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Expect expensive, quality and growth stocks to outperform
We believe that unless the risk-on environment returns driven by private capex cycle revival, the current paradigm of factor performance will continue and low risk, asset light business models with strong sustainable earnings growth will be in vogue.
We expect outperformance from the following factors: high operating asset turnover (OPATO), mid-low beta, low financial leverage, sustainable high ‘earnings growth’, high RoOA (Return on operating assets), high RoE, and select capital intensive stocks (low OPATO) which are positively impacted by government spending. On valuations, we prefer high P/B and moderately high P/E stocks. On market capitalisation, we prefer a mix of large-caps and industry leading mid-cap stocks. Based on the above factor preferences, our top picks are Nestle, Colgate, Asian paints, L&T, Shree Cement, Aurobindo Pharma, Tech Mahindra, Kajaria Ceramics, and Galaxy Surfactants.
* Factor performance changed post FY10: Our empirical analysis of the BSE 200 universe based on factor quintile performance since FY05 indicates that Indian stocks entered a different environment in terms of factor performance since FY10. During the previous bull-run (FY05 to FY08) factors which outperformed significantly were low asset turn (OPATO) (Q5-5.3x), high financial leverage (Q1 – 6.6x), high beta (Q1-6x), low P/B (Q5-6.1x), low RoOA (Q5 – 6.3x), low RoE (Q5 – 6x) and low market capitalisation (Q5 – 7.3x). However since 2010 there has been a paradigm shift and factors which changed course since then are high OPATO (Q1 - 3.8x returns), low beta (Q5 - 3.5x), high P/B (Q1 - 3.1x), high RoOA (Q1 - 3x), low financial leverage (Q5 - 2.4x), and high RoE (Q1 - 3.2x). However, during short spurts of bullishness (such as FY10, FY15 and FY17) factor performance reversed to FY05-08 patterns.
As against the above factors which changed course, high earnings growth remained the outperforming factor across time irrespective of the market environment.
* Cheapest stocks on P/B have been a ‘value trap’ post FY10: Cheapest stocks (Q5) in terms of P/B (typically stocks with high capital intensity and financial leverage) were amongst the best performing portfolios from FY05-FY10. However post FY10, the lowest P/B quintile stocks have been ‘value traps’ thereby resulting in the worst performing portfolio amongst the BSE 200 universe (0.6x). Primary reason for the huge underperformance of the lowest P/B quintile portfolio has been the deteriorating ROE from ~17% in 2008 to 6% in 2018, significantly below cost of equity as profitability deteriorated. On the other hand high P/B (Q1) stocks have outperformed.
* Expensive stocks on forward P/E have outperformed since FY10. Outperformance of high forward P/E stocks is explained by market awarding high valuations to growth stocks. However, on a trailing P/E basis the results are not conclusive as prolonged earnings recession and volatile earnings has distorted the observations.
* Low risk – high returns: Contrary to conventional logic, stocks with low risk as measured by lowest beta have outperformed significantly (Q5 - 15.6x) since FY05 except for periods of strong bullish environment such as of FY07-FY08.
* Mid-size stocks outperform over the long term: Although FY19 has been the year of mega cap outperformance, over the long-term, mid-size stocks (Quintile 3 portfolio) have outperformed the most. Mid cap stocks that are leaders in sectors with attractive growth prospects will outperform significantly.
* FY19 so far – Expensive, low risk and large cap stocks outperform: Amongst factors which have outperformed strongly in FY19 so far are: (a) high trailing P/E & P/B, (b) large market capitalisation, and (c) low beta while underperformance is observed at the other extreme.
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