DAILY VOICE | Concerns over potential interest rate hikes may impact mid & small-caps more: Siddharth Khemka of Motilal Oswal

#MARKET OUTLOOK, #Nifty, #Sensex

Siddharth Khemka, Head – Retail Research, Motilal Oswal Financial Services feels all the parameters are pointing towards expensive valuations and hence consistent delivery on earnings expectations becomes crucial going ahead.

The market rallied more than 120 percent from its March 2020 lows and gained 24 percent in the current year 2021 to scale new highs led by strong earnings delivery, benign liquidity and buoyant sentiments.

“At 3.3x, 12-month forward price-to-book for the Nifty is at a 15 percent premium to its historical average of 2.6x. 12-month trailing price-to-earnings P/E for the Nifty stands at around 27.6x, 42 percent higher than its long term average (LTA). Even the market capitalization-to-GDP ratio has currently rebounded to 111 percent (FY22E GDP) – above LTA of 76 percent,” said Khemka who has over 15 years of experience in the field of Equity Research and is currently heading the research desk for the retail business.

Edited excerpts:

Q: The market hit fresh record highs. What are the factors supporting the rally? 

The Nifty exceeded the 17,000 mark in August 2021 to reach a record high; adding 1,000 points in 19 trading days. Markets are scaling new highs led by strong earnings delivery, benign liquidity and buoyant sentiments. Good Q1FY22 earnings delivery has boosted hopes for a solid FY22 with 30 percent+ projected Nifty earnings growth, on the back of a strong 15 percent earnings growth in FY21.

Mid-Caps and Small-caps have been outperforming in CY21 amidst a very busy primary market activity. Q1FY22 Management commentaries across the board suggest an improved demand environment post June 2021, led by the easing of restrictions, lower active Covid-19 cases, and a pickup in vaccinations. Amid the buoyant sentiment and elevated activity in the primary markets, Nifty valuations remain rich at 21.8x 12-month forward EPS which is at a premium of 21 percent versus its long term average (LTA) of 18.0x.

At 3.3x, 12-month forward price-to-book for the Nifty is at a 15 percent premium to its historical average of 2.6x. 12-month trailing price-to-earnings P/E for the Nifty stands at around 27.6x, 42 percent higher than its LTA. At 3.6x, 12-month trailing P/B for the Nifty stands at 23 percent above its historical average of 2.9x.

Even the market capitalization-to-GDP ratio, which fell to 56 percent (FY20 GDP) in March 2020 from 79 percent in FY19, has currently rebounded to 111 percent (FY22E GDP) – above LTA of 76 percent. It is the highest since 2007. The ratio hit its peak of 149 percent in December 2007 during the CY03–08 bull-run. Thus, all these point towards expensive valuations and consistent delivery on earnings expectations becomes crucial going ahead.

Q: Where do you see pockets of opportunities at current levels?

BFSI, IT, Metals and Cement are some of the sectors which can be still looked at current market levels.

Cement: Cement sector is very well placed for a strong upcycle over the next few years with the revival in economy, robust demand in housing and other infrastructure projects. We expect 10 percent volume CAGR over FY21-23E, which should improve industry clinker utilization to over 80 percent (and over 85 percent in North and Central India). Eastern India, with around 25 percent capacity growth over the next 18 months, is the worst placed and is thus our least preferred region. With an improving demand outlook, we prefer companies that: a) are moving down the cost curve, b) have the potential for market share gains, and c) provide valuation comfort.

BFSI: We expect a gradual recovery in the growth momentum as economic activity recovers, which, along with a low cost of funds, would support margins. Fee income should witness improving trends. Collection efficiency is showing a steady improvement over June-July 2021 and will enable moderation in the slippages run-rate from 2HFY22. The restructuring book remains controlled. Banks are carrying an additional provision buffer, which should limit the impact on credit cost. We continue to remain watchful of the asset quality outlook in the near term.

IT: The IT industry is seeing a big change, with technology emerging as the cornerstone for large enterprises. Two themes are driving growth in the industry: (1) digital transformation and (2) cost control through increased automation. Managements remain confident of achieving double-digit revenue growth going ahead on the back of a strong deal pipeline around cloud, data analytics, cyber security, automation, and artificial intelligence (AI). Thus, we expect tech spends to remain a critical enabler for enterprises to transform in preparation for the new normal. Some of this has been factored into valuations as stocks trade at a significant premium to its historical P/E multiple. We feel the re-rating is justified, given the sector’s resiliency and better-than-expected recovery.

Metals: The strong rally in steel prices is likely to sustain on account of the following factors: (a) strong demand recovery in metal consuming sectors across the world; b) focus on de-carbonization in China, leading to production cuts; c) the Chinese government discouraging steel exports by way of removal of export rebates; d) higher raw material prices such as iron ore, coke, and coal; and e) temporary export tax imposition by Russia to discourage steel exports. On the other hand, aluminum prices would be supported by improved demand for the metal, production cuts in China, and the cap on capacity expansion leading to a market structurally in deficit over the next 2–3 years. While there are temporary headwinds in demand from the Automotive segment due to the semiconductor shortage, the worse is likely behind. While deleveraging would remain the key focus for companies, they are also eyeing growth, which would lead to higher capital expenditure.

Q: Do you think GST collection, e-way bill generation, and peak power demand is pointing towards better-than-anticipated economic rebound. Does it mean India will report more than 10% growth in FY22?

Most of the indicators that we analyze on a monthly basis to track the progress in economic growth paint a robust picture for economic recovery. The e-way registrations, toll collections, mobility indices, and power generation have increased at a faster rate. However auto registrations and merchandise exports have weakened in the recent months. Real GDP grew at a record 20.1 percent YoY in Q1FY22, albeit on a low base. Growth was largely attributable to 13.8 percent YoY growth in consumption and 56.7 percent YoY growth in Gross Capital Formation (GCF). The GST collection also remained above Rs 1 lakh mark for the second consecutive month at Rs 1.12 lakh crore for August 2021. With inflation too cooling off – the policy stance is likely to remain accommodative and focus on economic recovery during festive season. Overall, we expect real GDP growth of 7–8 percent YoY in Q2FY22 and around 9 percent YoY growth for FY22.

Q: Do you expect more earnings upgrade in Q2FY22 and why? Have you changed your FY22 earnings growth projections?

Corporate earnings in the first quarter of FY22 have been in line with the elevated expectations, aided by the deflated base of Q1FY21 and localized and less stringent lockdowns versus Q1FY21. Management commentaries across the board indicate an improvement in the demand environment post June 2021, led by the easing of restrictions, sharp reduction in active Covid-19 cases and pick up in the pace of vaccination.

Amid the likelihood of a normal monsoon season, we expect corporate earnings to recover as economic activity picks up and pace of vaccination accelerates further. The Nifty FY22E/FY23E EPS estimate has remained steady at Rs 732/Rs 865. The downgrades in Auto & NBFC sectors have been compensated by upgrades in Metals and Cement sectors.

Q: Auto sector hit badly in the last three months. What are major reasons behind it and how long this underperformance will continue? Is it the time to pick auto space or should one wait for some more time?

Demand and supply were severely affected by the second COVID wave, weighed by localized lockdowns and oxygen shortage over April–May. Commodity cost inflation led to raw material cost inflation which continues to hurt margin, but price hikes reduced the pain. Further the performance of passenger vehicle (PV) has been severely affected by the semiconductor shortage. Tata Motors’ JLR stated it would see a cut in production volumes by about 50 percent in Q2FY22. Domestic original equipment manufacturers (OEMs) such as Maruti and M&M could see an impact on volumes in Q2FY22.

Going ahead, the commodity cost inflation intensity is expected to plateau from 2HFY22, while the semiconductor shortage has impacted PV production recovery. The upcoming festival season could serve as a catalyst for demand recovery, particularly for the trailing 2-wheeler segment. Current valuations are largely factoring in sustained recovery (our base case), leaving a limited margin of safety for any disappointing developments.

We prefer 4-wheeler over 2-wheeler as PVs are the least impacted segment currently and offer a stable competitive environment. We expect commercial vehicle (CV) cycle recovery to slow over the near term. Maruti and M&M are our top OEM picks. Among the auto component stocks, we prefer Bharat Forge and Apollo Tyres. We prefer Tata Motors as a play on global PVs.

Q: Nifty Midcap100 and Smallcap 100 indices posted gains for 14th and 9th consecutive month respectively. Do you think the outperformance to Nifty will continue in coming months as well, and why?

Post the sharp rally in midcaps and smallcaps the valuations have turned expensive. However, if we remove loss-making companies from both the indices, then the Nifty Midcap/Nifty Smallcap indices are trading at a trailing P/E of 21x/23x FY21 earnings, at a marginal discount to the Nifty. Thus, the current valuations though not lucrative from a risk-reward perspective, but they do offer bottom up opportunities, given the gradual unlocking of the economy and an improved demand backdrop. The balance sheets and cash flows have also improved in FY21 as corporates tightened costs and deleveraged. Consistent earnings delivery versus expectations is now critical for further outperformance. Any risk-off owing to concerns over potential interest rate hikes may impact midcaps/smallcaps more in our view.

Q: Realty (up 21 percent) and IT (up 28 percent) were star performers in last three months. What is the reason behind their rally? Do you think it is the time to book profits in these sectors or one should keep holding the same?


Q1FY22 was one of the best growth performances of IT services companies, aided by broad based growth across geographies and services. The FY22 outlook for most companies also saw an upward revision, led by a strong start to the fiscal and a supportive demand environment. The commentary on the deal pipeline and conversions continue to be supportive in Q1FY22. While deal wins (+30 percent YoY) remain strong, there was some moderation from record highs in Q3/Q4FY21. The management commentaries continue to highlight a very strong tech-spending environment, led by Cloud migration-related work.

The median book-to-bill improved in Q1 to 1.3x (from 1.2x in Q1FY21), which provides us strong growth visibility for FY22. Managements expect the Cloud migration work to continue over the next 3-5 years. Further the IT companies added all-time high employees in Q1, despite a robust increase in Q3/Q4FY21. Strong hiring indicates expectations of continued momentum in deal wins and a robust demand environment. Some of this has been factored into valuations as stocks trade at a significant premium to its historical P/E multiple. We feel the re-rating is justified, given the sector’s resiliency and better-than-expected recovery.


The housing demand has significantly picked up due to the pandemic resulting in sharp reduction in the unsold inventory. On the other hand, the industry is witnessing consolidation resulting in demand shift towards organized players. Thus with increasing demand and limited supply, prices are increasing while the organized players are seeing market share gain. On the other hand, commercial/retail demand is muted. Thus investors should stick to market leaders in housing space as demand continues to be strong while pricing should hold on given limited supply.

Disclaimer: The views and investment tips expressed by investment expert on Moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.

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