Q2 to be third straight quarter of muted earnings growth; stress in telecom seen: Sanctum

Earnings season for the September quarter set in after giants such as TCS and Reliance reported their numbers last week. The Street is seen awaiting further cues from this event, even as the battle between liquidity and valuations continue.

However, the season could be the third quarter in a row of muted earnings growth with wide dispersion at the sectoral levels, Sunil Sharma, Chief Investment Officer (CIO), Sanctum Wealth Management told Uttaresh Venkateshwaran and Sunil Shankar Matkar of Moneycontrol.

“…we would note that money continues to be made at the stock-specific level despite a lackluster earnings story at the index level and active managers are outperforming the index by handsome margins,” he added. Here are the edited excerpts from that interview.

What are your expectations from the crucial earnings season in the backdrop of high market valuations?

This will be the third quarter in a row of muted earnings growth, with wide dispersion at the sectoral levels.

Over the past quarter, a few key trends were at play that is likely to have an impact on earnings. First, GST re-stocking was underway in July but as the quarter wore on, substantial working capital cycle, liquidity and operational challenges emerged.

Second, oil prices have risen, globally and at the pump, and were a contributory factor to the dip in consumer confidence. Sentiments were muted as small businesses grappled with the new regulations, consumers grappled with the changing tax structures and rising uncertainty on job security and job prospects.

Finally, commodity input costs have risen and the exchange rate weakened leading to rising cost pressures.

On a sectoral basis viz. IT, banks, pharma, metals and consumer, what is the expectation for earnings?

What we have reasonable clarity on is that NBFC and housing finance, alongside private banks, would appear to have done reasonably well. These companies were in a good position as rates declined to manage their credit spreads.

Further, rural credit has accelerated higher and consumer credit remains healthy. That’s evident in the robust auto sales numbers as well. Autos would seem to be in a decent space as well and the market will be focused on forward guidance. Materials appear likely to do well as data points continue to point to a decent operating environment.

Given the credit offtake for rural and continued willingness to purchase autos, the consumer appears to be in reasonably decent shape, courtesy farm loan waivers, declining borrowing rates and to a lesser extent, buoyant equity markets that have delivered returns year to date.

So the consumer appears to be doing reasonably well and so are firms in that space.

The areas we’re concerned about are telecom, for obvious reasons, but also manufacturing companies where input costs would be an impediment to earnings and margins.

To round things out, IT majors are likely to have delivered muted growth, as we witnessed with announcements this week. Pharma will also remain somewhat challenging but appears to be bottoming. The news flow on pharma has certainly improved in recent days with progress on FDA approvals.

With regard to valuations, the market is clearly communicating some level of comfort with current valuations and a willingness to look forward past the current quarter.

What is your call on markets if earnings disappoint once again in September quarter?

This is likely to be the third quarter in a row that earnings disappoint. But there are some factors to consider.

One, we’re witnessing a coordinated global recovery. The Indian market continues to be inward focused, but we think a recognition of an improving global macro backdrop is an important factual input.

The US, Europe, Japan and China are showing decent growth. Commodity producers are showing a cyclical improvement and India, despite the handwringing, has grown in the range of 5-7 percent, which puts us still in the top decile of most rankings.

Two, there are mitigating factors for the disappointment in earnings. The government’s efforts on Aadhaar linkage are creating an economy where credit will flow efficiently on credit ratings in minutes and not weeks. The availability of credit will lead to a rise in consumption demand, as Indian aspirations remain high and will eventually bring forth investment. The government also needs to stay mindful of the needs of the BOP, the bottom of the pyramid.

However, we would note that growth must come from spurring consumer demand, and generating rising consumer disposable income. A high participation taxation system is a far better alternative than a high taxation system that stifles consumer spending.

We continue to believe that India is in a structural growth phase and investors recognise this and remain invested.

It will as always be a market driven by sectors and individual stocks, and the sectoral story is likely to have wide dispersion in commentary, outlook and performance.

Finally, we would note that money continues to be made at the stock-specific level despite a lackluster earnings story at the index level and active managers are outperforming the index by handsome margins.

Do you expect economic recovery from 2018 onwards or is it a bubble creation by the government?

Valuations today are high, across geographies and asset classes, spurred by massive global liquidity and rising domestic flows of late. However, we’re not in a bubble. Whether you consider real estate, where traditional relationships on yield, rent relative to price, and income are all skewed disproportionately, or equities, we’d venture that valuations are high but not in bubble territory. We saw some froth in the market and we continue to see greed chasing growth, but it’s not widespread and the recent sell-off brought a healthy amount of fear back into the markets.

Are there any chances of domestic liquidity peaking at some point of time?

Liquidity is a chimera and can vanish quickly. We’ve seen the liquidity story collapse in previous cycles and are unwilling to ever say this time is different. Over the longer term, liquidity is just getting started in terms of India participation, but on a medium or short term basis, it’s fickle.

Now, liquidity is a structural trend and it’s gained momentum because of the virtuous cycle of returns generating a wealth effect and comfort in putting more money.

However, investing based on strong liquidity is not a positioning we’re prepared to assume. Investment must be made on the notion of value, future flow discounting, and margin of safety.

We’d say that liquidity has every chance of peaking at some point in time, but we’re unwilling to venture a guess on when that happens, and longer term, this is only the beginning.

Several market voices see no further upside this year to the Nifty. What do you think and what is your target?

Rational observation would suggest that call makes sense. That call is based on valuations being stretched to historically high levels and earnings growth not coming through. We are now in the third year of high index valuations. We generally do not assign as much emphasis to index valuations as we do to sectoral and stock valuations, our efforts are targeted at delivering high, risk adjusted returns to clients.

We’re increasingly witnessing that returns at a portfolio level and stock level are increasingly diverging from index returns. Winners are delivering disproportionately high returns.

We think markets are vulnerable in the shorter term as much will depend on earnings and we’re expecting a muted season. However, with the strength in flows and a willingness to look beyond yet another one-off quarter, we’d suggest that the index is likely to trade up 3-5% from current levels.

What sectors would be good bets for Diwali?

We’ve recently been adding to sectors with prospects for strong growth. We’ve added names that are positioned to benefit from the move to electric vehicles, specialty chemicals and the adoption of smartphones and fintech.

Within the traditional sectoral space, we think credit growth has been healthy for NBFCs and housing finance, and these companies will continue to benefit.

Private banks and capital markets players are likely to continue to deliver strong earnings. We’d choose a combination of traditional and emerging sectors listed above.

Which sectors should one stay away from?

The PSU space looks challenging, and we think stresses in industry could rise this quarter. Telecom incumbents look vulnerable as well with rising stress.