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Home  /  The Big Story  /  Lead Story  / No defence | APR 26 , 2014

Soumik Kar

Lead Story

No defence
Whether you assume an economic revival or a slump post-election, one thing is certain: defensives will disappoint

Chaitanya Dalmia

Depending on the mood of Mr Market — the fabled character created by Benjamin Graham, the father of value investing — either stock prices run ahead of themselves (bull markets) or stay in coma (bear markets) for periods longer than most can anticipate. When markets are coming out of a bear phase, they are apprehensive and don’t immediately take notice of the gradual, albeit real, positive changes taking place in fundamental factors.

Similarly, when the markets are euphoric in a strong bull phase, most things, news and stories, imply only one thing — everything must go all the way to the sky! However, eventually, the tide turns and the market participants merely attribute reasons for the movements ex post. So, even though trying to second guess what turn the markets will take is a fools’ game, you still have to take a calculated view of how things could play out. 

With respect to the ongoing Lok Sabha election, two distinct scenarios could emerge. First, let’s assume a bullish scenario: a stable government is voted into power and the coalition is a small one — after all, it’s easier to handle one or two sticky partners than a whole bunch of them with their distinct, yet unilateral non-coherent characteristics. Then, we can assume that for some quid pro quo for their respective states, the coalition partners will give a relatively free hand to the majority party. The partners may have a small negative list on which they may have a veto, but otherwise they would not be very unhappy to let the majority party take most decisions freely.

The majority party can then work on fixing things that have forced the economy to crawl back close to a Hindu rate of growth. Not just that, they will also then create a more congenial environment for the business community to invest, which will mean a host of new reform initiatives, from rationalising subsidies to eliminating supply-side constraints, from administrative reforms to legislative and financial market reforms, opening up of the economy and empowering regulators and making them work.

If this scenario indeed comes true, then the current mood of the market seems headed in the right direction. I dare say this is then only the beginning of the next major up move, regardless of what happens to the global liquidity taper. This will happen because global capital will continue to look for high yields even when the opportunity cost rises from currently being close to nil. Surely, if we get our act together, the money will flow in. Where it will flow in is the question. 

There are a host of sectors that are down in the dumps so far as their earnings, P/E multiple and their ownership is concerned. Even a slight swing towards a virtuous cycle by way of a few small steps can lead to much better growth environment. All the cyclical sectors — steel, cement, capital goods, autos, ancillaries — will then rebound with a huge turnaround. Some of the sectors have, in fact, already run up in anticipation of a potential rebound; the next sectors waiting in line to join the party are banking and financials and engineering. Within financials, housing companies with relatively stable balance sheets, catering to the mid-income segment, should do well too, though their stocks could lag since they have also run up quite a bit recently.

Then again, there are power companies that should breathe a sigh of relief once their fuel supply and revised power purchase agreements are in place. Chemicals and IT sectors could continue to do reasonably well, though the stocks of the former should fare better than the latter due to current valuations. Although oil and gas is deeply muddled in controversy, certain sectors that act as the shovels and picks for this industry could still do well. As for telecom, spectrum pricing puts telcos back in a spot of bother, although the pricing and data services were turning bright. 

Stocks of pharma and FMCG may stop being market darlings — they might actually end up bearing the brunt of over-valuation accruing to over-ownership. The roads and airports sector is beset with over-enthusiastic bidding and significant debt build-up in the balance sheets — this might end up as a mixed bag with some players coming out of the woods while others remain zombies for a while longer. In fact, this phenomenon shall be applicable to companies across sectors that have over-leveraged themselves to the brim. Unless they sweat their assets and make them productive, or choose to flog them off, they shall have to go through a prolonged period of pain where they keep servicing the debt but have next to nothing to show as earnings. Of course, this is assuming that after the recent RBI quip they wouldn’t be able to wriggle out as easily of their hitherto ‘nirvana’ route of packing the lenders off to the cleaners.

Now, consider a pessimistic scenario, which means a lame-duck government with a socialist mindset. In such a scenario, we are staring at another half a decade of stagflation, at least. Most business will keep languishing for a prolonged period, with a contagion in the banking sector requiring a huge recapitalisation of the sector. GDP growth shall remain mired or worsen, fisc could be strained further and inflation could rampage, leading to some corrosive moves in the external sector, including the current account deficit (CAD) and the value of the rupee. Such a scenario severely dampens the sentiment of the underlying businesses. Indeed, not just sentiment-wise, but even in terms of actual operations and earnings.

Market players would look for the earliest possible exit, especially the fickle foreign players who unfortunately dominate our markets. This would lead to not only wiping out the most recent gains from the ‘hope rally’, but also make us test the abyss seen at the time of the global financial crises, in terms of valuations. A few sectors might remain relatively unscathed by this mayhem, such as the defensives, but they might also correct somewhat, given their not-so reasonable valuations and over-ownership.

Realistically, though, my own sense is that the reality shall turn out to be somewhere in between these two extreme scenarios. The election result, even if comes as per market expectations, shall come with a winner’s curse. The new leader will have to spend some time cleaning up the mess of the last decade; he will have to manoeuvre his way with his partners, which could make him move in fits and starts. He may start with a few things and, implicitly, other things shall have to wait patiently in queue. And that makes the picture hazy from an investor’s point of view. There will be winners, but there will be fewer sectors that will perform and fewer stocks within those sectors that will make you money. 

Already, easy global liquidity and high local inflation has turned the market into a casino with foreign investors being the only participants. This, coupled with a benign economy, has turned the markets into a Keynes beauty contest. Everyone is rushing to buy at any price, outguessing what other investors may fancy, based purely on ‘safety’ (FMCG) or a unique concept  — recent internet-related IPOs globally, and Just Dial closer home. The schizophrenic market resembles a larger economic divide between the haves and the have-nots. Expensive things keep going higher and the majority of the other stuff stays in the trash can.

Trying to crystal gaze, it’s unlikely that consumption can go on at its recent historical pace, out of sync with the other parts of the economy. So, if we assume that the economic scenario shall remain grim, then, consumption plays, too, may not from here on beat inflation, driven by a combination of slower growth, increasing ad-spends, lower other income, exhaustion of tax benefits and a multiple de-rating. And if we attach a probability to the economy reviving, even 12-18 months from now, the core economy sectors should have a much greater delta, both in terms of earnings as well as multiples. 

Depending upon the risk appetite, one may choose from two themes. The first is companies with high operating leverage, which refers to companies that are operating with large fixed costs wherein a small increment in sales can have a magnifying impact on profits. The other theme constitutes companies with financial leverage where again a small increment in revenues can lead to a disproportionate rise in earnings per share because of the fixed interest costs. Of course, export-led sectors such as IT, pharma and select autos are somewhat immune to this, and should continue to beat inflation in either scenario. However, as their valuation is not particularly cheap, the returns may not be spectacular either.

I find it ironical that the majority of the crowd is heeding only one piece of Warren Buffett’s advice of owning great businesses, but ignoring his warning of “paying a heavy price for a cheery consensus” and his caution of avoiding the ‘rear-view mirror’. It is a very curious irony — a prominent Asian fund manager with a significant India presence thinks that the next bull market may be led by cyclicals (or something else, but certainly not FMCG, IT or pharma) but still doesn’t want to bet on it. This dichotomy seems to be an overriding theme of institutional investors loaded with virtually free, albeit fickle, money.

Given the fisc, the supply-sides constraints and the tenure of the government coming to an end, it is quite likely that we will see some parts of the economy being de-bottlenecked, with a rub-off on the larger economy as a whole, although this will happen only with a lag. Domestic liquidity should also find its way trickling into the capital market since the other sources to beat inflation, that is, real estate and gold, are finally losing sheen. Also, the majority view seems to be that the Fed taper will lead to outflows from emerging markets. This is a clear bear case for all the over-owned stocks in the Indian large-cap universe. After all, there is no real basis for justifying a 25X over a 35X for 99% of the universe, except under highly optimistic assumptions. 

Talking about valuations, I really wonder how much of this richness in the valuation has to do with growth, equity risk premium, and Mr Market’s present mood. Mr Market currently seems to be paying 35X for a company that’s expected to grow by, say, 20% CAGR over the next three years. If we assume that the fourth year onwards growth reverts to 15% and the stock gets de-rated to, say, 25X (say, a fair discounting for a high ROE business), this would imply a negative risk premium. Implicitly, Mr Market is suggesting that the company would keep growing its profits at 20% (and more) for a long time. This seems like Jack and the Beanstalk repeating all over again, if not Alice in Wonderland.

At the end of the day, it is Mr Market and his moods that shall determine for how long he wants to remain the voting machine, and when he changes his mood to become the weighing machine. I am eager to see how this unfolds as most others choose to back the top dogs.

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