Sectoral index story on risk, returns and valuations for December 2023

6 Feb 2024 , 07:42 AM

Before the sectoral story, here is the macro story

NSE released the index wise performance for its key sectoral, generic, and strategy indices for January 2024. This data goes much beyond returns; since it also includes the risk factors (measured by volatility, Beta, covariance) and valuation factors (measured by P/E, P/BV, and dividend yields). But, before we delve into the sectors, let us look at the January 2024 performance of the generic indices first, to get a picture of the macro market colour. Here is what we read from the macro picture for January 2024.

1. Since 1 month returns tend to be too volatile, we look at 3 month returns as of the end of January 2024. The Nifty returned 14% in the last 3 months between October 31, 2024 and January 31, 2024. However, the small cap indices did a lot better. For instance, Nifty Mid-cap 100 delivered 25.08% during this quarter while the Nifty Small Cap 100 delivered still better returns of 26.83. Nifty Microcap, also delivered 26.86%.

    

2. However, the dichotomies are clearer when you look at a longer time frame. Over a 1-year period, Nifty delivered 24.35% while the mid-cap index delivered 59.34% and the small cap 69.81%. The star was the Microcap index which gave 89.75% in 1 year. The relative performance looks similar over 3 year and 5 year CAGR returns also, although here the mid-cap appears to have outperformed the small cap index.

    

3. In terms of risk, the mid-cap, small cap, and microcap have a higher level of volatility but lower beta compared to the Nifty. But, more important is correlation. The mid-cap index has a correlation of 0.71 versus the Nifty and for the small cap it is 0.64, while for the microcap, it is 0.54. The moral of the story is that as you go lower down the market cap order, you get better risk diversification in the portfolio.

    

4. What about macro valuations? Clearly, the Nifty looks relatively undervalued compared to the mid-cap, small cap, and the microcap. This is across the P/E and the dividend yield parameter. However, the argument is that higher P/E is justified by higher growth.

Turning to the sectoral view of indices

Indian market has more often been a growth market and less often a value market. While pockets of value do emerge occasionally, it is the growth story that is in sync with the Indian economy transitioning from a $3.5 trillion economy to a $5.0 trillion economy over next 6 years. The short term picture gives a better picture of where the growth momentum is and that is the focus out here. The idea is to track the growth momentum for the different sectors. Intuitively, one can surmise that the high growth would come from specific segments like defence, capital goods, AI practice in IT, PSU stories, metals (with focus on rare metals); and the list can go on. To understand that story, let us turn and look at sectors from different perspectives of return, risk and valuations.

How sectoral indices fared on returns as of January 2024?

The table captures the key sectors and returns generated across different time frames. The table is ranked on 1-year CAGR returns to capture the momentum story best.

Sectoral  Index	1-Year  Returns	3-Year  Returns	5-Year  Returns
Nifty Realty	108.82	41.42	30.77
Nifty PSU Bank	57.69	52.92	16.47
Nifty Healthcare Index	46.79	17.65	17.86
Nifty Pharma	46.38	14.69	16.12
Nifty Auto	45.41	26.40	19.94
Nifty Oil & Gas	42.13	28.06	20.56
Nifty non-Banks	41.22	18.35	16.40
Nifty Consumer Durables	30.93	16.54	18.46
Nifty FMCG	25.57	20.73	14.93
Nifty IT	25.54	16.35	21.18
Nifty Metal	23.72	39.87	24.46
Nifty Private Bank	14.65	12.85	9.26
Nifty Financial Services	14.37	12.87	13.06
Nifty Bank	14.09	15.36	11.55
Nifty Media	13.68	9.96	0.63

Data Source: NSE Indices

The table may look like a melee of numbers, but there are some interesting takeaways in these data points.

• On a 1-year basis, capturing the momentum of these sectors, it is the Realty Sector that continues to lead at 108.82% that stands out as the pick of the sectors. The reasons are not hard to seek. Housing demand is robust up and commercial property demand picking up across select sectors, including the demand for data centres, warehouses etc. Special incentives by the state government in the form of stamp duty concessions have also helped boost the housing demand. RERA has also played its bit.

   

• What are the other big gainers and losers on the basis of one-year returns? PSU Banks are an obvious choice with 57.69% returns, but others like healthcare at 46.8%, autos at 45.4%, oil & gas at 42.3% and non-banking financials have also done very well. Let us turn to the bottom of the heap. Banks are under pressure and especially private banks. That can be attributed to the HDFC Bank effect, considering its weight. Media is under pressure, but that is largely about Zee, so we do not give it too much sectoral credence.

   

• Does the picture change if you look at 5-year returns? The top performing sector in terms of 5-year returns is still the realty sector. However, metals, IT, and oil & gas are in the top performers list on a 5-year basis. Over the last 5 years, metals rode the commodity cycle while IT has been a star except for a brief period in the first half of 2023. Even on a 5-year return basis, private sector banks are underperforming.

The 5-year returns are largely along expected lines, but the 1-year momentum data actually throws up some interesting surprises.

How sectoral indices fared on risk parameters in January 2024?

Returns are just one part of the story; the other side is risk. Here we look at risk in terms of three main parameters viz. volatility, Beta, and the correlation with the index.

Sectoral  Index	1-Year  Volatility	1-Year  Beta	1-Year  Correlation	1-Year  R2
Nifty Media	25.81	0.93	0.37	0.13
Nifty PSU Bank	24.31	1.37	0.57	0.33
Nifty Realty	21.92	1.10	0.51	0.26
Nifty Metal	21.01	1.34	0.64	0.42
Nifty IT	18.46	1.09	0.59	0.35
Nifty Oil & Gas	15.11	1.04	0.69	0.48
Nifty non-Banks	13.89	0.99	0.72	0.52
Nifty Private Bank	13.10	1.08	0.83	0.69
Nifty Bank	13.02	1.09	0.84	0.71
Nifty Auto	12.83	0.81	0.64	0.41
Nifty Pharma	12.64	0.45	0.36	0.13
Nifty Healthcare Index	12.59	0.48	0.38	0.15
Nifty Financial Services	12.55	1.07	0.86	0.75
Nifty Consumer Durables	11.08	0.60	0.55	0.30
Nifty FMCG	11.03	0.58	0.53	0.28

Data Source: NSE Indices

The above table is ranked on 1-year volatility starting with the most volatile sectors and going down to the least volatile sectors.

• In terms of standard deviation of returns, the more aggressive plays during the year like PSU banks, metals and realty are at the top. Media was more a Zee story. While realty and PSU banks also have a high return rank with risk rank, the return rank of metals is much lower. On the low volatile side, you have the likes of FMCG, Consumer Durables and healthcare, all relatively defensive sectors.

   

• Let us turn to Beta. Higher the Beta above 1, more aggressive the sector in terms of returns and risk. The high beta sectors in the year were PSU Banks, realty, metals, oil & gas, and IT. Once again, metals are a case of returns not being commensurate with beta. The low beta sectors were, obviously, FMCG, consumer durables and healthcare; which are relatively defensive sectors.

   

• Finally, let us look at correlation and R².  Correlation shows whether the sector offers diversification benefits versus the Nifty. Lower the correlation, more the diversification benefit. From that perspective, pharma, healthcare, and media offer the best diversification benefits. The R² shows how much of the performance is explained by the index movement. Obviously, for banks and financials, this ratio is pretty high, while it is low for realty, pharma, FMCG and consumer durables.

There were not too many surprises in terms of low risk plays. However, among the higher risk plays, metals were the one sector where returns did not compensate for the higher risk.

How sectoral indices stacked up on valuations in January 2024

Finally, we look at how sectoral indices stack up on valuations. We not only look at P/E and P/BV, but also at dividend yields; which is a better barometer of sectoral valuations.

Sectoral Index	Price/Earnings  (P/E Ratio)	Price / Book  (P/BV)	Dividend  Yield
Nifty Consumer Durables	69.34	9.94	0.41
Nifty Realty	55.90	5.44	0.25
Nifty FMCG	43.76	11.43	1.84
Nifty Healthcare Index	41.62	5.45	0.59
Nifty Pharma	36.05	4.89	0.74
Nifty IT	31.32	7.96	1.94
Nifty Metal	28.75	2.34	2.66
Nifty Auto	26.85	5.51	0.87
Nifty non-Banks	21.74	3.66	0.97
Nifty Financial Services	17.05	3.20	0.81
Nifty Private Bank	16.66	2.71	0.63
Nifty Bank	15.15	2.68	0.80
Nifty Oil & Gas	8.66	1.94	2.35
Nifty PSU Bank	8.52	1.44	1.69
Nifty Media	0.00	2.30	0.45

Data Source: NSE Indices

Here are some of the key takeaways from the three valuation parameters. Let us look at how the sectors stack up on each of these valuation parameters.

• In terms of the P/E ratio; consumer goods, realty, FMCG and pharma are among the most expensive, with P/E ratios in the range of 40X to 70X. However, in the case of FMCG and consumer durables, the high premium is generally justified by the brand value and the difficulty in replicating marketing networks. The intangibles are quite strong in these case4s, although the real estate sector cannot boast of the same. In the case of realty, the high P/E is an outcome of the high growth that is being imputed due to the recovery happening after a very long gap. However, in the case of realty, there may be a concern that the returns have come at a much higher valuation, so the risk also increases proportionately for the investor. Oil & gas and PSU banks are still available at single digit valuations, but there is a reason. In both these cases, the predominantly PSU dominance is just about seeing an upward revision in valuation. 

   

• How do sectors stack up on price to book ratio or the P/BV ratio? In a sense this is an extension of the P/E ratio argument. So, you have sectors like FMCG, consumer goods, IT and autos that have the highest ratio of P/BV. The first three are understandable, but in the case of autos, the market valuations have gone up much faster than the pace of asset creation and that could sober once the massive expansion plans show up on the balance sheet. A word of caution. P/BV cannot be applied to all sectors. However, in case of loss making sectors or in case of financial services companies, the Price / Book ratio does offer useful insights into the working of the sector. Even in long gestation businesses, P/BV can be a good proxy.

   

• How does the dividend yield picture look? This is the rupee dividend declared by the company as a ratio of its market cap. Generally, at a sectoral level, the companies that report high dividend yield are considered to be relatively undervalued. The Nifty has a dividend of 1.23%. In terms of sectors, there is metals at 2.66%, oil & gas at 2.35% and IT at 1.94%. Metals are cash cows and high dividends are one way of making the stock attractive, but the cycles are still too dependent on China demand. For oil & gas companies, it is about PSUs being asked to pay out higher dividends by the government. The real surprise is the IT sector and the FMCG sector at 1.94% and 1.84% respectively. For both sectors, the dividend has substantially improved over last few years. At the lower end you have consumer goods, realty, and private banks; but that is more on account of steep valuations.

A final word of caution! Just because a stock is underpriced or overpriced, it does not mean the price should gravitate towards the mean in the short term. However, over the long term, these ratios do tend to gravitate towards the historic average. The problem, as Keynes pointed out, is that markets can stay irrational much longer than investors can stay solvent!