Investors' faith in several richly valued stocks in the banking, consumer staples and pharmaceutical sectors will be tested, says Kotak Securities in a research note, since it foresees weak economic growth, weak investment cycle and anaemic job creation

Notwithstanding decent results in the March quarter, valuations of good-quality companies have become quite expensive, propelled by the market's view of low cost of capital in perpetuity. While potential withdrawal of monetary stimulus programs by global banks may coincide with potentially higher political uncertainty closer to India's general elections in early 2014, the market may react earlier as global currency and bond markets are flashing some warning signs, says Kotak Institutional Equities Research.

According the report, 4Q FY13 adjusted net profits of the BSE-30 Index grew 8.2% year-on-year (y-o-y) with automobiles, metals and mining stocks surprising positively. Coal India, Hero MotoCorp, ITC, Maruti Suzuki India, Mahindra and Mahindra (M&M), ONGC, Tata Motors and Tata Steel surprised while cement, consumer and telecom sectors disappointed significantly at the net income level during the March quarter.
 

However, according to Kotak research, the market's view on cost of equity over the next few months will determine whether valuations of fancied stocks sustain at elevated levels or not. The biggest issue for global equity markets and in turn, for Indian equity market is the potential exit of central banks from their quantitative easing (QE) programs. Low yields and the quest for yields everywhere have resulted in a compression of the required rate of return for investors, resulting in a decline in the acceptable cost of capital or equity, the research report said.
 

India has benefitted from the large global liquidity and the ensuing global yield compression, which has resulted in the equity market and all types of investors rationalizing much higher multiples for favoured sectors and stocks compared with normal level. “We note that valuations in the Indian market are largely determined by global investors like foreign institutional investors (FIIs) and foreign direct investment (FDI) given large inflows from FIIs and aggressive open offers by multi-national companies (MNCs) to increase their stake in their Indian unit. Even FDI investors have participated in the process with cheap money perhaps fuelling their decisions to increase their shareholding in their Indian subsidiaries at inflated valuations of borrow low and buy moderately higher earnings yield,” the research note added.

Kotak said,”"We do not see the on-going improvement in macro-economic parameters translating into strong economic growth; a weak investment cycle and anaemic job creation will pose challenges for consumption and GDP growth over the next 12-18 months. At 15.5X FY2014E and 13.8X FY2015E ‘EPS’ (free-float basis), the Indian market looks fully valued.”

According to the brokerage, the quality of earnings in Q4 was not very good, once again. This has been the case over the past few quarters and the market seems to be ignoring some of the issues that can be no longer be treated as one-off items. Here are the areas of concern...

Low underlying growth in consumer staples

Volume growth moderated to low-to-high single digits over the past few quarters from mid-to-high- teens growth previously.

High share of other income in the profits of several companies

This is particularly true in the case of consumer staples companies. This raises a rather uncomfortable fact that consumer staples stocks on core earnings are trading at even higher multiples compared with their overall optical multiple.

“We think financial other income should get a multiple of around 15x (inverse of post-tax return on cash) and operating other income a similar 12-15x multiple,” Kotak said.