Stock market has rallied to all-time high valuation and the broader market is too expensive: Is that true?

Agencies

Source: Bloomberg

However, market discourse has more to do with the valuations of broader markets. Let’s look at those data points too.

is trading at 25.9x one year forward EPS – a premium of 22% over the last 10 years’ average, but 24% cheaper than October’21 highs.

Agencies

Source: Bloomberg

Interestingly, the Midcap Index is trading at a 26% premium to Nifty vs a 10-year average of 16% (post-covid era average is 25%). Hence, while the premium persists, it is not in unchartered territories, especially given the fact that it had reached 56% premium in September’20.

Source: Bloomberg

Even more interesting is the fact that Nifty Smallcap Index is trading at a mere 2% premium to Nifty. Compared to the historical average of about 17% discount, this premium could be seen as high, but does it qualify to be called frothy?

Source: Bloomberg

From the above charts and data points, it’s clear that markets are trading at above-average valuations. However, they do not seem to be in a frothy zone, especially if the and capex momentum is good.

Let’s look at earnings growth and capex data too. Our analysis of historical data from BSE 500 companies indicates that India's CAPEX/PAT ratio has generally remained within the range of 80% to 100%. Because projects take time to complete, CAPEX pickup has lagged behind the significant increase in profitability since FY20 (PAT increased from INR 4.0 trillion to INR 10.1 trillion in FY23). As a result, the ratio of CAPEX to PAT has significantly decreased from its historical average and may only increase in the upcoming years.

The BSE 500 FY24E PAT of INR 12.7 trillion is interestingly 3.2 times higher than the FY20 PAT of INR 4 trillion. BSE 500, on the other hand, is currently only 2.9x of what it was at the end of FY20. Data indicates that during this time, market returns have lagged behind growth in earnings.

Source: ACE Equity, BSE 500, Investec Securities

We saw the comparison of BSE500 returns vs earnings growth in the last 4 years.

To better comprehend the phenomenon of Midcap outperformance, let's take a closer look. As opposed to the Nifty Midcap 100 Index's 3x PAT jump between FY20 and FY24E, Nifty PAT is predicted to have increased by 2.4x. The observation that markets reward greater growth is not surprising.

Source: ACE Equity, Investec Securities


The data clearly shows that markets have largely tracked earning growth. Nifty returns have tracked Nifty earnings growth and likewise, Nifty Midcap 100 Index has tracked underlying growth.

Source: Bloomberg, ACE Equity, Investec Securities

The story is the same when we consider the Nifty Smallcap 100 Index. The aggregate Net Income for this index’s constituents has jumped 3.3x from INR 201 billion in FY20 to INR 660 billion for CY23.

Not only have markets only tracked earnings growth, but FII holdings are at the lowest level seen in the last 11 years:

FII flows are only anticipated to increase because India is one of the few major markets with double-digit growth in ROE, corporate earnings, and nominal GDP.

The growth in earnings is mostly attributed to Domestic Cyclicals. Since 2008, this industry has done essentially nothing. It has a very low representation in the major indices as a result. One of the main causes of the major indices' underperformance relative to the larger markets is this. Given the under-ownership and increased visibility of earnings growth in this segment, there is a compelling argument for domestic cyclicals to outperform over an extended period of time.

Domestic Cyclicals include Communication, Consumer Discretionary (primarily Auto), Energy, Industrials, Materials, Real Estate and Utilities. Between FY20 and FY24E, while the BSE 500 aggregate earnings are likely to jump 3.2x, the aggregate earnings of Domestic Cyclicals are likely to jump 3.9x – their share in BSE500 earnings would move from 41% in FY20 to 51% in FY24E.

And markets have been rewarding the earnings growth and change in trajectory.

In the past, equity markets have rewarded growth and the expectation of growth. India is in a favourable position because Indian markets appear to be robust in terms of both corporate and macroeconomic earnings growth. Although premium valuations make sense, there is only so much room for expansion, particularly in industries with oversupplied and slowing growth. The future looks promising for industries whose growth is accelerating and which are not over-owned.

(The author is Alok Agarwal, Head - Quant & Portfolio Manager, Alchemy Capital Management. Views are his own)