Optimists believe there is always a bull market somewhere. Right now, we have a bull market in pessimism. If one were to go by hearsay, nothing seems to be going right for the economy. The new RBI governor is being looked upon as a knight in shining armour but the jury is still out on if his band-aids can stop the haemorrhaging of confidence. The recent spike in the market would have you believe that all is well but foreign institutional investors (FIIs) continue to desert the Indian debt market and are on tenterhooks as far as their equity exposure is concerned.
This is a sea change from a year ago when, powered by QE3, FIIs couldn’t have enough of India and smugness among policy makers was not in short supply. Unlike FIIs, who have the option of investing in other equity markets, domestic institutional investors have to keep playing the rotational game locally. The other common refrain always has been, “When there is so much opportunity in India, why should we invest abroad?” To find out if there was any truth or just a case of a known devil being better than an unknown one, we dug deeper and looked up the compounded sales and profit growth of BSE 500 companies from FY08 to FY13 as well as compounded stock price performance from FY08 till date. We left out financial companies and had a cut-off of ₹1,000 crore in sales and market cap for the latest available period. You can find out more about the companies that made the shortlist, on page 108.
FY08 was a good starting point considering that markets would soon go into a tailspin, making FY09 a year to forget. Coordinated central bank intervention resulted in the Lehman Brothers bankruptcy becoming a bad memory. Then it was business as usual…until now, the reasons for which we will revisit later. Poring over the final sheet revealed that in the top 10, six companies were from the FMCG and consumer durables space. As we went lower, the consumption theme became even more prominent and was joined by the usual suspects — pharma and IT. Sure, if one looks at the benchmark over the past five years, returns have been sub-par, but domestic consumption stocks have enriched investors many times over. So, what accounts for their dominance?
Wind beneath wings
Nandan Chakraborty, managing director, institutional equity research, Axis Capital, says even before the Lehman crisis hit us, the government had embarked on its own re-election-cum-stimulus programme in rural India through NREGA. That percolated into the rest of the economy and only added fuel to the capex boom that happened through FY04 to FY09. The capex boom created its own multiplier effects and the result of this boom was increased hiring in the service industry like banking and telecom. Chakraborty says, “The people who work in the service industry are, on average, higher spenders compared with manufacturing and agriculture. Also, hiring in services grows disproportionately to the capex made in the economy.”
The external stimulus, post the Lehman crisis, was the icing on the cake and it just kept the consumption gravy train going. Margin growth at FMCG and durable companies were also aided briefly by a fall in metal and crude prices in the aftermath of the credit crunch. The confluence of all these positive factors only increased the investment attractiveness of the sector at a time when other sectors in the economy were not doing so well. The net result was investors had the best of both worlds; not only did underlying earnings go up, the defensive premium for FMCG companies also went up. The list of gainers includes not only old favourites like GSK Consumer, HUL, ITC and Asian Paints but also cooker-manufacturer TTK Prestige, tile-maker Kajaria Ceramics and agro-inputs multinational Bayer CropScience.
Go west, stay there
Domestic pharmaceutical companies with their sizeable exports also joined the party. Soumendra Lahiri, head of equities, L&T Mutual Fund, says, “Pharma combines the flavour of FMCG and currency. Not only is consumption regular like FMCG, most Indian companies have 60% of sales coming from exports.” The other thing that helped: “Valuations are not stretched as with the FMCG counterparts. Most FMCG companies trade at a multiple of 25X to 35X compared with 15X to 25X for pharma companies.”
Another point of difference despite sharing the ‘defensive’ tag is that unlike most FMCG stocks, which tend to move more or less like a pack, a pharma company’s growth is a function of its respective product pipeline and distribution capabilities. That is clearly visible in the performance of Lupin, which is the only domestic pharma company to deliver positive return every year from FY09 to FY14 till-date.
Lupin’s fantastic run has only increased investor expectations and while for the past few years it has done well in the US, there is no guaranteeing that it will continue to do well. Dr Reddy’s is a textbook case of a good pipeline drying up. It is only now that DRL is getting its groove back and whether Lupin could go down the same path remains to be seen.
Also basking in the glow of the US market were software companies, which, too, have a sizeable presence in the outperformers list. However, besides majors such as TCS and HCL Tech, only Mindtree and Tech Mahindra have registered consistent returns. While a heavyweight like TCS has a range of capabilities that it can deploy and HCL Tech was an early mover in the infrastructure management services space, what explains the underperformance of Infosys or Wipro? Both had internal changes in top management and that could have impaired their performance to some degree.
Besides the gradual improvement of business sentiment in the US over the years, the relative outperformance of select IT mid-caps can be attributed to the shrinking of the valuation gap between the large and mid caps. Even though there is a gap now, it is not as much as earlier. In the meltdown of late-2008 investors sold all IT stocks indiscriminately. The US financial sector is the biggest revenue source for Indian IT companies and hence, after the Lehman collapse, the fear was that the entire sector would take a bath. Due to the bailout, IT revenues did not go down as much as feared and mid caps were available at throwaway prices. Lahiri says, “Mid-cap IT was trading at 5X to 6X. When the companies are growing at 15-20% and have a 20% RoE, you can’t trade at 5X. A move from 5X to 10X is enough propulsion.”
A depreciating rupee aside, the prognosis for net margins of software companies is not very bright. Over the past five years, sales have grown faster than net profit. UR Bhat, managing director, Dalton Capital Advisors, says, “The incremental business is coming at lower and lower prices and it is apparent that they do not have pricing power. They are getting volume by underbidding and showing some growth.” That is a point of view that Chakraborty subscribes to. “Net margins of IT companies are unlikely to improve because the gain from the depreciating rupee will be ploughed back into the business. Over the past few years they did not plough back as there wasn’t too much growth and hence, margins will remain low.”
Peering beyond
The turbulent period from FY08 till FY10 provided for much buying opportunity and that is where the catch is when one looks at the compounded stock return from FY08 till date. While FY09 was a bloodbath, the bounceback of FY10 felt like heaven. And this is where the distortion begins. Professor Aaron Levenstein, after intense observation, remarked, “Statistics are like a bikini. What they reveal is suggestive, but what they conceal is vital.” This time is no different. If one takes away the FY10 return, post the AIG bail-out bounce, many swans transform into ugly ducklings. Prominent among them are Infosys, whose near 15% return drops to under 4%; Hindustan Zinc, whose 17% return becomes a barely there 0.5%; Whirlpool, whose 24.5% evaporates to -2.2%; and Procter & Gamble, whose 28% return shrinks to 3.5%
While FMCG and durable companies have had a dream run, given the slowing economy, their armour is developing chinks. The stock price movement in FY14 so far is testimony to that and many companies have lost some of their gains. Though down trading could happen if the slowdown intensifies, it could be temporarily delayed because there could be another splurge in a run-off to the general elections.
Bhat says though the list has a motley bunch of outperformers, high unit value buys such as two- or four-wheelers could face pain unlike staples such as soaps, detergents and tooth paste because consumers can postpone their decision to buy a two- or four-wheeler, but not items of daily use.
Lahiri, however, believes that consumption could remain strong for another decade and demand saturation is more of an urban than rural phenomenon. He explains, “The business risk for consumption is minimal as companies will continue to increase their product and market breadth. The only risk is valuation.”
The fact remains that so long as the outlook continues to be grim as it is now, the defensive premium for FMCG may not fall as much. Bhat, however, feels that cannot be taken for granted, given the uncertainty prevailing in the minds of FIIs. While most domestic portfolios are underweight staples owing to expensive valuations, FIIs over-own it. Bhat’s worry is that the unwinding of FII debt exposure over the next six months could roil equity markets too. That being the case, emerging market allocation funds could sell what they can. “Infra and PSU banks have already been clobbered. Over-owned FMCG and pharma stocks could have a ready market when they want to sell without much price destruction,” he says.
Foreign fund managers wouldn’t want to run a reinvestment risk by getting out of overvalued FMCG stocks but if that scenario, indeed, comes to pass, then it could create all-round panic, given that bulk of the $200-odd billion FIIs have in India is held by regional and emerging market allocation funds. Net-net, going forward, what FIIs do with their FMCG holdings will decide whether the sector delivers a benchmark-beating return.
Then, as Lahiri recollects, “Most mid-cap stocks that delivered an outstanding return were unknown, under-owned or undervalued. Now it has gone to the other side, valuations have gone haywire, they are no longer cheap and growth has become a challenge.” The topper, TTK Prestige, fits very neatly into this definition. In June 2008, FII holding in the stock was 2% and its market cap was about ₹100 crore. Today, FII holding is 16% and the market cap is ₹4,000 crore. Moreover, stock return has been drying up over the years. After delivering blockbuster returns from FY10 till FY12, the stock returned 8% in FY13 and 2% in FY14 till date. FIIs might soon find out they have been sold a valuation lemon and as dividends they will get a lifetime supply of pressure cookers and pots and pans.
Guessing game
If one assumes that most consumer stocks have had their day in the sun, where could the next bunch of outperformers possibly come from? Could it be high RoE companies in FMCG and pharma as in the 1990s or will another liquidity-fuelled run propel metals, capex and banks or a continued transfer of future liabilities via welfare schemes enable more consumption? Lahiri is very bullish on companies catering to the rural market, and that includes two-wheeler companies, tractor makers, pesticide manufacturers as well as telecom companies. He feels given the rising labour cost in rural areas, there will be a lot of focus on improving productivity through mechanisation and use of weedicides to keep farm labour costs low. There is precedence to what Lahiri is alluding to.
The outperformers list has two pesticides companies in the top 10, Bayer CropScience and PI Industries. Bayer is the bigger of the two and has had a stellar run in FY14 so far. Unlike a fertiliser company, a pesticide manufacturer has the freedom to price and can, therefore, take much greater advantage of rural wealth.
The pesticides play makes sense but why does Lahiri like telecom, a sector that he was earlier bearish on? “Competitive intensity has come off quite significantly and the sector has seen the worst. From being a 25% RoCE business, it has come to 6%. Whether 6% can become 15% is the call. It is a consumption theme, too. Many in rural India who earn ₹5,000 a month, spend ₹800 on talktime.”
Bhat is as edgy as Lahiri seems confident. The wizened investor says that for an economy of our size, the flip-flop in policy making is laughable. “Road and power projects are stuck at various stages of approvals. If things improve, then metal, mining, bank stocks could jump tremendously. Investors took policy makers seriously and invested millions and now the government says land acquisition is not possible because I am changing the rules.”
Where Bhat sees trouble, Chakraborty senses an opportunity. “Given the Land Acquisition Act, land will get scarce and anybody who has a well-funded project underway will do fantastically well. Cement and port companies will have a massive edge over somebody new coming in.” The same rationale can be extended to power or infra companies, which are not completely steeped in debt and have assured feedstock.
Giveth and taketh
The UPA dream team may have turned out to be a nightmare but the Fed and ECB’s open spigots have helped. Now, apparently, Uncle Ben is doing a rethink, verbally at least and that has rattled Indian stock and currency markets. Question, then: are things so bleak that any mention of a trivial withdrawal of QE infinity makes public fund managers quake in their Guccis? The past experience of rent-seeking promoters and bankers has shown that when dire stimulus is needed, a high hemline and a low interest rate works best. While there is no limit to how high a hemline can rise, there certainly are constraints to how much the RBI can lower rates.
That is because a rather deadly combination of a rising US bond yield and increased hedging costs are at play. After Bernanke’s murmur about QE tapering, the US 10-year now yields 2.91% and the one-year forward hedging cost for dollar/rupee is just over 7%. The Indian 10-year now yields 8.5% after its spike to 9% and foreign institutional investors, therefore, no longer find the carry trade rewarding. The only incentive then to lure in flows from non-resident Indians is a high enough interest rate. Lahiri reminds, “If you look back at the past decade, India had the benefit of easy access to capital. That has changed quite dramatically. Today, capital is no longer cheap nor plenty.”
The recent bounce notwithstanding, Chakraborty is circumspect about broad-based investor interest in the market. He says, “When the market is cheap enough to climb a wall of worry, then you can take risks. In 2009, interest rates were not so high. Today if I am getting 7% to 8% post tax in short-term money, my hurdle rate to that extent is higher plus whatever happens to the rupee-dollar.”
A lot of hope is now pinned on a new government rekindling animal spirits. Capex has to revive as consumption has done its bit and a profligate government is fast running out of options. Uncle Ben will further add to our gloom if he walks his talk and Aunt Merkel will send the dollar skyrocketing if her party fails to hold on to power in the upcoming elections. “May you live in interesting times” is a Chinese curse and there is plenty of it coming our way.
