Sectors: Rotation, risk and return – Part Two

Risk return tradeoff

Theory says that expected return should rise as risk rises that is the risk return profile should be upward sloping from left to right but we see realized risk return profile is downward sloping. The given scatter plot looks at the realized risk return tradeoff and we see Auto and Consumption, in second quadrant, have done extremely well and regrettably there aren’t any in quadrant three which might have figured in our buy list.

Price volatility vs. earnings deviation

Though various studies looking at the relationship between price volatility and earnings volatility are inconclusive comparing these two will aid us spot aberrations in the market. For instance, the scatter plot given below compares the price volatility and EPS deviation of the sectors and as highlighted in the scatter plot Metals and Media are at extremes, further away from the quadratic curve while others lie close to the curve. And when we look at the PE ratios of Metals and Media (as shown in the charts in the appendix) we see that the latter has been consistently trading at higher premium over Nifty while the former has been broadly trading at discount to Nifty.

Few months from now we might see Auto relocating from second quadrant to the fourth quadrant as the sector slows; SIAM has cautioned of slowing vehicle sales. Currently PE ratio of the sector is at 56th percentile of its historical. Media too due its rich valuation might move deep into the fourth quadrant. We believe IT has structurally moved to slower growth phase but due its low valuation, PE ratio which is almost at par with Nifty and also currently at 12th percentile, the sector can be accumulated. Moreover weak monsoon and drought is many parts of the world tell us that inflation might not moderate hence RBI might not cut rates as expected. We expect IT to outperform Auto in coming days.

Sectors: Rotation, risk and return – Part One