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what to buy: 3 sectors which will drive earnings over next 2-3 years

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Financials, auto and oil and gas will drive earnings over the next three years, says Gautam Duggad, Head Of Research – Institutional Equities, Motilal Oswal Financial Services.

Motilal Oswal Strategy Report is something which almost the entire market watches out for very closely. How are you looking at the Nifty earnings picture, the Nifty EPS for this year and next year and even one year ahead?
As far as earnings are concerned, after five consecutive years of earnings downgrade, last quarter was the first quarter where saw a beat in earnings and then the first earnings upgrades after many years. I remember we had upgraded earnings by 9% at the end of the second quarter result season in October-November and as we step into this third quarter, when we released our preview 10 days back we had again upgraded numbers by 3% to 4%. So between the two quarters, we have seen a 12% earnings upgrade on Nifty for FY21 and FY22. As far as EPS is concerned, we are at Rs 516 for FY21. This number was Rs 454 at the bottom in March-April and from there, we have come to Rs 516.

If we indeed deliver this number, it will be a growth of 11% which will be the highest in the last five or six years. In a year ravished by pandemic and lockdowns, we have seen so many challenges but the growth in earnings for Nifty FY21 will still be higher than the previous four or five years. As far as FY22 is concerned, expectations are running very high. We are right now at around Rs 700 for FY22 which will be a growth of more than 30% from where we will end in FY21. Clearly earnings expectations are very high now, corroborated by upbeat management commentaries on demand in multiple sectors, improvement in asset quality or rather the fears on restructuring as far as the BFSI sector is concerned. It is a big one because it is roughly 40% of the index. Fortunately, those fears have not materialised.

At the margin, we are seeing that the drivers of earnings are cyclicals. For example, in this quarter, we are expecting almost 80% of incremental YoY earnings growth to come from metals and cement. They have run up from 17-18 times to 21 times on FY21 earnings and 17 times on FY22. Clearly these are not cheap valuations. They are factoring in a lot of improvement in earnings ahead, but if you go back into the previous cycles, you will always find that at the beginning of an earning sub cycle, when markets turn, the near term valuations always look juicy.

The question is how much belief is there in this earnings improvement over the next two or three years? If these earnings materialise, we have a lot more to look forward to over the next two or three years. Having said that, in the short term, it is very difficult to predict. Things will depend on how the result season proceeds and what commentary we will get. Then there is a big event ahead of us on the 1st of February.

Over the next two to three years, where is the biggest delta coming in as far as earnings are concerned and how much of that is the Street already pricing it in?
Obviously it is going to be BFSI or the financials. We have seen earnings improve from Rs 90,000 crore for our Nifty BFSI universe to around Rs 1,10,000 crore for FY21 and expectations of FY22 is Rs 1,50,000 crore. Given that it is a large part of the index, it ends up being the primary driver of the earnings growth.

Second, things are turning around for auto. FY18 was the peak year of earnings for auto when the Nifty Auto universe did earnings of Rs 30,000 crore. From there, it has been three years of downward journey and we are ending FY21 with Rs 10,000 -11,000 crore. Things are expected to go back to Rs 30,000 crore in FY22.

The third biggest driver of earnings is oil and gas, primarily Reliance where we are expecting earnings to move to Rs 1,20,000 crore in Nifty oil and gas from Rs 80,000 crore in FY21. It looks very high but we had already done Rs 1 lakh crore of earnings two years back. So, these are the three big sectors where incremental earnings or delta is expected to accrue from. All the stable sectors are continuing to do very well.

We are expecting FY22 earnings to pick up, led by TCS and Infosys which will see 16-17% growth and then come sectors like consumer and healthcare which are expected to show 14-15% earnings growth in FY22. So, the big delta will come from auto, BFSI and oil & gas. As far as stocks are concerned, our preferences in BFSI remains quite stable throughout the last eight or nine months. HDFC Bank can remain the core part of the portfolio along with Kotak Bank, but the real spice will come when you see corporate banks showing improvement or rather further improvement in asset quality.

Given the provisioning coverage ratio is 70% to 85%, the room for earnings upgrade remains quite high out there. So, those are the three or four sectors where we are expecting FY22 earnings to see material improvement.

How are you analysing the broader markets and themes? Where are you witnessing durable demand, pricing power coming back, margin profile improving and hence your clients are discussing those kinds of names or sectors or themes?
In the broader markets, over the last two months, I have noticed one very important change in the behaviour of our clients. The amount of queries or discussions that we are having on cyclical sector in the last two months, I have not had for the last four years.

One of the sectors where the earnings is going to be strong and commentary is going to improve further is cement which is benefiting from multiple themes like housing, infrastructure and people expect the fiscal spending to get a leg up in the Budget. In cement, we like UltraTech, JK Cement and Dalmia Bharat.

The other important cyclical sector which is not a large part of the index and contributes more to the broader market is metals. For the last three or four years, metal stocks had gone nowhere. So earnings also have not gone anywhere. But now we are expecting earnings to pick up substantially. In FY21 last six months, we have seen a rally in commodity prices. The underlying commodity prices of rebar or HRC prices from our analyst would have upgraded the earnings three or four times in metal stocks in the last four months. That is one important sector where earnings are picking up. We like Hindalco and JSPL among metal stocks.

Besides this, it is a mix of multiple other themes but the biggest underlying or overarching theme in India right now is the consolidation of market share in favour of bigger players or branded organised players in every segment — be it consumer staples, consumer durables, BFSI or IT. Vendor consolidation is a very important topic in IT sector over the last one year, post pandemic and then as I said without repeating it, BFSI remains at the forefront of the big theme of financialisation of savings.

Within the BFSI sector, while traditional lenders are very well known, non-lending financials are seeing a lot of improvement — be it in insurance or companies which are a play on capital markets.

Lastly, consumption remains an evergreen theme in India. If urban demand were to improve in 2021, a lot of this discretionary consumer stock or consumer staple stock which are a play on urban markets can continue to do well. What we like out there has remained constant for the last four or five years. Hind Lever, Titan, Britannia, Pidilite and may be Tata Consumer are some of names which right now are doing quite well, but if I were to summarise it in one line — cyclicals are showing a lot of potential over the last two or three months.

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