By Prateek Agrawal
Alpha is the excess return a manager delivers over the relevant benchmark. One can generate alpha by successfully focusing on performers in the index or by focusing on stocks outside of the index and taking an active risk.
Taking active risk would pay off if the growth trajectory of the selection is higher than that of the index in a lasting manner which would cause compounding in this part to be higher. Moreover, there should be an element of positive surprise, the more continuous the better, given that markets are now very efficient and discount any news very rapidly.
This was not the case in the period FY07 to FY21. In this period cumulative earnings growth of the Nifty index was 30% more than that of Nifty Midcap index, pointing to larger earnings momentum for large caps. This is changing. In FY22, 85% earnings growth was registered by the Nifty Midcap index vs just 35% for the Nifty Largecap index. The phase coming ahead for us should see much better and sustained breadth of earnings growth. This should provide good rewards for alpha seekers, something that proved difficult in the past when earnings breadth was narrow.
The reasons for expecting good earnings breadth, with elements of positive surprise, are as follows:
Reform intensity has been intense: Earlier the reforms were structural like demonetisation, RERA and GST and caused disruption. Larger businesses and higher quality ones were able to tackle the disruption better. Smaller businesses were impacted. Now, reforms are increasingly pro-industry. Initiatives like PLI have provided a boost to several businesses. This has resulted in stronger than expected growth rates in profits and this could continue. Profit margins of companies have improved sharply over the past few years.
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Bank NPAs low, credit growth strong: In the past, only retail focused banks were able to provide visible growth. However, now most banks have been able to deliver strong growth. In Q2FY23, banks delivered the highest ever profits at an aggregate level. Many entities here present a great combination of cheap valuations and growth and provide opportunities for alpha.
Businesses are bouncing back from Covid lows: In the first phase, the larger businesses did better as they could manage the supply chains better. With the economy opening up, smaller businesses are now seeing a strong comeback and delivering a strong uptick in profits.
New sectors with growth trajectory: The Western world is focusing on diversifying its sourcing away from China, and India is emerging a winner in a few spaces. Due to higher energy costs in Europe, there is a possibility of some shift of business to India. This improves growth prospects. Chemicals is a key beneficiary here. In addition, sectors like electric vehicles have emerged.
Capex cycle is now getting stronger: For a long period, the government was the sole driver of capex. Now, while higher interest rates hurt the capex cycle, yet we are looking at strengthening the cycle over the next period. Government revenues are strong and that should help government capex.
The above point to strength in several large spaces in the economy. Widespread and sustained earnings momentum and positive government policy direction should provide good alpha opportunities.
The writer is executive director, Business & Investment Strategy, Motilal Oswal AMC