IIFL Diwali 2018 Picks

Dear Investor,

In the past one year, though Nifty 50 has given a return of ~4%, BSE Midcap and BSE Smallcap have plummeted 10% and 15% respectively. The positive returns of Nifty 50 were largely driven by just 5 stocks i.e. Infosys, TCS, Reliance Industries, ICICI Bank and HDFC Bank.

Whereas the carnage in mid and small cap stocks was caused by mutual funds’ selling owing to new categorization of MF schemes, GSM/ASM circular of SEBI, change in equity taxation, etc.

In addition, liquidity crisis led by IL&FS default, was extended to other NBFCs, which were already reeling under increasing interest rate environment.

The macroeconomic indicators are worsening due to rising crude oil prices, weakening INR against USD, fear of subsequent interest rate hikes by the RBI, US Fed rate hikes and concerns related to trade war.

Moreover, state elections in MP, Rajasthan and Jharkhand over December 2018 – January 2019, and general elections in 2019 have made investors cautious on equities.

However, retail investors continue to invest in equity mutual funds via SIPs. Notably, Indian mutual funds have received SIP inflow of `64,675cr in CY18 (9M) compared to `59,482cr in CY17.

The total AUM of Indian mutual fund industry was at `22.04 lakh crore in September 2018. This reflect that, today retail investors are more financially educated and upbeat about investing in mutual funds, despite recent disturbances.

On the economy front, RBI has maintained the GDP growth rate at 7.4% for FY19, as various indicators suggest that economic activity has continued to be strong.

However, it has raised concerns over rising input costs leading to contraction of profit margins and tightening in the domestic and global financial markets. RBI has also downgraded the CPI inflation projection to 4% in Q2FY19 from 4.6% and 3.9-4.5% in H2FY19 from 4.8% in October 2018 meeting.

However, it changed the stance to ‘calibrated tightening’, which means more rate hikes are on the cards.

In the debt market, we believe bond yields are expected to remain range bound with an upward bias in the near term on concerns of rising interest rate hikes by RBI, fiscal slippage, surging FII outflows and interest rate hike by US Fed.

In line with IIFL’s endeavor of providing our clients with prudent financial advice, we recommend investors to focus on stocks with clear sustainability of earnings growth than percentage of growth.

This report highlights the current macros and growth outlook of the Indian economy coupled with our top stocks and mutual fund recommendations. Happy investing!!!

Crude oil prices – The joker in the pack

The crude oil price has gone up ~38% in last one year as OPEC has created dearth of oil to support the crude oil prices, in addition to undersupply created by Iran sanctions.

Meanwhile INR has also depreciation ~12% against USD which has magnified the impact on India. As per RBI, the price of the Indian basket of crude oil has increased sharply by US$13 a barrel since August 2018.

The Economic Survey of the Government of India has estimated that a $10/barrel rise in crude oil price can increase WPI inflation by 1.7%, widen CAD by $9- 10bn, and reduce economic growth by 0.2-0.3%. India’s current account deficit widened to $15.8bn (2.4% of GDP) in Q1FY19 due to a higher trade deficit of $45.7bn.

However, US has been pressurizing Saudi Arab to compensate the undersupply created by the Iran sanctions and the latter has given positive indications. If this materializes we will see moderation in the prices of oil.

In the case if oil prices continue to rise, the CAD will widen and weaken the INR against USD, and accelerate inflation forcing RBI to further hike interest rates.

This may lead to a negative impact on interest sensitive sectors, however positive impact will be witnessed in export oriented and import substitution stories.

Widening spread between bond yield and earning yield

The spread between earnings yield and bond yield has been widening since November 2016. Currently it is near all-time high, at ~230bps, due to rising bond yield and premium equity valuations.

In the current environment filled with turmoil, the chances of mean reversion are significantly high. Bond yields are not likely to soften anytime soon, therefore equity yields must rise.

Recent correction reduced the premium equity valuations

Currently, the market is trading at ~6% premium to its 10-year average P/E ratio compared to a premium of ~12% a month ago. Further, due to recent correction, the Nifty 50 is now trading below +1 std dev P/E ratio.

Besides, recovery in economic scenario and commodity prices are favorable tailwinds for corporate earnings growth.

In FY19, corporate earnings may still grow at ~14% against a previous expectation of ~20% growth due to worsening macros. This is still better that the single digit growth rates of past couple of years.

The current correction has given an opportunity to investors to invest in good quality businesses at reasonable valuations after a long spell of over-valuation.

Investors should focus on sustainability of earnings growth than percentage of growth while investing in current round of market uncertainty.

As smallcaps and midcaps are down by more than 30%, one can start to bottom fish in good quality companies but avoid averaging stocks whose fundamentals have deteriorated significantly.