Equities in 2022: Shift to test match mode from T20

Markets in 2021 were in no mood for a breather. After defying sceptics with a 15 per cent gain in CY2020, the benchmark Nifty 50 followed it up with a 24 per cent gain in CY2021. The broader Nifty 500 too returned a good 30 per cent for the year.

With its 2021 performance, the Nifty 50 has managed positive returns (in a calendar year) for 6 consecutive years and in 9 of the last 10 years — enough to make those who entered the markets over the last decade believe stocks never go down, and those who endured bear markets prior to the last decade think it was more of a blip! However, rather than see this as the new normal, one must guard against the trap of hot hand fallacy.

While there is no “Paul the Octopus” when it comes to market predictions, as we attempt crystal ball gazing into 2022, there are ample reasons to be cautious.

Starting with valuations, the Nifty 50 is trading at a FY22 PE of around 24 times and FY23 PE of 20 times (Bloomberg estimates). On a trailing basis it is trading at a PE of 25 times, which is a 16 per cent premium to its 10-year average and in line with its 5-year average. While it may look like it’s not trading at a significant premium to historical levels, digging deeper into the contributors to earnings indicates some amount of over-valuation.

Much of the contribution to earnings is coming from highly cyclical companies like metals which have seen substantial growth in earnings benefiting from the commodities boom. Four commodity companies (Tata Steel, JSW Steel, Hindalco and ONGC) with cumulative Nifty weights of around 4 per cent are expected to contribute around 18 per cent to the cumulative net profits of Nifty 50 companies in FY22 (vs 10 per cent in FY21). Out of the absolute increase in net profits of Nifty 50 companies in FY22, these companies are contributing to around 45 per cent of the increase. Commodity and metal company earnings tend to be highly volatile and this can impact earnings either way.Financials is a heavyweight in the index and is expected to contribute around 25 per cent to cumulative net profits in FY22 and drive earnings growth in FY23. Slower credit offtakes and spike in bad assets can play spoilsport.

This apart, investors also need to factor risks of multiple compression in 2022. Broadly, the PE has been expanding over the years. Out of the absolute returns of 275 per cent in the index in the last decade, around 170 per cent is from multiple expansion with earnings growth contributing less to the returns. Multiples can contract due to various factors. For example, Warren Buffett refers to interest rates as ‘gravity’ for financial valuations. Higher the interest rates, higher the force of gravity on valuations. With interest rates expected to rise globally, including in India, the force of gravity may start getting stronger and cause multiple compression.

Another factor to keep in mind is the sustainability of earnings trajectory, given potential headwinds for economic growth. Analysts (Bloomberg consensus) expect earnings growth of around 18 per cent in CY22. While earnings growth driven by a recovering economy can sustain, it would be prudent to bake in some caution. At the same time last year, the US Fed was not even ‘thinking about thinking about tapering’ and right now they have not just started to taper, but decided to accelerate it and indicated multiple interest rate hikes for the year. Monetary tightening is also on the cards in India this year. The looming slowdown in China post unwinding of the real estate boom there, and ripple effects on global growth are other aspects to be considered. The impact of these on GDP growth and earnings growth of corporates needs to be monitored. For example, after a near 40 per cent growth in CY10 earnings post the global fiscal and monetary stimulus in the aftermath of the financial crisis during 2008-09, the earnings growth for Nifty 50 tapered to single digit percentage growth for the next few years. Growth slowing down can also result in multiple compression.

Also read: Fixed income outlook for 2022

Game plan for 2022

Into 2022, investors are faced with two choices — missing out on further gains in the market if the momentum continues, or losing out on the gains made over the last year or few in case the bears get to have their time in the markets. If your choice is the path of caution, then here are some of the steps you can take in early 2022.

One, book profits in some of the new-age and other companies where the valuations are completely disconnected from fundamentals. While this is a judgemental call, comparison with international peers for new-age companies, and with historical valuation levels for other companies that have been trading for many years is one way. Holding on to companies trading at excessively high multiples may not be worth the risk in the current context.

Two, in maintaining your equity portfolio and reinvesting from exits in over-valued companies, focus on companies with strong balance sheets, preferably generating positive free cash flows, those that can maintain their margins in an inflationary environment, and are trading at discount/in line or at best modest premium to their historical valuations. You may not get companies that check all the boxes — for example, Indian IT services companies may check the first 3 boxes, but are trading significantly above historical valuations negating the first three positives. The margin of safety is more when valuation is reasonable and some of the other boxes are ticked. For instance, telecom has pricing power today and a player with manageable debt would be a better fit in a portfolio. There may be some opportunities in undervalued PSUs.

Another segment would be holding companies. Some trade at significant 50-60 per cent discount to underlying asset value, and may offer opportunities for long-term investors. Investors can also look for entry points in sectors where there is a long runway of growth given low penetration levels, like in insurance, electric vehicles, defence, etc. Given the broad market outperformance in 2021, investing in 2022 should be entirely bottom-up.

Three, although US markets too are prone to correction, , some diversification into quality and reasonably valued companies listed there is also a good option. For example the new-age peers of Indian companies in the US markets trade at a significant discount compared to their Indian counterparts although they too have strong growth prospects and fare better on profitability metrics.

Four, reducing some equity exposure in overall asset allocation and parking in debt options is worth considering. These could serve as useful ammunition whenever a market correction materialises. Whether this year or not, eventually, corrections happen in markets, and they end up being as severe as we have seen in 2000-01, 2008-09, 2010-11, 2015-16 and in 2020. If the powder is not dry to reinvest in markets when corrections come, valuable opportunities will be lost.

Also read: Gold outlook for 2022