We are seeing this market struggling to move higher. Yes we are listening to a lot of participants who are really bullish on market from long-term perspective but since last six months we have been in a narrow range. What is holding this market from moving much higher from current levels apart from the outcome of the Gujarat election?
In the last six months, we have really not seen any acceleration in the earnings. So broadly in the last three years the earnings have been flat whereas the market has kind of moved on from 14.50 PE to closer to a 20 PE. It has been a PE re-rating which has actually led to the market returns rather than the earnings growth. Now what has held up the market in spite of this lacklustre earnings growth is a very strong liquidity flows in the domestic market which has actually led to the markets sustaining the strength.
Going forward, we do expect the revival of earnings growth probably starting from two quarters from now. Hopefully, the earnings growth over the next two to three years should compensate for the lack of growth which we have had for the last two to three years. That should ensure that the markets would give some kind of steady state returns over the next two to three years. But if there were some macro event which were to happen and which could derail the earnings growth, then the markets could be in a bit of a trouble.
Let us talk about the cement space. That space is buzzing at least on the news front if not on the price front. Now two months back, there was the petcoke ban and then after two months it was lifted and that too only in three northern states. We made a lot of fuss that this would impact very negatively but now the ban is lifted, would you see significant upside in stocks now?
If you look at the cement sector, broadly in the last three to four years they have been re-rated from 6-7 EV/EBITDA to now closer to 10 to 15 EV/EBITDA depending on the strength of the company. These are typically much higher than what commodity business would get and probably reflects the fact that it has translation from commodity to say some kind of branded commodity.
But having said that, the last two to three years the sector has had the benefit of lower raw material prices like energy prices have been lower and definitely there is a case for some kind of restrictions coming on petcoke, probably one year, two year down the line. In that case, they would have to shift to a more expensive energy source. There is going to be pressure on the raw material cost and the sector depends a lot on pricing discipline which has held up so far in the last five to six years.
But should that pricing discipline break in a couple of markets, then definitely there is a very big earnings vulnerability there. The fact that today we are at a kind of peak EV/EBITDA multiple even from five-year, ten-year perspective, makes me a little cautious on the sector right now.
Let us talk a bit about some sectors that you are fairly upbeat on at this point of time. It is IT and pharma. What makes you so bullish on these two?
IT is a very big valuation call because if you look at any valuation metric either in terms of price to earnings, price to book or free cash flow, today versus five-year, ten-year average or vis-à-vis the market, it is trading at a significant discount. Now the market is probably pricing in some amount of decline in the profitability over next two to three years but that may not be the case. It could still be a low-growth sector in terms of earnings.
Still the earnings growth for the next two to three years could be in high single digit but probably the market prices are factoring in either a decline or flat earnings growth for the next two to three years. The fact that most of the companies have an excellent capital allocation in terms of returning the excess the cash either by a buyback or a dividend also makes the valuation quite attractive.
The second part is some of the IT companies on the midcap side are actually growing significantly higher than the sector and possibly represents a very good bet because they are still trading at a very reasonable price to earning multiple comparable to any other midcap company. So, there remains the case of probably a combination of value and growth in IT midcap companies.
Consumption is a space where there have been complains that valuations are a bit high. Is that the only reason why you are negative on the space? because the promise and the potential is there because rural India has recovered so that is why many people are saying that yes consumption will be the story for 2018 but is your concerns only valuation?
Valuation is probably the only factor which is holding me back. I am quite convinced that this sector is headed for growth but the fact is today if you look at an FMCG company, ex-ITC, all of them are probably trading at a 25-30 multiple on an FY19 basis and could hold good for most of the consumption oriented sectors whether it is FMCG or home building or even apparels. Most of them are trading at a 25-30 multiple which is at a record high and so that is probably the only factor which is holding me back from making investments in this sector.
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