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Less euphoria in valuations by ‘asset approach’, while EVA from existing assets set to rise; GDP revival led by asset creation and exports manufacturing

* Amongst the two major valuation approaches (‘asset approach’ using P/B ratio and the ‘income approach’ using P/E ratio), NIFTY50 index is currently trading at relatively reasonable valuations on P/B basis at 3.6x, which is 0.77s.d. above LTA, largely driven by cheaper valuations of capital intensive sectors. Peak P/B was hit at 6x in early 2008 when the NIFTY50 RoE hit 29% on the back of high operating and financial leverage as compared to the sub optimal 12% currently.

In fact, 46% of NSE200 universe in capital intensive sectors is currently trading at P/B z-score of less than zero. Augmenting the picture further, existing assets are expected to improve their productivity or EVA (Economic value added) in the form of improving RoEs from around 10.5% in FY20 to 15% in FY23 largely led by capital intensive and cyclical stocks.

* Back testing for the past 20 years, the average one year forward returns for NIFTY50 have been around +7% from similar levels of P/B. Average positive one year forward returns for NIFTY50 have been around +26.9% from similar P/B levels seen in FY04-06, with conditions of improving EVA (FY04-06: RoE rose from 18% to 25%) and rising investment rate driven GDP growth. On the flip side, the risk of a drawdown from such levels of P/B is an average fall of around -14.7% accompanied by declining economic growth, falling investment rate and declining RoE trend seen during FY11-12.

* Valuation by ‘income approach’ distorted as RoE (12%) and PAT/GDP (3.1%) in FY21 rising from the lowest levels in past two decades vs. the 2008 peak levels of 29% and 6.4% respectively: On the income approach (P/E basis) the NIFTY50 is at 22.4x (+1.4sd) and approaching pre-GFC level reached in Nov’07. Our backtest over the past two decades in the pre-covid era indicates largely negative one year forward returns from above +1s.d. levels but currently we note two major distortions:

* Record high valuations of low volatility, high RoE and growth stocks (Discretionary consumption, Staples, new age NBFCs, Insurance, Healthcare and IT) further flaring up selectively due to the impact of covid on profitability and slowdown in domestic consumption which is reflected in weak PFCE and services sectors within Q1FY22 GDP.

* Relatively weak profitability (RoE) of certain capital intensive and cyclical sectors is inflating their P/Es (Telecom, Industrials, Auto). However, segments which appear significantly cheap relative to the index on the income approach are largely from the capital intensive sectors (Metals, Utilities, PSU bank, Energy, Tobacco, and Coal)

* The above distortions have resulted in the market outperforming despite +1 s.d. on P/E basis sustaining from June’20 for the first time over the past two decades and rendering it to be an ineffective factor for gauging forward returns. While on the ‘asset approach’ the P/B continued to be below the long term average mark right upto Dec’20 starting from Mar’20 and turned out to be a much better valuation metric for predicting future returns.

* As explained in our earlier note (link), rising risk appetite of investors and sharp rise in stock price are reducing the expected returns from equities. Our NIFTY50 target is 17,800. We are OW on Banks, Industrials, Telecom, Utilities, Insurance and Cement.

* Top picks: Large caps: HDFC Bank, SBI, HDFC Life, Bharti Airtel, Tata Motors, Motherson Sumi, Hindalco, NTPC, Ultratech Cement, ONGC

* Mid & Small caps: Tata Communications, Hindustan Aeronautics, Oil India, CESC, Alkem Laboratories, TVS Motors, INOX, TCI Express.

* Investment rate and exports manufacturing continue to drive Q1FY22 GDP growth which is relevant for sectors driven by the ‘asset approach’ of valuations, while RoE is improving due to sharp increase in profitability of capital intensive sectors:

* Bulk of economic recovery since Q4FY21 has been driven by ‘asset creation’ or ‘investment rate’ which touched 32% in Q1FY22 and manufacturing in the exports segment. Investments from new age economy sectors to further augment the investment rate.

* On the other hand, domestic consumption (PFCE) and contact intensive services sector associated with the ‘income approach’ of valuations continued to struggle.

* PAT to GDP rose to 3.1% in FY21, which was the highest in seven years thereby, improving the RoE of the NIFTY50 index which is expected to move into positive EVA zone (RoE of 15%) over FY21-23 largely driven by improvement in profitability of capital intensive sectors such as metals, utilities, telecom, industrials, banks and discretionary consumption.

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