Against inflation, equity valuations may get hurt

Market


From aircraft to the screws that hold them together, inflation is wreaking havoc for manufacturers and services providers alike. The global supply chain disruption that has come as a fallout of the covid-19 pandemic has pushed the prices of many commodities to levels never seen before. Costlier packaging material and freight have added to the rising cost of raw material, pinching companies hard.

Fast-moving consumer goods, paints, consumer durables and cement are some examples of sectors where companies saw severe gross and operating margin compression in the September quarter earnings, overshadowing robust volumes aided by gradual demand revival.

An expensive bet

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An expensive bet

The jury is still out on whether this steep inflation is transient or not, but forms are passing on the burden of increased costs to customers to protect margins from further erosion. However, while hiking prices, firms are careful that they don’t put off potential customers and hurt the nascent demand influx. That companies are striving to save margins is comforting for investors in these sectors. Also, this risk is not unique to Indian firms. Analysts at fund-flow tracker EPFR Global highlight that four out of five US firms reported third quarter earnings that exceeded consensus expectations. However, three out of five US businesses report they raised prices in the past 90 days as headline inflation climbed to a 31-year high of 6.2% in October, said EPFR’s latest report.

Yet, global equity investors are yet to completely fathom the threat of inflation on their portfolios. Lance Roberts, chief portfolio strategist at US-based RIA Advisors recommends that equity investors brace for a correction. “Ignoring the inflation risk is likely unwise. Previous spikes in the inflation spread aligned with weaker economic growth, stock market contractions, or crashes,” he said in a note to clients on 13 November. “However, at the moment, a correction is the furthest thing from investors’ minds. So, while price inflation may be a problem, there is inflation in ‘irrational exuberance’ of late,” Roberts said.

In Indian equities, the downside risk arising from input cost inflation is more pronounced, considering the steep rally and rich valuations. The MSCI India index has surged 46% in the last one year, comfortably outperforming MSCI Asia-Ex Japan’s 6% returns in the same span, according to data from Bloomberg. The former is trading at a one-year forward price-to-earnings multiple of 22 times while the latter is at 14 times. The valuation gap between India and its emerging market (EM) peers has narrowed, but India remains an expensive bet among Asian markets.

Analysts at foreign research house CLSA Ltd point out that investors are paying more than twice the book multiple for Indian assets compared with the rest of the EM cohort, despite the market offering the same profitability. That corporate earnings estimates are yet to be significantly revised higher, adding to the discomfort on valuations. “Across most of the sectors, valuation trades at premium to the last 10 years’ average. Earnings upgrade is missing because of concern on inflationary environment impacting margin for the year. Consensus modelling Nifty-50 EPS to increase by 43%/7% year-on-year (y-o-y) for FY22E/23E,” analysts at IDBI Capital Pvt. Ltd said in a recent report. EPS is short for earnings per share.

So, according to CLSA, elevated inflation is the top reason to book profits on India. “High energy costs, peak margins, and stimulus withdrawal top our list of concerns. For at least the past two decades, elevated energy prices have been closely associated with phases of Indian equity underperformance. We are now back in such an episode of energy pricing for the first time since 2013,” said the CLSA report dated 12 November.

Although companies are raising prices to battle inflation, management commentaries suggest that some of them expect margin pressure to sustain for a few more quarters. “Judicious price hikes and efficiencies did not help mitigate the full impact of input cost inflation, resulting in depressed gross margins in 2QFY22. Consequently, coverage EBITDA margin saw a reduction of 210 basis points y-o-y (FMCG -90bps, paints -910bps, and quick services restaurants -70bps), around 60bps lower than what we were building in,” analysts at Nirmal Bang Securities Ltd said in a report.

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