Are overheated valuations dragging down growth? Pratik Gupta answers

"Demand had been depressed for a while. What has happened is firstly, things were never as good as the companies were talking about back two-three months back, but equally we do not think it is as bad either as how things are perceived to be right now. It is not doom and gloom. It is not a perpetual slowdown," says Pratik Gupta, Kotak Institutional Equities

We are underperforming global markets and now the earnings in a sense have been marred with a string of disappointment. What has changed in between last quarter and now that the management commentary, the growth outlook and the demand environment is looking so sluggish?
Pratik Gupta: Yes, you are right. We believe we are already seeing at Kotak series of earnings downgrades across the board in most companies and the December quarter will also not be very strong based on the early commentary about the festive season, this is as far as the consumer sector is concerned.

What has happened is firstly, if you recall back about three-four months back after the Indian election results, there was this perception the government spending on capex would slow down and you will see a shift more towards revenue expenditure and also the monsoons turned out to be good, so there was an expectation that consumer demand would finally pick up.

Demand had been depressed for a while. What has happened is firstly, things were never as good as the companies were talking about back two-three months back, but equally we do not think it is as bad either as how things are perceived to be right now. It is not doom and gloom. It is not a perpetual slowdown.

This is a short-term speed bump we are going through as far as the consumer sector is concerned and also in some cases we have come across the unorganised sector coming back and competing, especially when some of the organised players had raised prices, that has led to competition coming in and that is another reason why it has impacted demand, so that is as far as the consumer sector is concerned.

As far as the exporters, there you are seeing a still somewhat weak global demand environment. So, whether it is IT services or the auto ancillaries or chemicals where there is still a lot of competition from the Chinese players and the end product demand in the US and Europe still remain somewhat weak.

So, it depends on which sector we talk about, but by and large the earning season has been somewhat disappointing. For FY25, at Kotak for the Nifty, if you strip out some of the one-offs like the OMCs or some one-off factors, we think earnings this year in FY25 will be down to about 13-14%, but next year we think earnings FY26 will be back to about 16-17%. So, there has been a bit of a slowdown, but the bigger issue is still valuations. We are still quite an expensive market.

You are not of the view that we should buy the market. You still feel that even though the markets have gone down 5% on the Nifty, 15-20% in mid and smallcap stocks, we are nowhere close to the value zone?
Pratik Gupta: No, no. From a valuation perspective, we are not there. If you look at India, if you look at the Nifty, we are at about almost 22 times FY26 one-year forward earnings. If you look at India's premium to MSCI emerging markets, even though at one stage the premium had reached almost 95%, but with China's rally and with our little bit of a market decline, the premium is still quite substantial about 75%.

Compared to India's historical average, we are trading well above the last 5-10-year average. If you look at the midcap index, that is where really the froth is, the midcap and smallcaps. The midcap index is trading at about almost 30 times, smallcap almost as a Nifty 23 times and yes, there is faster growth in some of the smallcaps, midcaps, but there is also typically either weaker governance or weaker balance sheets or the management depth is not there and liquidity in the stocks is not as strong, so there is a reason why typically largecaps trade at a premium. Here in India, we have got the opposite. And from a valuation perspective, these are just headline indices.

If you look at the individual stocks, you look at some of the consumer discretionary names, you look at chemicals, you look at across the board, we still see pretty significant overvaluation. So, our sense is you will correct a little bit more in the short term or maybe you trade sideways for a long time and we are still far away from the value zone.

Let us look at consumers. Consumers are slowing down. Banks, NPAs are going higher. So, when you say that next year you expect earnings growth in mid-teens, if I could take a leap from your answer, what gives you the confidence that things could come back because financials are slowing down, auto sales are slowing down, consumers are slowing down. Then, what makes you optimistic about a recovery?
Pratik Gupta: So, firstly, this is not something which is structured in nature. What we believe is this is a short-term slowdown partly because companies, the organised sector players, which is mainly a listed market, they got a bit too aggressive and optimistic, raised prices, and we have seen unorganised competition come in.

So, one is the competitive intensity we think will moderate as there are some price cuts or prices just stay stable for a bit. Second, you do have a seasonal uptick, even though it is a bit lower than expectation, you have the wedding season coming up as well.

And I think the other big factor is government spending, which in the first four-five months because of the heat wave, because of elections, monsoons, that was quite limited in the first four-five months and that should start coming through from the second half onwards and this will continue. I mean, this is not going to be just a short-term phenomenon.

The elections are out of the way. You will have the Maharashtra elections also getting out of the way. So, a lot of the government capex, the state government capex, that will start coming through.

And from a global perspective as well, we have already been through a bit of a slowdown. The Fed is cutting rates. The ECB has cut rates.

Even China is sort of trying to stimulate its economy. So, even the worst of the global downturn seems to be over. So, all things put together, we think growth should come back a little bit, not dramatic. We are not expecting a very sharp recovery in earnings growth going back to 20-25%. It is still going to be mid-teens, not something quite dramatic.

Where is it that you actually see some of these bottom-up cases other than, of course, consumption and banks which is just flagged off? The sort of megastars of last year, if you will, your defence, PSUs, the railway stocks, etc, do you think they will make a comeback? I mean, we were just stacking up the list. Some of them have fallen about almost 30-40 odd percent from their 52-week peaks.
Pratik Gupta: Yes, you are right in terms of the price correction which has happened already. But we have been quite negative on the defence stocks and most PSUs, especially the oil and gas PSUs for a while and that stance still continues. Main reason is, even now, the valuations are still quite expensive for most of the defence stocks, many of the PSUs, not so much the PSU banks but the oil and gas PSUs and so on, and we think there is still more downside.

In some cases, we have seen earnings cuts. We have had some regulatory changes. Recently in the CGDs you had the APM gas allocation being cut, which will impact their earnings. But by and large, in the short term, meaning the next one year or so, we do not see too much upside with the defence and PSU stocks.

Eventually, if you have a 5-year, 10-year view, sure, these businesses may still make you, the stocks may still make you money from current levels, but we still remain quite cautious on the defence stocks in particular and most of the oil and gas PSUs.

For financials to come back, everyone has been making a case that the only cheap space in this market is financials. Go for it.
Pratik Gupta: Financials, we think, will unfortunately for at least another quarter or so still stay in the doldrums. The reason being, you also have the RBI rate cycle, which will kick in, in our view from January onwards and we are expecting anywhere between depending on how inflation and the global central banks and the currencies move, but anywhere between 75 to maybe even up to 100 bps rate cycle.

Now, in that environment, typically what happens is your NIMs will probably come off a lot more and also in the very short term because of the consumer slowdown, especially in the microfinance area, personal loan area, we are seeing asset quality concerns coming to the fore.

Again, we do not think this is very widespread. We do not think this is something structural to be worried about. We are at the start of a very bad NPA cycle as such.

This is just a short-term issue. So, we are still positive on the banks. But I would just say, it is still about a quarter away before we start seeing banks beginning to perform and markets looking past the one or two quarters of margin decline.

Other segment which is turning out to be a little bit of a mystery and help us understand here and that is definitely autos. There are those markers indicating a slowdown. But then when you think consumption, how can you not talk about the India story without having auto in your portfolio?
Pratik Gupta: So, autos also, we have been a bit wary of the valuations. Partly our view has been that demand will not be as strong, which is unfortunate, that is what has happened and you are also seeing disruption from the EV players as far as the two-wheeler segment is concerned.

As far as four-wheelers are concerned, it is more a valuation concern we have wherein we will still see single-digit volume growth.

We are not expecting too much. In this sort of a weakish consumer environment, for the next couple of quarters we see the risk of more earnings downgrades rather than upgrades.

And for the auto ancillaries as well, most of them supply to global OEMs, some to the locals. When your end customers are not doing well, either because of end market demand issues or because of higher competitive intensity, you will typically see weak revenue, weak margins and again, over there we see valuation concerns, earnings downgrades as a risk.

So, we are still cautious. The only, if I just name a stock here, M&M is probably the only auto stock that we like, where valuation is still reasonable, 20 times core earnings one year forward, stripping out the subsidiaries valuation. But most auto stocks, we would be generally cautious right now.