next five years, the infrastructure and capital goods sector presents a sizeable opportunity. However, the sector is currently at a discount of 35-plus per cent to its long-term average on PE as well as PB basis. Some companies in this space have good order books and earnings visibility, and are available at PE levels of 8-15x.

The value theme has not played out in India over the past year. However, in an environment where interest rates are declining, value stocks can appreciate as they offer high earnings and dividend yields. Globally also, with central banks becoming dovish and reducing rates, we are seeing value stocks starting to perform.

With value emerging in the markets, investors can get exposure to these themes, sectors and companies through proper asset allocation and fund selection. Investors can allocate 50-60 per cent of their corpus to large- and multi-cap funds which can provide stability to the portfolio. It would be prudent for investors to allocate 20-25 per cent of their corpus to mid- and small-cap funds from a three to five-year perspective. Investors can allocate 20-30 per cent of their portfolio to thematic funds focussed on consumption, pharma and value. Investors should build up their equity exposure gradually through SIPs.

The writer is Co-CIO of Aditya Birla Sun Life AMC

Published on September 15, 2019
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