Daily Voice: Unmesh Sharma of HDFC Securities explains why he's underweight on IT space, added exposure to FMCG

Earnings growth for our coverage universe of 229 stocks got benefited by low input costs and hence far outperformed revenue growth in FY24. In our view, the advantages of soft input costs have largely been consumed and hereon earnings growth must be demand led. So, earnings growth is expected to be closer to revenue growth in FY25, as base effect also catches up. Signs of the earnings growth moderation was visible in Q1FY25 itself when we witnessed 0 percent YoY earnings growth for coverage universe (ex-OMCs, 13 percent YoY growth). It contrasted with 20 percent and 22 percent YoY growth in Q3FY24 and Q4FY24, respectively. We believe YoY earnings growth for Q2FY25 will be in high single digits and for FY25E, it is expected to be 6 percent (ex-energy 13 percent).

Have you increased exposure to FMCG and IT space?

FMCG

FMCG stocks have undergone a moderation in valuations in last couple of years before a recent pickup. Further, there have been a gradual volume growth recovery, which makes us have a close relook at the sector. We expect consumption demand to witness a slight pickup in FY25 driven by normal monsoon, gradual rural recovery, and transmission of input cost benefits to consumers by FMCG companies. Hence, we have become constructive on the sector and increased allocation, as reflected in HSIE model portfolio.

IT

Led by BFSI clients, green shoots are visible in the demand environment for IT services sector but macro uncertainty and subdued discretionary spendings continue. Furthermore, deal conversions to revenue transmission has improved marginally which reflects early signs of recovery. In view of the short-term uncertainty but bright long-term prospects for the sector, we have built in a gradual recovery in next two years.

While sector is awaiting a convincing growth environment, valuations have already moved up and now Nifty IT is trading at +2 standard deviation above mean levels leaving little room for further appreciation. Hence, we continue to be underweight on the sector. We would await more convincing data before turning decisively positive on the sector.

Are you considering fresh entry into defence and railway stocks?

We don’t have any coverage on defence/railway stocks, nonetheless we have keenly tracked valuations of stocks in these sectors. In our view, the defence and railway themes are potent, and these will continue fueling earnings growth of the involved companies for several more quarters, however many stocks have run ahead of their fundamentals meaningfully. Hence, we wouldn’t recommend a fresh entry until valuation softens to more palatable levels.

Do you see better opportunities in new IPOs?

In our view, investors are able to identify the nuances to attribute high PEs to profitability and sustainability of delivery.

We think the best way to look at IPO situations is on a case-by-case basis; the individual business models are different and so are the markets and customers they service. It’s not prudent to club them together because the key drivers for these companies especially mortality are different. We take a bottom-up approach to evaluating these companies and focus on the sustainability of their respective business models. It’s important to have a degree of embedded scrutiny when looking at these new-age tech companies in order to evaluate which of them will have successfully disrupted and changed their industries in the next decade.

Your take on consumer staples?

Consumer staples segment has been witnessing gradual demand growth revival led by summer portfolio and varied degrees of rural recovery observed by the companies. Hot beverages and refreshment portfolios which remained subdued due to heatwaves in Q1FY25 are expected to show decent growth as summer recedes. Further, normal monsoon and moderate inflation bodes well for rural consumption.

Additionally, soft input costs regime has continued which has helped staple companies invest towards A&P and pass on benefits to consumers. In view of all these factors supporting the segment, we have turned constructive on the sector. It can be noted that given our positive view on the sector, we have been reducing our extent of being underweight on the sector in last two quarters and now we have turned marginally overweight, as reflected in the HSIE model portfolio.

Do you think Fed may not be aggressive in interest rate cuts, and the RBI may go for one rate cut in 2024?

The market is building in a rate cut - also confirmed by recent comments by the Fed Chairperson in recent Jackson Hole Summit. The question is what’s the quantum? Based on bond market, 30 percent of the market thinks we can get a 50-bps rate cut in September FOMC meet while the majority thinks it is going to be 25bps. Economic data on growth and inflation in the US put us in the second camp. Further, if we consider FED’s stance for CY24, we expect Fed to cut rate 2-3 times (50-75 bps in total) by December-end. Accordingly, RBI is expected to take a cue from this and begin rate cut cycle with a 25bps cut in CY24.

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