Equity 2017: Use volatility to cherry-pick stocks

As we set foot in 2017, one point everyone agrees on is that this is going to be an extremely difficult year for the equity market. The uncertainty arising from significant global events such as Donald Trump taking over the reins of the US, the Brexit roll-out and the Federal Reserve’s impending rate hikes can cause major upheavals in global fund flows.

On the domestic front, demonetisation, the upcoming Union Budget and timely implementation of GST will set the tone for domestic stock price movement.

The earnings picture Contrary to common belief, the earnings growth in Sensex companies in FY17 has not been too bleak. Sensex EPS is expected to increase to 1563 in FY 17, registering growth in high double digits. While the banking sector, which accounts for almost a third of the Sensex’ free-float, will drag the overall earnings due to increased recognition of stressed assets, the presence of private sector banks such as HDFC Bank, HDFC and ICICI Bank in the Sensex basket is expected to salvage the performance of this group in index earnings.

The automobile pack, which has a strong contingent in the Sensex with 11 per cent share in Sensex’ free-float market cap, has put up the best show, led by Maruti and M&M that are expected to register earnings growth of 54 and 37 per cent in FY17. The Pharma sector, despite the run-ins with regulators, has reported bottom-line growth above 20 per cent this fiscal. While IT earnings lost momentum with single-digit growth recorded by the biggies, metals and mining stocks and capital goods stocks are expected to grow earnings above 15 per cent, thanks to a low base last year.

The earnings growth in 2018, according to consensus estimates, is expected to be better at close to 20 per cent, with Sensex EPS at 1872 for FY18. With the asset quality review (AQR) likely to be complete in a couple of quarters, the profitability of banks is expected to improve, bolstered by the treasury gains due to falling bond yields and falling cost of funds.

The Auto sector is expected to chug along nicely with Tata Motors and M&M growing their earnings over 25 per cent even as the growth in Maruti’s bottom line tempers down. The index heavyweights, Reliance Industries and ONGC, whose earnings were impacted by exceptional items in FY17, are also expected to record growth in high double digits.

If we accord valuation of 16 times PE multiple to the Sensex FY 18 EPS of 1884, the upside in the Sensex could be around 12 per cent.

Demonetisation and the Budget But there are many imponderables that can throw a spanner in the works. The jury is still out on the impact of demonetisation on company earnings. But with reports of more than 90 per cent of the banned notes having returned to banks, the hit on consumption in the organised sector is likely to be smaller than originally envisaged.

That said, the snail’s pace at which remonetisation is taking place is causing a cash crunch that is affecting goods and services transactions that take place in cash, in select regions. The impact appears greater in the informal sector, outside the listed companies’ space. While this fall in demand can be temporary, the higher scrutiny on transactions fuelled by black money is likely to have a more long-lasting impact on sectors such as real estate and gold jewellery.

The impact of demonetisation on Sensex earnings is, however, likely to be minimal.

The additional revenue that can be raised due to higher taxes and the PMGKY scheme will help the Centre meet its fiscal deficit target and push through welfare schemes for the rural and agri sector. A cut in corporate tax in the Budget will also give a kicker to stock prices.

Themes for 2017: Consumption over investment The consumption theme is likely to stay strong in 2017 while investment remains a laggard. There are various reasons for this. One, the 24 per cent hike in salaries of government employees, coupled with OROP pay-outs, will increase demand for consumer discretionary products. Two, the south-west monsoon has been normal this year and it will help improve rural demand, once the cash crunch eases. Three, lower borrowing rates are again conducive to consumer durables, automobiles, real estate and so on. Four, there is expectation that the Union Budget of 2017 will give a thrust on consumption over investment, with an eye on the upcoming state elections. Five, India’s demographic trend of increased urbanisation, growing upper middle-class and increasing per capita income make consumption a strong theme to bet on for the long term. Make use of market volatility to buy automobile, auto ancillaries, consumer durables, building materials, etc.

Cyclicals over Defensives Investors are likely to be wary of pharma stocks until the regulatory warnings cease and companies spruce up their act. IT companies that have not made inroads into digitisation are likely to be by-passed and overvalued FMCG stocks could see reduced investor interest. On the other hand, cyclical sectors such as oil & gas and metals and mining can be good bets thanks to the revival in global commodity prices. Some construction stocks are also appearing promising with improved project implementation in roads and railways. Some capital goods stocks, especially industrial consumables, also appear interesting.

Large and mid-caps over small-caps Given the higher risk from global fund flows, large-caps can be better bets in the coming year. Select mid-caps can help improve your portfolio returns. The correction since August has helped bring the PE of the BSE mid-cap index down from 34 to 29. However, steer clear of small-caps that continue to trade at high PE multiples.

The bottom line The domestic story is good and many sectors are recording strong growth. But stock prices will be buffeted by the uncertainties cited above. It will be best to utilise such rough patches to buy stocks with sound fundamentals with an eye on the long term.