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Little Value in Most Parts of Mkt, Expect Low Returns in ’24: Kotak

Kotak Institutional Equities Warns of Limited Margin of Safety in Current Stock Prices Navigating the Stock Market’s High Valuations

Source: Article by ET Bureau published on Dec 29, 2023, in Economic Times titled “Little Value in Most Parts of Mkt, Expect Low Returns in ’24: Kotak”

Analysis for a Layman

The stock market has been rising rapidly recently, but Kotak’s research team believes that many stocks are now too expensive compared to their underlying fundamentals. This applies to various sectors, including mid-cap and small-cap stocks, as well as large blue-chip companies in sectors like automobiles, IT services, and utilities.

In essence, current stock prices appear to be ignoring potential risks and are overly optimistic about positive future developments. For example, state-owned stocks like NTPC and BHEL are trading at valuations that seem overly optimistic considering their likely financial returns.

Kotak’s assessment suggests that this gap between stock prices and reasonable value estimates leaves very little room for error for investors. If market sentiment were to weaken, it could lead to corrections in stock prices.

For investors, this implies that they should be prepared for lower returns from Indian equities in 2024, especially in light of the uncertainties surrounding elections. Kotak advises adopting portfolio protection strategies such as averaging out investments rather than making overly optimistic purchases during the current market rally.

It will be interesting to see if other financial institutions share this cautious view as the new year begins, which may help temper some of the euphoria among retail investors.

Little Value in Most Parts of Mkt, Expect Low Returns in ’24: Kotak

Impact on Retail Investors

For retail equity investors, the warning about high market valuations suggests the possibility of reduced or negative returns in 2024:

1. Inflation Concerns: Persistent high inflation with rising interest rates could dampen the growth prospects of consumer-focused stocks. This may bring stock prices back in line with less optimistic economic realities over the next year.

2. Overpriced Sectors: Sectors that have seen significant price appreciation, such as capital goods, may require continuous positive news to sustain their valuations. However, inherent cycles of orders can lead to fluctuations, making the current pricing seem unrealistic.

3. Foreign Investment Flows: Wealthy investors who have returned from global investments and exits from initial public offerings (IPOs) have contributed to the rapid valuation increases. Changes in policies or global economic conditions could reverse this trend, to the detriment of buyers.

4. Retail Investor Behavior: Historical trends show that retail investors often enter the market closer to market peaks, drawn by past returns. In 2024, market corrections could dent the confidence of systematic investment plan (SIP) investors more than long-term, savings-focused participants.

Therefore, in light of India’s relatively robust economic outlook, it is prudent for investors to adopt a bottom-up approach and focus on identifying value in individual stocks rather than relying solely on overall market sentiment. Allowing positions to run without reasonable milestones could result in giving back recent gains.

Impact on Industries

The cautious outlook on market valuations has implications for sentiment-driven sectors that have witnessed significant fund rotations, including:

1. Capital Goods & Infrastructure: Sectors that have priced in optimism regarding order books and capacity utilization may face the risk of downgrades in growth estimates if macroeconomic growth slows down.

2. Technology: Stocks with high price-to-earnings multiples that have factored in several years of robust growth may be vulnerable to earnings shocks caused by potential weakness in US and EU demand or margin pressures.

3. Automobiles & Consumer Durables: Discretionary product categories that have seen retail investor enthusiasm amid high ownership costs may face reality checks as consumers delay discretionary spending due to prolonged high interest rates and sticky inflation.

However, some contrarian industries may benefit as capital moves towards more realistic sectors when market exuberance moderates:

1. Private Lenders: Relatively undervalued banking institutions may witness renewed investor interest due to their asset quality resilience and potential for credit growth.

2. Global Cyclicals: Categories such as metals, minerals, and oil & gas, which closely follow global commodity dynamics, may appear relatively attractive compared to sectors where stock prices seem disconnected from fundamentals.

Overall, the market’s moderation could help distinguish sectors with solid fundamentals from those riding high on market sentiment. This will improve investment clarity in 2025, based on actual company performance, rather than narrative extrapolation alone.

Long Term Benefits

Addressing the issue of expensive stock valuations and aligning them with fundamentals over a 3-5 year horizon can have several long-term benefits for India’s capital markets:

1. Investor Trust: Periodic realignments of stock prices with reasonable growth outlooks can boost the confidence of both domestic and global investors, ensuring a stable flow of funds to fuel India’s growing economy.

2. Balanced Growth: Allowing room for upside surprises fosters agility and competitiveness. Stocks that need to deliver real performance, rather than relying on future promises, are incentivized to innovate.

3. Startup Ecosystem: Besides the listed markets, curbing excessive funding at unrealistic levels for loss-making startups encourages companies to focus on unit metrics and sustainable growth. This enhances ecosystem stability.

4. Efficient Resource Allocation: Overvalued stocks often lead to skewed investment priorities based on narratives rather than realistic opportunities. Moderating such valuations redirects capital toward viable opportunities, thereby improving overall capital productivity.

Therefore, after experiencing exuberance driven by favorable pandemic-related factors, a temporary market correction seems to be a step toward more sustainable equity returns. This will be led by India’s robust economic drivers over the next decade.

Short Term Benefits

In the short term, the prospect of reduced equity valuations has both positive and negative implications:

Positives:

1. Better Entry Points: Investors who have been waiting on the sidelines for reasonable valuations may find opportunities to allocate capital if there is a significant correction, especially in overpriced mid and small-cap stocks.

2. Margin of Safety: Even long-term investors may have the chance to enter new positions or average down existing holdings at more favorable risk-reward levels, enhancing portfolio resilience for the coming years.

3. Sentiment Adjustment: Elevated retail investor enthusiasm, often driven by trailing returns, may moderate closer to long-term trend levels. This can help stabilize both fund flows and speculative activities, particularly in derivatives.

Negatives:

1. Impact on Wealth: Sharp downward movements in stock prices, even if temporary, can dampen consumer and entrepreneur sentiment, potentially affecting the momentum of the economic recovery.

2. Funding Challenges: A sudden and extreme aversion to risk can constrain funding for startups, given the substantial exposure that even banks and debt funds have to this sector. Policymakers must be nimble in providing support to prevent a funding crunch.

Overall, some moderation in stock prices is a healthy part of the price discovery mechanism for India’s maturing capital markets. However, authorities must carefully manage any market bumps to ensure they do not turn into prolonged equity downturns that could hinder the prospects of the real economy, impacting jobs and livelihoods.

Companies Impacted by Kotak’s “Low Returns” Call

Indian Companies Potentially Losing:

  • Mid- and Small-Cap Companies: Kotak’s bearish outlook on broader markets, after their recent rally, could lead to profit-taking and potentially hamper further growth for smaller companies. This could impact companies across sectors like consumer discretionary, infrastructure, and financials.
  • Mega-Cap Stocks: Though still seen as less risky, Kotak highlights concerns about their valuations reaching “non-value” territory. Companies like Reliance Industries (RELIANCE:NS), HDFC Bank (HDFCBANK:NS), and Infosys (INFY:NS) could face headwinds if sentiment shifts towards lower valuations across the market.
  • Automobiles and Components: Singled out for “maximum distortion” in valuations, companies like Maruti Suzuki (MARUTI:NS), Tata Motors (TATAMOTORS:NS), and Bosch (BOSCHLTD:NS) could see selling pressure as investors look for value elsewhere.
  • Electric Utilities: With NTPC and BHEL specifically mentioned as overpriced, this sector could face profit-taking and dampened investor interest.
  • IT Services: Similar to autos, companies like HCL Technologies (HCLTECH:NS) and Wipro (WIPRO:NS) could be impacted if investors decide to rotate out of sectors with overheated valuations.

Indian Companies Potentially Gaining:

  • Defensive Sectors: Companies in sectors like pharmaceuticals (Lupin (LUPIN:NS), Sun Pharma (SUNPHARMA:NS)), consumer staples (ITC (ITC:NS), HUL (HUL:NS)), and utilities (Tata Power (TATAPOWER:NS), Adani Green (ADANIGREEN:NS)) could benefit as investors seek safer havens.
  • Valuation-Conscious Small-Caps: Smaller companies with attractive valuations and strong fundamentals could attract investors looking for bargains outside the overheated segments.
  • Companies with Dividend Track Records: Consistent dividend-paying companies, like Bajaj Auto (BAJAJAUTO:NS) and HDFC (HDFC:NS), could appeal to investors seeking income during a period of lower expected returns.

Global Companies Gaining/Losing:

  • Global Investors with Diversified Portfolios: Investors with exposure to different asset classes and geographies might be less impacted by the specific Indian market concerns.
  • Global Investment Firms with Value Investing Strategies: Fund managers focused on finding undervalued stocks could see increased interest in the Indian market if valuations adjust as predicted.

Market Sentiment:

  • Cautious to negative for the Indian market, particularly mid- and small-cap segments and sectors highlighted by Kotak.
  • Increased focus on valuation and risk management by investors.
  • Potential rotation towards defensive sectors and companies with lower price-to-earnings ratios.

Note: This analysis is based on the provided information and may not be exhaustive. Other companies could be impacted depending on their specific sectors, valuations, and investor perceptions. The actual impact will depend on the evolution of market conditions and investor sentiment.

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