Unmesh Sharma is the Head of Institutional Equities at HDFC Securities.
In terms of earnings, “there are certainly individual sectors that will feel the pinch of inflation, but we essentially expect corporate India to register strong double-digit growth in FY23, largely driven by the heavyweight sectors”, Unmesh Sharma, head, institutional equities at HDFC Securities, said in an interview to Moneycontrol.
Also, on expected rate hikes, he feels the direct impact on corporate earnings will come in the form of rising borrowing costs. “India Inc. has done a good job of deleveraging itself and so in an overall sense, the impact will be less severe than it would have been otherwise,” he said.
But he does not expect double-digit market returns. “We believe the broader market will probably not provide double-digit returns. At an aggregate level, we do not see value. The market would remain range-bound (with single-digit positive or negative returns) with volatility persisting at a high level especially when we get closer to key policy decisions,” Sharma said. Edited excerpts:
Do you think earnings will still grow in double digits in FY23 considering the inflationary risk and expected rate hikes?
The short answer is yes. The HSIE (HDFC Securities Institutional Equities) Research team has a wide coverage. Based on the analysis of our coverage universe, we have calibrated the total corporate profit pool contribution for each sector, which is largely indicative of India Inc. According to our calculations, oil and gas account for around 22 percent of total corporate profits and metals account for around 12 percent. Cumulatively, they account for 34 percent of total corporate profits where the underlying commodity prices are high and remain buoyant due to various geopolitical issues and demand-supply mismatches.
Furthermore, BFSI (banking, financial services, insurance) accounts for around 26 percent of the total profit pool and we are confident about the sector’s performance in FY23. So essentially we have around 60 percent of total corporate earnings where we are expecting strong double-digit growth in FY23.
While inflationary pressure will dent earnings in other sectors such as cement, FMCG (cast-moving consumer goods), pharma, chemicals, etc., we expect them to be able to pass some of these costs to the consumers in a calibrated manner and still register moderate growth. This might lead to interim pressure on margins.
Meanwhile, there are certainly individual sectors that will feel the pinch of inflation, but we essentially expect corporate India to register strong double-digit growth in FY23, largely driven by the heavyweight sectors. When it comes to expected rate hikes, the direct impact on corporate earnings will come in the form of rising borrowing costs. India Inc. has done a good job of deleveraging itself and so in an overall sense, the impact will be less severe than it would have been otherwise.
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What are the key risks that the market will face in the current financial year? Also, do you think inflation is a major risk or is it just a temporary phenomenon?
We believe that the time for applying the nomenclature (inflation being ‘temporary’ vs ‘transitory’) is behind us. Inflation is real and widespread across the globe. The CPI (Consumer Price Index) climbed up to 6.95 percent in March 2022, led mainly by inflation in food, clothing, and fuel and light. Inflation of course is a major risk especially as the second-order impact of, say, rising fuel prices is yet to show up in earnings. However, the larger risk for the market remains the reaction of central banks.
The US Fed (Federal Reserve) has turned decisively hawkish with economists now clamouring to make increasingly hawkish forecasts for rate hikes in 2022. While there is divergence between central banks (a hawkish Fed followed by European Central Bank or ECB versus China and Japan), we can see early signs of the tide now turning in India. Indeed, the RBI (Reserve Bank of India) at its previous monetary policy committee (MPC) meeting had declared that it will be prioritising inflation over growth for the time being.
Furthermore, with most central banks hiking rates and taking a hawkish stance, the RBI can’t be left too far behind. The RBI will eventually have to raise rates as well to curb rising inflation in India. With rising input costs eating into corporate profits in many industries, and the excess liquidity being drained out from the market, inflation and subsequent rate hikes are likely to be the key risks that the market will face in FY23.
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What are the biggest themes you are betting on for coming years and why?
There are a few subtle long-term themes in action in the economy currently which can throw interesting investing ideas. Driven by sustained growth delivered by IT companies and a burgeoning startup ecosystem over the last few years, urban disposable income has been rising. It is leading to low-ticket consumer discretionary growth such as food and beverages, apparels and retail. Further, rising disposable incomes of IT sector employees are leading to real estate growth in cities like Pune, Bangalore and Hyderabad. This has a multiplier effect on the growth of building materials and household appliances.
We are bullish on growth of all these mentioned sectors. Also, with structurally falling interest rates in India (with minor blips), investment avenues have been reducing, making direct and indirect equity clear winners for the long term. It is also evident with rising SIP (systematic investment plan) figures over the months. Hence, we remain positive on insurance and capital market companies.
Can we still expect double-digit market return in FY23 despite concerns like inflation risk and rate hikes?
The short answer is no. We believe the broader market will probably not provide double-digit returns. At an aggregate level, we do not see value. The market would remain range-bound (with single-digit positive or negative returns) with volatility persisting at a high level especially when we get closer to key policy decisions. However, specific sectors and stocks will still deliver healthy gains and, hence, active portfolios will deliver positive returns.
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We believe a ‘back to basics’ approach will work—bottom-up stock picking looking for structural earning growth at reasonable valuation.
Do you expect the consolidation seen for the last couple of quarters to continue for some more time in the IT space?
Yes, we are expecting some continued consolidation in the IT sector going forward, more so in the Tier II companies due to stretched valuations. Over the past six months, the Nifty has contracted 6.8 percent while the Nifty IT index has fallen 13.3 percent. We expect the IT index to underperform for a few more months before moving upwards again.
Recent results have already seen some margin contraction as travel and employee expenses inch back up. That being said, the IT sector has strong structural tailwinds that are expected to last for the forthcoming years. The direct impact of the Fed rate trajectory is expected to be relatively moderate as tech spend by BFSI companies are expected to continue.
What is the basis behind your investment style and have you changed the same over a period of time as we have been facing a lot of risks including the Ukraine-Russia crisis, a spike in commodity prices and soon, the end of the low interest rate environment?
At HSIE, our research team publishes a model portfolio which has consistently outperformed the index (nearly 500 basis points outperformance versus Nifty over the last 12 months). The investment approach has a value bias with a keen focus on consistent earnings growth delivery while maintaining healthy returns on equity. Given steep commodity inflation over the last few quarters, we have remained cautious on commodity consumers.
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We believe it would be an uphill task for them to pass on cost inflation to end consumers given we are in the early stages of a demand recovery post Covid. In our view, expensively priced stocks of various sectors will keep getting hammered in an inflationary scenario when earnings growth delivery comes under pressure. A rising interest rate scenario will impact them adversely as well.
Are new-age tech companies available at attractive valuations now, after trading at much lower levels compared to their issue prices?
Given the sky-high valuations some of these companies got listed at, the selloff was expected and justified. These new-age growth stocks where the expected cash flows are far off into the future are usually the first to fall during a market selloff. This is in line with our expectation of long-dated securities falling most in a rising rate (and hence cost of capital) environment. Needless to say, this impacted stocks with a high contribution of NPV (net present value) from terminal value, sometimes in excess of 100 percent. The initial rally in these stocks was largely retail-led and arguably unjustified.
The broad-based market selloff at the start of CY22 comfortably shook off the froth in the market. We think the best way to look at these companies is on a case by case basis; the individual business models are different and so are the markets and customers they service. It’s not prudent to club them together because the key drivers for these companies, especially mortality, are different.
We take a bottom-up approach to evaluating these companies and focus on the sustainability of their respective business models. It’s important to have a degree of embedded scrutiny when looking at these new-age tech companies in order to evaluate which of them will have successfully disrupted and changed their industries in the next decade.
Where do you see India compared to the world in terms of performance given the huge foreign direct investment (FDI) flow we have seen in the last couple of years?
The Indian equity market has vastly outperformed its peers over the past five years—the Nifty has given an absolute return of around 86 percent while the MSCI Emerging Markets index has given a measly 34 percent. We think India will continue to attract a good portion of the FDI flows into emerging markets; the Indian growth story is well and truly intact as we propel towards a $ 5 trillion economy. This transformational move will undoubtedly attract capital to fund this growth and participate in the growing pool of corporate profit in India Inc.
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