investing: Opportunity in Dichotomy: How to invest in times of Covid-19

Equity markets have rebound strongly from their Covid-19 bottom and are now trading at all-time highs. This has happened while the economy has still not achieved its previous levels in its entirety and only some indicators are ruling higher than pre-Covid levels. Many commentators have pointed this out as a disconnect between the real economy and the markets.

Our take on this is as follows:

Point 1: A damage to a quarter of earnings does a very small damage to the overall value of the firm (in the vicinity of 1 per cent) while a cut of interest rates (discount rate) by 1 per cent does increase the value of the firm by a much bigger amount (15-20 per cent).

Interest rates have declined during the Covid period and it is no longer only on the 10-year G-sec. Rate transmission has been good and people are now able to borrow at historically low rates.

Point 2: While the economy may not be back to earlier levels, earnings on the index have been significantly higher. After spending 7 years in the Rs 400s, Nifty EPS crossed Rs 500 (544) in FY21, registering a growth of over 15 per cent over FY20. Going forward, Nifty EPS is expected to see a strong bounce and cross the Rs 700 level (around Rs 720) in FY22. Q1FY22 results are pointing towards the same.

Markets are reflecting a combination of the above two points and are around 30 per cent higher vs the pre-Covid peak level. This clearly shows that the index levels are sustainable.

Let us look at how corporate earnings are strong, while the economy is not. The table below seeks to explain this. The answer lies in distribution of profits.

The above data has been collected by Centre for Monitoring Indian Economy (CMIE) and showcases the profits of top 3,000 non-financial companies in the market. This is the set of companies that are relevant for most investors. If one sees the table above, it clearly shows that the top three deciles of 300 companies each has done quite well. These companies are delivering profits that are 50 per cent to over 100 per cent higher (as a set of 300 companies). The strong performance has been aided by a move away from unorganised and smaller organised sector companies. Better commodity prices have helped as have better exports.

As one moves beyond the top three deciles (i.e. 900 companies), the impact of Covid-19 is clearly seen with the aggregate of last 300 companies being continuously in a loss since July 2018. Last 900 of these 3,000 companies are still to report profits at an aggregate level.

I believe the above clearly explains a lot of what has been happening. I do believe that Covid-19 has accelerated the move towards larger companies and much of this move may prove permanent. Policy would seek to provide some support to the more impacted of these companies and since the number of companies struggling is still high, we do expect the policy environment to remain supportive for quite some time going forward, providing an opportunity to equity investors.