Multiplier effect of tax cut likely to be felt in the medium term; Sept’20 NIFTY50 target up 8%.
“Like it or not, the US Government ‘owns’ an interest in Berkshire’s earnings of a size determined by Congress” – Warren Buffet (2018 Annual letter) Current rally in stocks is warranted: The above excerpt from Buffet’s 2018 annual letter captures the impact of the corporate tax cut from 34.94% to 25.17% on the intrinsic value for shareholders of India Inc. We believe that the upmove since Sept 20 in the market just reflects this transfer of part of claims of government of India to the shareholders of India Inc.
Multiplier effect of the tax cut on aggregate demand provides positive outcome over medium term: Empirical studies on the impact of tax cuts on aggregate demand vary but they agree on the duration of the impulse effect lasting more than revenue expenditure. Similar tax cuts by the US in 2017 did result in improving aggregate demand for a couple of years but the impulse effects seem to be fading away currently as expected.
Beta rally gets a fresh catalyst: We had indicated in our earlier note that the ‘Beta rally’ in India is gaining momentum due to improving global and domestic liquidity as central banks turn more dovish, subdued oil prices, government actions and moderating equity valuations. The tax rate cut has brought in a significant catalyst to the beta rally and we believe it could continue.
High growth profitable segments paying marginal tax rates to benefit the most: Segments in the economy which are witnessing higher demand growth than the nominal GDP with robust profitability and paying the marginal tax rate of ~35 % (select segments within Finance, Consumption, services and manufacturing) will be benefitted the most because they will get incremental perpetual stream of ‘growth capital’ at zero cost. The next group to benefit will be the segments which have robust profitability but whose growth has slowed down due to weak demand, thereby allowing them to cut prices.
Ability to crowd in private investment will be key for capex related sectors: Private sector capex has been weak, except for few sectors such as consumer discretionary, staples, IT, Auto and Chemicals but their contribution to the overall capex is not meaningful. Special tax rate of 15% (effective 17%) should help in attracting greater green-field investment, but lack of capital intensity in sectors seeing demand could hamper overall capital formation.
We raise our Sept’20 NIFTY50 target by 8% to 13,400 reflecting an equal amount of earnings upgrade. One year forward target multiple remains unchanged at 17.7x (+ 0.5 s.d. of LTA).
Top picks: L&T, Siemens, Ultratech, SBI, HDFC Bank, Bandhan Bank, TVS Motors, Jubilant Foodworks, Interglobe Aviation, Dr.Lal Pathlabs, JB Chemicals and Pharma, BPCL.