Kotak Institutional sees `frothy' valuation of many PSU stocks

The Indian market has become increasingly overheated in recent months, with robust performance across various caps and sectors pushing stocks to elevated valuations. In its latest report, domestic brokerage Kotak Institutional Equities identified key factors supporting these high valuations, including euphoric sentiment among non-institutional investors who are less price-sensitive, a strong macroeconomic backdrop, and a favorable earnings outlook.

Given this backdrop, the brokerage noted that the Indian market currently offers limited value across sectors and stocks. It categorised the market into three valuation segments: sectors trading at fair valuations, full valuations, and frothy valuations.

'Fair' valuations

The brokerage identified only the financial sector and a few stocks in other sectors as trading at 'fair' valuations. It said that the banks have recently lost some of their gains, while life insurance companies have managed to maintain their gains from the past few weeks.

The brokerage noted that bank valuations are currently at reasonable levels. However, it ruled out any significant rerating in bank multiples due to headwinds like lower net interest margins (NIMs) and the potential for higher credit costs, driven by rising delinquencies in certain segments of unsecured personal loans.

Despite these challenges, the brokerage does not foresee any negative triggers that would lead to a significant derating of bank multiples. Microfinance institutions (MFIs) and public sector undertakings (PSUs) have already experienced some derating over the past month, primarily due to concerns over higher credit costs.

‘Full’ valuations

The brokerage categorised consumer staples, healthcare, IT services, and pharmaceuticals as sectors trading at 'full' valuations. It noted that most stocks in these sectors in the recent weeks have experienced a significant rerating for various reasons.

According to the brokerage, consumer staple stocks have seen meaningful rerating on the expectation of a recovery in volumes due to better affordability among low-income households over the next few quarters due to likely stable prices of products and moderate growth in household incomes, which would reverse the trend of a steep increase in product prices and modest growth in household income of low-income households seen over the past 4-5 years.

IT services stocks have also seen a similar rerating, driven by expectations of a volume recovery. However, the Q1 FY25 results did not provide strong evidence of an imminent rebound in underlying demand.

'Frothy' valuations

The brokerage categorised investment-related sectors and PSUs as trading at 'frothy' valuations. The multiples for these sectors have soared to astronomical levels, driven by the market's expectation of a sustained strong investment cycle.

"Faith in various ‘narratives’ surrounding PSU stocks, which we find rather hard to digest given the astonishing levels of revenues and profits required to justify the current market capitalizations of most PSUs, " it said. 

"We are reluctant to use the valuations of major benchmark indices to get a handle on the market’s valuations (undervaluation or overvaluation) in the context of the exuberant behavior of a section of market participants, which attaches very little importance to valuations anyway, huge divergence in the performance of different parts of the market and wide dispersion in multiples across sectors and within sectors," Kotak Institutional noted. 

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