bnp paribas: As Nifty heads south, tilt allocation towards largecaps, defensives: Kunal Vora, BNP Paribas

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As foreign investors have pulled out over Rs 12,300 crore from Dalal Street this month so far, Kunal Vora, Head of India Equity Research, BNP Paribas, says domestic investors should tilt their allocation towards largecaps and defensives. “We see higher valuation comfort in Nifty50, which has underperformed the mid cap and small cap indices over the last one year,” he says adding that he is also bullish on the manufacturing theme. Edited excerpts:

Given the way markets are behaving globally now, amid concerns related to inflation, war and tightening by central banks, are we nearing a stage where fear will begin to dominate the sentiment on Dalal Street?
Indian markets have been resilient despite a spate of negative news. There have been growing concerns on the economic impact of geopolitical conflicts, which added to the existing concerns like rising inflation and tightening of monetary policy. Despite a rise in inflation expectations and a reduction in growth forecasts, Indian markets have done fairly well compared with a majority of its peers and India’s premium to Asian peers is now close to an all-time-high.

Expectations of strong 15%+ earnings CAGR over FY22-24 and strong domestic inflows are supporting the market. It is unlikely that we would see the full impact of surging inflation and its impact on growth in 4QFY22. However, we would watch out for management commentary on this as any earnings disappointment this season may dent the market sentiment.

Which pockets of the market do you like at this stage and which ones would you prefer to stay out of? Which are the themes or sectors that you are giving the highest weightage on at the moment?
Considering the economic risks discussed above, we believe investors should tilt their allocation towards largecaps and defensives. We see higher valuation comfort in Nifty50, which has underperformed the midcap and smallcap indices over the last one year.

We think manufacturing as a theme could make a comeback on the back of the PLI scheme, global corporates looking to diversify their supply chains, rising capacity utilisation levels in India, low interest rates and structural reforms that the government has undertaken like the corporate tax rate cut and GST implementation. Infrastructure looks attractive with the capex and infra development push in the budget. We think the government’s GatiShaki theme will drive investments in critical areas such as roads, railways and ports.

Financials seem well positioned as credit growth is likely to pick up. The worst of asset quality issues seem to be behind us and sector valuations have contracted. The telecom sector has gone through the pain of high competition, low tariffs, regulatory issues and high spectrum costs, most of which are behind now, in our view. In pharma, we think hospitals and diagnostics segments are well poised for long-term growth.

Domestic consumption has slowed and is facing multiple near-term headwinds. We expect mostly weak results and commentary in the near term.

How tough do you think would it be for India Inc to impress this earnings season? The beginning hasn’t been good so far.
We expect moderation in growth and rising cost pressure to be the key themes during this earnings season. Earnings season has just begun but the initial results from IT services, financials as well as operational updates from consumer companies indicate this trend. There has been a spike in commodity costs in March, full impact of which we will witness only in 1QFY23.

In consumption, we believe sectors catering to affluent India such as consumer durables, real estate, PVs, paints, jewellery and hotels should outperform the sectors catering to the mass-market such as FMCG, which are witnessing a higher impact of inflation.

When it comes to IT stocks, do you think select midcaps will continue to outperform their largecap peers?
Demand for digital technologies continues to stay strong. Select mid-caps are better positioned to see higher growth due to their services portfolio and vertical exposure being well aligned to capture strong digital demand. That being said, valuation premium of some of the mid-cap IT services stocks, to their respective historical averages, is much higher than that of large-cap IT services stocks and could weigh on their stock performance when inflationary concerns are high.

What’s your assessment of the consumption theme at this stage? Would you be recommending your clients to pick some of the staples or discretionary stocks that are off their record highs?
The domestic consumption sector is facing a double whammy of weakness in demand and rise in raw material costs. Our recent on the road visit to rural areas signifies that rural income growth is lagging the cost increases and is impacting the consumers’ spending power. High-energy inflation hurts rural India and there is also high inflation in mass consumption categories like FMCG and telecoms.

Rural wage growth and MSP increases are still moderate and we have not seen any meaningful benefit of the spike in global agricultural commodity prices for Indian farmers yet. With the inflation pressure impacting the affordability for mass consumption, companies will be unable to pass on the rising cost to consumers, without any adverse impact on sales volumes. Sectors like autos are still facing the Covid induced supply-side disruption.

Though these sectors have seen decent corrections from their peaks, returns might remain muted until there is a better visibility on the abating of inflation pressures and supply side issues.

Are their pockets within the consumption basket that you think have the capacity to withstand inflation, display pricing power or increase their market share?
So far, our preference has been for businesses catering to affluent India, which has been well positioned amid the pandemic given higher savings because of work-from-home, salary hikes, strong stock-market returns, curtailed discretionary expenses and low interest rates. However, resilience in this segment could also be tested as we are seeing headwinds such as rising interest rates and spiralling of fuel costs, lower potential returns for the stock market after strong gains over the last two years and return of expenses from commuting, children’s education, entertainment and travel.

Consumers might have to prioritise their spending amid high inflation and we expect the telecom sector to do well despite being a mass consumption category and despite large tariff hikes. The consumer durables companies in segments such as air conditioning are well placed with a stronger summer season.

Do you think foreign investors can once again turn net buyers on a monthly basis within this calendar year? How worried should one be about the ongoing outflow?

The twin challenges of inflationary pressures and rising bond yields, globally, remain a worry for foreign investors. We have seen this exodus of foreign capital across emerging markets, as foreign investors look for safe havens in the rising interest rate scenario. What gives comfort is that FII holdings in India are already at a multi-year low and the Indian macro situation is relatively better compared with its emerging market peers.

A bulk of FII holdings and outflows have been concentrated in BFSI and IT sectors and we see valuation comfort emerging in these sectors after the recent underperformance. We believe that the flow’s turnaround will depend on the earnings resilience of India Inc.



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