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Capital-intensive, cyclical and value stocks likely to continue their outperformance ; digital economy stocks to produce spectacular binary results over the long term

* Capital-intensive, cyclical and value stocks have been outperforming since FY21 thereby reversing the trend seen over FY12-FY20: Factors such as ‘high capital intensity’ (low OPATO – Operating Asset Turnover), ‘low asset valuation’ (or low P/B), ‘high financial leverage / high beta’ and ‘low RoE’ have consistently driven stock price outperformance within the BSE200 universe since FY21. This behaviour is a departure from the trends observed from the period FY12 to FY20 wherein expensive and low-volatility stocks outperformed. Size as a factor significantly outperformed during FY21, but there has been no major difference in performance over FY22 and FY23-TD. Overall, the 3 factors mentioned in the Fama-French model (market risk, size and value) have outperformed post FY20.

* Is it a false beta rally? The above trend is the longest period of outperformance seen from the aforementioned factors since the peak of the investment and credit cycle in India in 2011-12. Also, the outperformance is continuing despite an unprecedented QT cycle by the US Fed, hence differs from the short-lived false beta rallies seen over the past decade in terms of sustainability.

* Outlook: We attribute the paradigm shift in performance of factors, sectors and styles to the pockets of demand emerging in the economy and corporate profit pool trajectory, which is being led by stocks related to the ‘investment rate’, ‘credit cycle’ and ‘high-end discretionary consumption’. Also, the digital economy is entering a structural growth environment and will result in spectacular binary outcomes over the longer term for related stocks. (Please refer to our thematic note on internet companies by our sector coverage team - Link). Except for the digital economy and discretionary consumption sectors, most other capitalintensive and balance sheet driven stocks are reasonably valued despite the outperformance post FY20.

Top picks: SBI, IndusInd, ABCL, SBI Life, L&T, NTPC, Coal India, NHPC, UltraTech, JK Cement, Ashok Leyland, Balkrishna Industries, Bharti Airtel, Tata Communications, HCL Tech, Indiamart, Greenpanel, Century Plyboard, Indraprastha Gas, GAIL, ONGC, Gujarat Fluorochemicals, Brigade Enterprise, Phoenix Mills, Tata Motors, Dabur India, Nestle, Jyothy Labs, Sapphire Foods, Metro Brands.

* Risk factors changing favourably resulting in outperformance of cyclicals: We attribute the paradigm shift in factor performance to the robust demand outlook in sectors such as construction, manufacturing, electricity, telecom, commodities, etc which are related to the investment cycle. Also the credit cycle is picking up as investments rise along with higher-end discretionary consumption. The aforesaid economic environment is resulting in balance sheet driven and cyclical stocks reducing their riskiness as they improve their cashflows, profitability and RoE. While such stocks will still rank lower on risk attributes such as relatively low RoE and high leverage, these risk factors are moving favourably thereby allowing the stocks to outperform

* Extremely expensive low-volatility stocks with sub-par growth prospects unlikely to outperform: The defensive strategy of investing in extremely expensive and low-volatility stocks with mediocre growth prospects (less than nominal GDP growth of ~12-13%) could potentially go out of vogue as the Indian economy enters a strong cyclical recovery post the pandemic. This defensive strategy worked well in an environment where the investment side of the economy was on a downhill since FY11. However, FY21 reversed the sustained decade-long run for factors such as low volatility in earnings and extremely expensive stocks, underperforming cyclical factors. IT bucked the trend but was largely driven by expectations of a strong cyclical upmove in IT spending rather than a defensive idea and has recently corrected due to slowdown in IT spending. However, the jury is still out on the extent of digitalisation benefits to large IT services firms, which can alter their growth trajectory although some of the pure-play internet and digital economy stocks could see rapid growth.

* Prospects of spectacular binary results from new-age stocks over the longer term, especially after the volatility seen recently: Bull market rally in technology and new-age sectors and subsequent burst is not a new phenomenon for India and was last observed during the 2000 bull market. Back-testing of some of the largest stocks by market capitalisation during the 2000 bull market indicates binary outcomes over the longer term as some of them went on to become multi-baggers even from the high levels of Dec’99 while others lost significant value

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