After making easy money, shift focus to quality & space leaders

From March 20, 2020, we have witnessed a strong reflation rally in the markets around the globe. Supported by lower interest rates and easy liquidity and a strong move towards space leaders, which have shown strong earnings momentum, equity markets have risen significantly higher than pre-Covid19 highs, even as the economies are just about coming back to pre-Covid19 levels.

Going forward, we do expect the earnings momentum to continue, excluding for the commodities basket. In commodities, particularly steel, domestic margins have cracked. However, the home improvement categories should all do well. Autos could have done better had it not been for the chip shortage.

We continue to believe these stock valuations are sustainable. The earnings increase of 15% over FY20 and a discount rate cut of 1% over the same period do explain most of the market upmove. On top of this, we are nearly six months into FY22. FY23 is expected to see an earnings uptick of between 15 to 20%. This implies that over the next six months, the market should have delivered another 8 to 10 per cent.

However, given the fact that Fed taper may be around the corner and in India also policy normalisation is expected post October, we believe the traded yields may move up while policy rates may stay constant.

In the past taper period, high quality free cash generating businesses across market caps and sectors did relatively much better. In 2013, the year when US bond yields went up sharply, quality businesses did very well and delivered positive returns.

The attached table demonstrates this. In the table wherever there is a 1, it means that the stock has made a new all-time high. The same space is coloured green as well.
If we look at good performers in the year, large-cap businesses like HDFC Bank, TCS and Infosys did well. Consumer businesses as a space did very well. Many midcap businesses like Relaxo, PI, Aarti, Kajaria did well too.

The fact that such a period also coincides with lower commodity prices helps. High quality compounding businesses are mostly those that typically use commodities as inputs and thus stand to see better margins, helping sentiment and valuations. Consumers did well in this period. Also, if money raising becomes incrementally more difficult, businesses that are free cash flow generating are sought after. I do believe that money gets concentrated into stocks that are sectoral leaders in quality and growth.

I think, going forward, the market focus should be expected to turn to the quality space. This part has already started to do relatively better and portfolios with such businesses did quite well in August. This can continue.