Seeking a Safe Haven

By the end of August 2018, the market was scaling new heights. The Sensex and Nifty were hovering around 38,900 and 11,800 respectively as easing trade war tensions and robust growth outlook propelled them to new highs. But the rally soon turned into carnage on the back of rising crude, falling rupee and the liquidity crunch induced by the IL&FS crisis. Pretty soon, in October, the Sensex was at 33,350 and the Nifty at 10,030.

While the benchmark indices have since recovered, the storm triggered by the IL&FS default hasn’t quite died down. The September quarter earnings of Nifty companies have caused disquiet as well. Only 13 exceeded expectation and 17 were in-line with estimates. Even as analysts were expecting the earning cycle to start recovering, there have been more earning downgrades than upgrades for FY19. “The September quarter earnings season has been uneventful so far, with headline numbers broadly meeting estimates with a few disappointments,” stated a research note by Motilal Oswal Securities.

Companies across sectors are grappling with input-cost inflation, which would weigh on operating margins. Investors are nervous due to the recent state election results and the upcoming general elections could only add to volatility. With heightened volatility being a given, investors are surely hunting for a place to hide, be it in FMCG, pharma, private banks or specialty chemicals.

Overvalued Defence 

In the dying months of 2018, markets across the world have seen massive bouts of unpredictability over US President Donald Trump’s refusal to de-escalate the trade war with China. And the recent uncertainty over his disagreement with the Fed has only added fuel to the fire. The Dow Jones Index lost 15% in December over concerns of rising interest rates and the impact of trade wars on the economy. 

But Gopal Agrawal, senior fund manager at DSP Mutual Fund, believes that there is an upside to the trade war. “In the current environment, where trade protectionism is at the peak, I believe the government will increase spending to keep the momentum of the economy going and create jobs. Domestic manufacturing sectors such as FMCG will be the biggest beneficiaries,” says Agrawal. 

FMCG companies traditionally have been seen as defensive stocks for volatile times. But currently, they are trading at a very high valuation despite the recent correction. Some of the prominent ones such as Hindustan Unilever, Dabur, Colgate-Palmolive and Procter & Gamble currently trade between multiple of 45x-70x on one-year trailing basis (See: Expensive goods). 

As of January 3, Hindustan Unilever, Dabur, Colgate-Palmolive and Procter & Gamble traded at 74.06x, 51x, 47.57x and 79.46x, respectively. Going ahead too, the valuation seems expensive. On a two-year forward basis, these companies enjoy a multiple of 40x-55x. 

The valuations seem stretched as the companies registered low double-digit to single-digit growth in H1FY19. Net sales of Hindustan Unilever, Dabur and Colgate-Palmolive increased year-on-year by 11.45%, 8.53% and 7.67%, respectively in the September quarter. And even, in FY18, Hindustan Unilever grew by a dismal 1.45% (year-on-year) and Dabur could manage only 0.61% net sales growth. At the same time, HUL’s total expenditure in the September quarter grew 9% (year-on-year) driven by a 16% rise in the cost of raw material. Total expenditure of Dabur and Colgate-Palmolive also grew 6.94% and 8.03% respectively. 

The double whammy of flat topline and rising input costs is hardly deterring investors. While the earnings of most FMCG companies are expected to show incremental growth, the stocks may become more expensive if investors continue to flock to them. 

Agrawal sounds a cautionary note, while recommending FMCG stocks as a safe bet. “In this uncertain situation, consumer staples are relatively safer because people have to consume non-discretionary items. But the valuation is not cheap. Some correction also might take place with FIIs exiting,” he says.

U-turn

Even as FMCG stocks continue to be in favour despite their super premium multiples, pharma stocks are trading at a discount despite things looking up for the sector. Pharma stocks have been out of favour for around two years with the Nifty Pharma Index down 28% from its two-year high of 12,226 in November 2016. Now with the possibility of a turnaround in earnings and relatively cheaper valuations, mutual fund managers see them as a secure bet. 

The big Indian pharmaceutical companies are expected to return to double-digit growth this fiscal, riding on recovery in sales in the US, depreciation of rupee against the dollar, and improving domestic demand, according to Crisil. Following two years of single-digit growth, Crisil estimates revenue to grow 10-12% which is enough buffer to weather a sharp rise in input costs (See: Bouncing back). 

Pankaj Tibrewal, equity portfolio manager and senior VP, Kotak MF, believes that the pharma sector provides good cover against uncertainty. He warns, however, that one has to be stock specific. “You need to identify pockets where earnings growth would be decent, and FDA risk is lower. A lot of domestic pharma companies fit into these categories,” says Tibrewal. He adds that some pharma companies could compound their profit by 20-25% over the next three years. 

DSP’s Agrawal also feels that pharma stocks could witness renewed interest. “The money can move into pharma, and I believe that it’s a safer bet than FMCG due to lower valuations,” he says. Indian pharma companies such as Aurobindo Pharma, Cipla, Lupin and Sun Pharma, currently trade at a one-year forward multiple of 15x-30x. 

Alongwith pharma, analysts expect the specialty chemicals sector to rebound. Rise in the cost of production of chemicals in China due to tighter environmental norms and depreciation of the rupee has put India’s specialty chemicals sector on a solid footing. And as global tailwind is on the side of the sector, Aarti Industries bucked the trend and was up 23% in 2018. 

“Clearly, because of the China issue a lot of customers are trying to find a second source of supply. Indian players are benefiting from it,” says Tibrewal. 

A sharp depreciation in the rupee has also given a step-up to exports, which make up for a large share of specialty chemical companies’ revenue (See: Turnaround on the cards). The earning of Aarti Industries and SRF have disappointed over the past two years, but backed by a confluence of these factors, earnings CAGR of both companies is expected to be around 20% and 21% between FY18 and FY20 respectively.

Opportune Time

There is an opportunity in every crisis and mutual fund managers see one in the NBFC pickle. And they believe that bank stocks could benefit at the cost of India’s shadow banking sector, which is facing severe liquidity crunch. Commercial banks are poised to re-gain lost ground and emerge as a primary source of lending, according to mutual fund managers. The bond market has witnessed yields hardening by 150 basis points since the start of the financial year, making borrowing expensive for NBFCs. With liquidity tightening, mutual fund managers expect commercial banks to step in and benefit. 

“Some of the private sector banks, where leadership has changed, could do well in the current market scenario,” says Tibrewal. He adds that asset quality and loan book of banks is also improving, making the sector more attractive. Sunil Singhania, founder, Abakkus Asset Manager, concurs with Tibrewal. He believes that NPAs have peaked out and corporate banks are set for better days. “No fresh NPAs are coming up in corporate sector banks. The banks had to do provisioning for NPAs earlier, but that provisioning will reduce now,” he says. 

The Q2FY19 results have come in line with the fund managers predictions. Both ICICI Bank and Axis Bank posted a decline in provisioning and contingencies by 11.3% and 6.8%, respectively, compared with quarter-ended September 2017. Interestingly, gross NPAs of both banks also reduced by 25-27 basis points in the comparable period (See: Lighter and swifter). Private banks despite an improvement in numbers, are trading at a lower P/BV than NBFCs. Axis Bank and ICICI Bank are trading at P/BV of 2.2x and 2.3x for FY20 respectively, while top NBFCs such as Bajaj Finance and HDFC trade at 6.8x and 4.2x, respectively.

Banks are also expected to benefit from an improvement in steel and power sectors. According to the RBI, the total outstanding loans of banks to the power sector stood at Rs.5.65 trillion as of March 2018. Close to Rs.1 trillion of these loans had turned sour or had been recast. Similarly, banks also have a significant exposure — of Rs.3.26 trillion — to the steel sector, which is also grappling with rise of NPAs. However, a resolution of these cases will alter India’s steel sector landscape, says Crisil’s May report. 

“About a fifth of India’s crude steel capacity held by these companies will move to stronger hands resulting in better working capital and liquidity management. That, in turn, would lead to improvement in utilisation levels,” adds the report. It states that over half of the steel sector’s outstanding debt of Rs.3.26 trillion will stand resolved. “There has been a resolution of the biggest NPA sector, which is steel. In two or three years, the power sector, to which banks have exposure, will incrementally improve due to the resolution of bad debts,” says Singhania.

Passing Blip

Investor mood has remained subdued due to the depreciation of the rupee and political uncertainty following the upset in three major states in the recently held assembly elections. The RBI is also cautiously optimistic. After two successive hikes, it kept interest rates unchanged in October and December due to a benign inflation trajectory and improved investment activity. In October, the central bank also lowered its inflation projection to 4.5% from 4.8% for the second half of FY19. However, it said that there is a need to keep a close vigil on prices over the next few months, due to upside risks such as oil prices and a weak rupee.

Crude correcting from $82 to $60 has brought a spring in the step of investors but there is uncertainty about how long will the respite last. While the US will continue the present supply of oil, Saudi Arabia, the de facto leader of OPEC and other top oil producers have decided to cut global oil output. OPEC members will curb 0.8 million barrels per day output versus its October level while the non-OPEC allies will reduce 0.4 million barrels per day. It means there will a combined cut of 1.2 million barrels per day against an earlier expectation of 1 million barrels per day. Hence, this will reflect in global supply. 

But mutual fund managers are far from panicking. “Oil prices are high and FIIs are selling in both the equity and debt market. Therefore, the liquidity surplus has turned into a liquidity deficit. Though these problems can sustain for a quarter or so, I am not utterly bearish from a one-year perspective. The situation will normalise in three to six months,” says Agrawal. He, in fact, is of the view that worst fear — rise in interest rates — is behind us. “Crude oil prices have peaked. India has already witnessed the impact of rising CAD and inflation has cooled off. The market has factored these issues in,” says Agrawal. 

Apart from macro headwind, the BJP’s defeat in three major states — Rajasthan, Madhya Pradesh and Chhattisgarh — has further fuelled uncertainty over the outcome of general elections. 

However, the election uncertainty is just a near-term hiccup, according to Tibrewal. “Issues that matter are companies earnings growth and economic situation. In 2004, 2009 and 2014, elections had only a near-term impact. There would be volatility in the market but, over the long-term, the effect is nullified,” says Tibrewal. Between 2003 and 2004, ahead of general elections, markets dipped after poll results as Congress put together a coalition government with regional and smaller parties. But the Sensex recovered handsomely, hitting the 20,000 mark in January 2008. In 2009, the market fell again due to the global financial crisis and the mood didn’t improve with Congress short of clear majority. However, after dropping to below 8,325 in March 2009, Sensex managed to climb back to 20,000 mark by November 2010. In August 2013, the Sensex dived to a four-year low but rallied closer to the elections in 2014 as it sensed the formation of India’s second largest majority government. The indices have continued to post gains since then, with dips in February 2016, March 2018 and the most recent carnage. 

Tibrewal believes that volatility and corrections are opportunities for investors to buy quality stocks. “We have seen that buying equities in the worst of conditions like global and economic turmoil always turn out to be the best time. So one has to focus on whether these issues are temporary,” he says.