CNX NIFTY @ 10,000 or 8,000 - The Journey from Here

CNX NIFTY index comprising top 50 stocks by free float market capitalization is a good barometer of corporate profitability in India. The index has been on a steady uptrend for over 15 months now touching a high of 9709 on 6^th June 2017.

While valuations (PE) are clearly high at 24+ level (profitability yield of 4.17%), there are two factors that give an interesting insight:

• There are good quality stocks which are still trading at very reasonable valuation i.e. ICICI and Reliance.

• The sectoral divergence is high

o   Segment A: Sectors governed by domestic demand i.e. Financial Services, Consumer, Cement, Auto and Media & Telecom are trading at valuations of 31.

o   Segment B: Sectors with export orientation including IT and Pharma are trading at valuation level of around 18.

o   Segment C: Utilities (Infrastructure & Power) and Commodities (Coal, Oil, Gas & Metal) are trading at a valuation level of 16. It is further not helped that largest companies in this space are PSUs which usually trade at a discount to their private sector counterparts.

It has resulted in an extremely skewed position wherein 27 companies in domestically driven sectors contributing around a third of the index profits are contributing over half of the index value. While analysts are predicting a profitability expansion of 15% to justify such high valuations, only companies in segment A may be able to post that kind of profitability expansion that too in the most favourable scenario. 

 

Figure 1: Identify which graph represents profit share?

An analyst report that I was skimming through highlighted how ITC can grow profits at 12% on the back of a 6% volume expansion since ITC has done precisely that in the last year. If ITC continues to do that for eight more years, its net margins would exceed 100% - a logical fallacy. These are very unfair assumptions for a rationale investor, and a profitability expansion of 15% is a very liberal estimate for Segment A companies. 

Segment B has been hit hard by pricing pressures and immigration issues, however may still remain on track to post a low single digit profitability growth of around 5%. The same would hold true for Segment C companies owing to cyclicality of commodity prices and the space in which these companies are in.

Combining all these factors, we are looking at a profitability expansion of 8-10% on a very liberal basis for FY2017-18. A NIFTY EPS of around 431 would imply an index level of 10,300 at a valuation level of 24.

 

What is a Fair Valuation Level 

 The low interest rate regime has pushed us into an era of abnormally high PE. I think it would be unfair to assume a trading range of 16-24 for PE ratio going forward, rather 18-26 remains like a more reasonable spread. While PE ratios have traded outside this range, the days for which such anomalies have existed have been limited and usually retreat has been fast and quick. For instance, just before US housing meltdown in Jan 2008, NIFTY was trading around 28 and retreated quickly at such a pace that immediately after Lehmann bankruptcy, it was flirting with a level of 10 in Sep 2008 (less than 7 month after its four one-night stands with 28+ level). And, in less than 3 months post Lehmann bankruptcy, it had again returned to a respectable level of 16-18.  

Having said that, it does look like valuation levels are still very steep for Segment A companies, none of which is a growth company in the mould of Google, Facebook and Amazon (growing at over 5% per quarter). While all these growth companies are trading with a consolidated PE of 22 in US where interest rates are less than a quarter of what they are in India. The premium being paid by investors for quality stocks in a fast growing emerging economy (a la Alibaba) seems beyond any semblance of reason. 

Figure 2: PE Ratios for Growth Companies in US

 

Please consider valuation of Apple to put things in perspective: consolidated profitability of NIFTY-50 companies is just a bit more than the net profits reported by Apple for the year 2016. Yet the valuation is over 40% higher at $1.05 trillion combined market cap of these 50 companies in a country where discount rate ought to be higher on account of higher interest rates. 

A Long Term Conjecture on Indian Economy: Looking at Parallels Elsewhere

I think it is safe to assume that Indian economy is at the cross-road at which US Economy was 12-15 years back. The stock market index was dominated by companies in financial services, consumer driven segments, commodities (oil & gas) and utilities.  The new age technology companies except Microsoft had yet to prove their worth over the big guys, particularly after tech meltdown of 1999-2000.

The below two tables try to establish a correspondence between Global Companies of 2005 with Indian companies of today and identifies a pattern that allows us to project forward in 2025-2030 for India (all projections are subject to random errors).

 

	Most Valued Global Companies: 2005	Most Valued Indian Companies: 2017 Order has been slightly changed to reflect correspondence
1	Exxon Mobil	Reliance Industries
2	General Electric	ITC
3	Microsoft	TCS
4	Citigroup	HDFC Bank & HDFC
5	British Petroleum: non-US	ONGC
6	Bank of America	State Bank of India
7	Royal Dutch Shell: non-US	IOC
8	Wal-Mart	Avenue Super-mart no retail company is in NIFTY-50, so an outsider has been considered
9	Toyota: non-US	Maruti Suzuki
10	Gazprom: non-US	Coal India Ltd.
11	Johnson & Johnson	Hindustan Unilever
12	Pfizer	Sun Pharmaceuticals

	Most Valued Global Companies: 2017	Most Valued Indian Companies: 2025-30
1	Apple	??
2	Alphabet (Google)	??
3	Microsoft	??
4	Amazon	??
5	Berkshire Hathaway	Life Insurance Corporation (LIC)
6	Exxon Mobil	Reliance Industries
7	Johnson & Johnson	Hindustan Unilever
8	Facebook	??
9	Alibaba: non-US	??
10	JP Morgan Chase	ICICI
11	Wells Fargo	Kotak
12	General Electric	ITC

  

This leaves us with six vacancies to fill up. Unfortunately, unlike our Honourable Prime Minister, I do not believe there is a Make in India story here. These places are likely to be occupied by Microsoft India, Google India, Apple India, Amazon India, Facebook India and PayTM (or may be Uber) and none of them would be listed here. As I speak now, these companies together have quietly moved to amass a turnover of INR 27,000cr in India. 

Corporate Profitability: Building a Base Case

What is the significance of this in the context of Index? Well, it essentially means Indian economy is entering a phase where a large part of corporate profitability would be cornered by the companies not a part of the Index, and hence Index EPS may not rise by as much as economic growth may predict.  It may not be of immediate consequence, but cautions the investors against betting for multi-year double digit growth. It is hard to believe that the Segment A companies in India can grow at a pace of over 10%. All of these are old economy mature companies with growth rate rarely in excess of rate of economic expansion.  

§  Segment A companies primarily comprising old economy companies may see a 9% volume expansion on the back of strong economic growth (this assumes impact of demonetization obviates completely as GST is rolled out and no new companies win over large chunks of market share from NIFTY-50 companies, a la Patanjali)

• Generally profit margins contract in years that see strong volume expansion as companies hire surplus manpower to cater to the growth phase, so we can expect a profitability growth of no more than 6% in base case. A +1% impact on account of GST roll-out (not without risks) and +1% on account of NPA resolution (for public sector banks and ICICI) may push profitability growth to 8%.
• Segment B companies comprise IT and Pharma, both of which are foreseeing strong pressure on margins amid declining volume growth. A volume growth of 9% and a profitability growth of 2% is a fair estimate.
• Segment C companies are coming off a very favourable pricing cycle and repeating the same looks difficult. However, oil & gas marketing companies may actually benefit from the low oil prices since they operate in a retail monopoly at least for the time being. A profitability growth of 4% in base case seems not too far-fetched.

This would result in a NIFTY EPS growth of 5-6% depending on how the relative free float weights evolve. At an EPS of 420-425, NIFTY may trade in the range of 7,500 – 11,000 in the next one year period. Considering that analyst estimates earnings to grow at 15% in FY2016-17, the considerable negative surprises in terms of earnings would lead to multiple contraction and at a multiple of 20-22, the most likely value of NIFTY in June 2018 looks to be in the range of 8,400 – 9,300. Yet, it may be noted that Government action and announcements can keep Analysts misguided for another year by just pushing growth envelope further down the lane, which can keep PE multiple at inflated level even next year.

Counter-point: Till when can Index Heavyweights fuelled rally continue?

At the current level of 9588, NIFTY may look expensively valued, however it needs to be mentioned that amongst the 8 companies contributing 50% to the index, only 3 (L&T, HDFC Bank and ITC) are trading above a PE level of 24 while four (Reliance, Infosys, TCS and ICICI) are trading below PE level of 18. Our upper bound on NIFTY at 11,000 is a full 15% above the current levels. This leaves room for considerable upside until the next trigger, which is Q1 FY2017-18 earnings. The next leg of this rally can perhaps be fuelled by Reliance and ICICI along with further inflation in multiples of HDFC sibling.  An 8% upside in Reliance and ICICI and 4% upside in HDFC siblings and L&T along with similar correction on IT counters would imply NIFTY can scale 9,800 easily. In the wake of GST roll-out, some more broad-based buying on Segment A counters can push NIFTY up in the range of 9,900-10,100 which would be the short-term top for the index.

What is more interesting is how long it to find the likelihood if it can stay there or is there a further upside from the top? Here is where it becomes interesting. There are some positive events that can really make the index stay where it is?

• 15% profitability growth by HDFC twins is not that unlikely, which can take their PE’s to a 30+ range that leaves a scope for 10% upside from current levels.
• ICICI is likely to post a profit growth of 15%+ which can expand its PE to 24-level i.e. a 20% upside from current level.
• If Reliance JIO is listed this year, Reliance can get a minimum boost of 20-25% in its stock price.
• TCS has a buyback and that can take up its stock price around 8-10% over the current levels as EPS would definitely outgrow profitability growth.

All of these factors may have a one in two likelihood of materializing, but all four rolling out together have a probability of around 10-12%. There is a one-in-ten chance that 33% of index expands by 15% i.e. 480 points implying top is maintained. So even though the remaining index remains flat (as positive sentiment linked to these companies is likely to rub off on other companies preventing their fall), then we are looking at year-end target of 10,000+.

 

Technical View: When would the correction happen?

 

In the first week of July, the index would complete fourteen months of continuous uptrend that began in Feb 2016 with a 10% mid-term correction. This followed a fourteen month bear run (with intermittent corrections) in which the index shed 25% of its value.

The preceding fourteen-month period has a three phase segregation:

• A 6-month period spanning Feb-Sep comprising 135 trading sessions that took the index up 33% to within touching distance of 9,000 level.
• A 3-month corrective phase in which the index retraced around 12% (demonetization induced correction).
• As Analysts over-reacted to demonetization and actual earnings belied the same, the index is about to complete another 6-month bull period which would end in June. The 135-trading sessions would end in July 1^st week and index would be 25% above its bottom in Dec if it manages to touch 10,000. 

What would be the trigger for this market to correct itself? Well, the Q1 FY2017-18 earnings can be such a trigger as the jacked up estimates may fell to materialize. However, in the absence of muted global triggers, we may see only an orderly correction.

There are two scenarios that could roll out:

• Scenario 1: The market enters a fourteen month long bear phase with NIFTY fall to around 8,800 level by Dec, rising again to 9,000+ just before FY end and again continuing a downtrend (as our base case earnings materialize) that would end in Aug 2018 at 7,600 – 8,000 level (a PE level of 18-19x over FY2017-18 earnings).
• Scenario 2: The market corrects for 3 months and falls to 9,000 level but as earnings broadly match expectations and index heavyweights continue to outperform as outlined earlier, it goes back up 20% to 10,800 – 11,300 level (a PE level of 25x over better than base case FY2017-18 earnings – 10% profitability expansion) by April 2018, from where we can see a steep decline triggered by global macro-economic shock.
• Scenario 3: Counter-point - There is steep correction over 1 ½ month and then as index heavyweights match expectations, the index climbs to 9,900 – 10,100 level by FY-end.

We assign a 60-65% likelihood to Scenario 1, 8-10% for Scenario 2 and around 10-12% likelihood for Scenario 3.