Tier-1,2 or 3 stocks: An investor’s quandary

Updated: September 6, 2019 2:56:30 AM

The ongoing global and domestic economic slowdown raises concerns about the market’s valuations in general

Indian market valuations, Tier 1 stocks, Tier 2 stocks, Tier 3 stocks, investing india, investing silver, investing in stock market india, investing futures, investing gold, investing chart, investing in stock market, investing in mutual funds, investing in startups, investing moneySeveral construction materials (cement) and auto stocks also trade at rich multiples despite their inferior business models.

The ‘trifurcation’ of the Indian market (based on valuations and quality of companies) has also increased investment challenges for investors. In theory, it should be easy to invest by concentrating on Tier-1 and Tier-2 stocks and ignoring Tier-3 stocks but investors may get whipsawed in the short term if the governance of companies or operating conditions were to change. They could get hurt even in the Tier-1 and Tier-2 stocks if they were to misprice the risks of disruptions to the business models of the companies.

Tier-1 stocks (price >> fair value of the stocks)
These comprise top-notch consumer staple and discretionary stocks, private financials and a few IT companies, trade at rich valuations with their prices being well above their fair values. In most cases, stocks trade at over 35X 12-month forward P/E and 3.5X 12-month forward P/B. The high multiples of these stocks may hold up if India was to deliver 6.5% plus GDP growth but could see potential de-rating if domestic economic growth was to slip below 6%.

Several construction materials (cement) and auto stocks also trade at rich multiples despite their inferior business models. We expect such companies to lose a meaningful portion of their market capitalisation over time as their investors realise that their supposedly strong business models are quite vulnerable to changing technologies as in the case of auto OEMs and are effectively commodity businesses trading at multiples of branded business as in the case of cement stocks.

Tier-2 stocks (price < = > fair value of the stocks)
These comprise other private financials, most IT and pharmaceutical stocks, trade at ‘fair’ valuations with some at a decent discount to their fair values and some slightly above their fair values. These stocks trade at 15-25X 12-month forward P/E and 1.5-2.5X 120 month forward P/B. So-called ‘corporate’ bank scrips such as AXSB and ICICIBC could see further re-rating on lower loan-loss provisions and higher RoA/RoEs, a few of the smaller retail and MSME banks and NBFCs could see re-rating of the multiples if the economy was to recover and Tier-2 IT companies could see some expansion in multiples if global BFSI demand was to recover and the companies were to see industry-specific growth to which they have high exposure.

Tier-3 stocks (price << fair value of the stocks)
These comprise the vast majority of stocks such as PSU banks, HFCs and NBFCs, electric and gas utilities, metal & mining and oil & gas stocks, trade at inexpensive valuations (below 12.5X 12-month forward P/E and 1.25X 12-month forward P/B) and well below their fair values. However, many of them suffer from severe governance challenges. These stocks may see a re-rating of multiples if their majority owners were to fix their governance issues. However, they may languish at low multiples without any investment interest from the vast majority of investors.

The ongoing global and domestic economic slowdown raises concerns about the market’s valuations in general. Global economic slowdown has deep implications for earnings of IT and global commodity stocks and domestic slowdown on earnings of consumption-related sectors. Also, we are not sure if multiples will hold up for the super-rich consumption-related stocks if India’s economic growth was to remain subdued for the next few quarters.

(Edited extracts from Kotak Institutional Equities Research)

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