The corporate earnings for the September quarter so far can be characterised by improving data points on multiple fronts. With positive management commentaries, markets seem to find a northward direction.
However, it will also depend on the spread and intensity of COVID cases, development around the vaccine, and incremental government/ regulatory actions to support the economy, said Siddhartha Khemka, Head - Retail Research, Motilal Oswal Financial Services Ltd.
In an interview with CNBCTV18.com, Khemka said that he is bullish on the IT, healthcare and specialty chemicals while
'Buying on Decline’ would be a better strategy with a defensive portfolio positioning.
Here are the edited excerpts from the interview:
Q. Major IT players have announced their Q2 earnings. What is your assessment of the sector and outlook going ahead?
IT service companies delivered sequential growth of 2–5% in QoQ CC terms in Q2FY21, aided by broad-based growth across geographies and verticals. This was meaningfully ahead of our expectations, indicating a faster-than-expected recovery in technology spends by corporates. While supply-side issues were largely contained in Q1FY21, Q2FY21 saw demand normalizing across segments. Q2FY21 has seen sustained earnings momentum in IT, resulting in a healthy earnings upgrade for the second consecutive quarter.
Management commentaries remained upbeat across the board. Lastly, a fresh round of dividends and buybacks provides a strong cushion for sustained re-rating, in our view. IT management teams have indicated that this may mark the beginning of a multi-year technology upgrade cycle by enterprises, providing decent visibility for the sector’s earnings. Therefore, we continue to maintain an Overweight stance on a positive outlook on the IT sector. We expect the relative earnings outperformance of the IT sector to sustain for the remainder of FY21. Despite the recent run-up, we believe the IT sector still trade at reasonable valuations, given the underlying impressive FCF / return ratios / payout metrics, and offers an attractive risk-reward proposition.
Q. Post pandemic, deal wins will be crucial for the IT sector. Also, the tougher US visa rule is a matter of concern. How are these factors, you think will play out and the strategic changes will be needed to undermine concerns?
Management commentaries indicate the pandemic has acted as a tailwind for the sector. Enterprises are undertaking cloud adoption at a faster pace and digital transformation at the workplace has accelerated, with the strengthening theme of vendor consolidation benefitting the well-entrenched and evolving business models of Tier-I IT.
Companies have seen a good mix of large and small deal wins in Q2FY21. The effect of pricing discounts is also expected to wane off for most players from this quarter. Deal pipelines improved in Q2FY21 versus Q1FY21. TCS reported $8.6 billion worth of deals wins versus $6.9 billion in Q1FY21. Infosys reported a deal win of $3.15 billion in Q2FY21 versus $1.7 billion in Q1FY21. Similarly, HCL Tech reported 15 transformational wins versus 11 in the last quarter. Wipro too indicated improved demand since 1Q. The deal pipeline is strong and at pre-COVID levels, with a good mix of large and small deals.
Q. What are your expectations from the overall Q2 earnings?
Corporate earnings are expected to recover from the sharp damage they suffered in Q1FY21 on account of the lockdown. Q2FY21 has been characterized by a sequential recovery in demand/supply as unlocking measures took effect. We expect MOFSL Universe's revenue to decline 6 percent YoY. However, on a sequential basis, revenues should see 31.7 percent growth. MOFSL Universe's PBT/PAT is expected to decline 6 percent/7 percent YoY in Q2FY21. Metals, Cement, Private Banks, Healthcare and Technology are expected to post strong PAT growth. On the flipside, Telecom and Retail are expected to post losses. Automobiles/ Capital Goods/Oil &Gas/NBFC/PSU Banks /Consumer/Utilities should post YoY PAT decline.
Q2FY21 has been characterized by improving data points on multiple fronts. COVID infections have started tapering off toward the end of the quarter and economic activity has picked up. Pent-up demand and inventory filling ahead of the festive season are helping the underlying recovery. Even the southwest monsoons have been good and widespread, creating a strong backdrop for the rural economy. Coupled with that, other macro indicators like electricity demand, GST collections, E-way bills, auto sales, railway freight, merchandise trade and manufacturing PMI showcase the healthy sequential pickup in underlying economy and demand.
Overall, we expect earnings to show gradual recovery in H2FY21, contingent on the progressive opening up of the economy and another round of stimulus from the government. Corporate commentary in Q2FY21 earnings around sustenance of demand after the festive season would be an important indicator to watch for H2FY21 corporate earnings.
Markets have recovered gradually. Do you expect the Nifty to hit a record high by December?
After the rally from March 2020 lows, the Nifty at 21x P/E is trading at a premium to its long-period average, thus leaving limited scope for upside and is not as attractive as it was a few months back. Even globally, after a sharp run-up in Nasdaq, Tech cos there too witnessed selling on account of concerns of high valuations. COVID-19 has become one of the biggest threats to the global economy and financial markets in several decades. While the first round of the pandemic spread has caused havoc across large economies, there is a fear of the second wave of pandemic spread. We expect the market direction to depend upon the spread and intensity of COVID cases, development around the COVID vaccine, and incremental government/ regulatory actions to support the economy.
Q. What will be the next triggers going ahead for the market and what are major risks according to you?
The overall market structure remains positive, but we could witness more sector/stock specific actions going forward. Also, intermittent profit booking cannot be ruled out, given that, Nifty valuation at 21x 1-year forward P/E is higher than the long term average of around 18.5x. Any weakness in the market could be looked at as a buying opportunity to add quality stocks to the portfolio. We expect the ongoing quarterly earnings season to show strong sequential recovery. As the lockdowns are eased and demand recovery takes shape gradually, the commentaries are improving. Demand is gearing toward normalcy faster than expected and Supply pressures are easing. However, sustenance of this recovery rests on the interplay of the health crisis (COVID-19 active cases have started flattening over the last few weeks) and the quick return of the economy to normalcy.
Although there are several concerns like the second wave of coronavirus, geo-political tensions between US-China / India-China, the overhang of the upcoming US elections, the overall market structure seems to be positive as the economic growth improves and is gradually coming back to normalcy. Hence, 'Buying on Decline’ would be a better strategy with a defensive portfolio positioning.
What impact according to you the US elections will have on Indian markets?
Regardless of who ultimately wins this year’s election, an increase in government financial deficits is certain. This condition alone, without the added benefit from either candidate’s policies, bodes well for emerging market equities. Increased debt, excess liquidity, Covid-19 relief bill (if it is not passed until the election), central bank policy stance, lower bond yields will be very much in place and even after the election is over. These factors have been in support of the equity markets in the past and will be supportive in the future too.
Global financial markets are waiting for US Presidential elections, and the polls are getting skewed towards the probability of Democrat Joe Biden's victory every passing week. President Donald Trump’s handling of Covid-19 and the Black Lives Matter protests and the collapse of the US economy are hammering him lower in the opinion polls. With a ‘Biden’ win, we could be looking at a probable increase in corporate taxes, capital gains taxes, and income taxes related to the sale of real estate, which would make equities and real estate less attractive as investments. With a ‘Trump’ win, we can expect political pressure from the top to keep taxes and interest rates low, and a regulatory environment that favours business. Together, these policies would likely contribute to an increase in economic growth and inflation which is positive for global equity markets.
What sectors you think will outperform going ahead and why? Which sectors you will recommend investors to avoid and why?
From the next 2-3 years perspective, we are bullish on IT, Healthcare, and Speciality Chemicals. Investors can benefit from these themes which are playing out well currently and it's crucial to build a portfolio around these themes for 2-3 years to create wealth.
IT sector is likely to benefit from a tailwind of rising tech spends. The propensity of clients to spend on digital transformation/cloud/security etc. has increased in the COVID era. Deal pipelines remain robust and order-books are healthy. Besides, the consistent capital return policies adopted by Tier-I IT names would help drive the sector RoE’s incrementally higher and support the valuations at the margin. IT offers relative earnings comfort coupled with a solid balance sheet, cash flow, RoE and payout metrics in such current volatile and disruptive times. Tier-I IT companies have best in class balance sheets, resilient business models and excellent management pedigree and yet valuations are not expensive.
Healthcare is a defensive play. Though the sector had been under pressure for last few years, the pandemic has opened up a lot of opportunities for the sector. We have not only seen an improved regulatory environment but also higher demand. The government recently raised the import duty on APIs and also notified incentive scheme to boost the domestic production of APIs for bulk drugs and medical devices in the country which are likely to support domestic manufacturing and higher growth.Indian Specialty Chemical manufacturers are benefiting from the increasing trend of de-risking of procurement from China by global chemical leaders (China plus one strategy). Also, many domestic companies have increased capacities and have invested in improving their R&D capabilities to garner market share globally. There are many investment opportunities with this space with companies catering to agrochemicals, CRAMS, API, niche chemicals, etc.