This will tell you whether to buy cyclical stocks now - The 5 Minute WrapUp by Equitymaster
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This will tell you whether to buy cyclical stocks now

Dec 19, 2014

In this issue:
» The big risk that RBI is ignoring
» How Russia prepared for the catastrophic slump in oil prices
» Swiss central bank makes negative interest rates a reality!
» Roundup on markets
» ...and more!

 Chart of the day
At a time when the economy and commodity prices, particularly oil, are expected to have a big say on stock returns, which kind of stocks are likely to look attractive? The answer is obviously cyclical stocks. Stocks belonging to cyclical sectors tend to throw up the biggest returns when the cycle turns. And hence stocks that are otherwise vulnerable to slump in GDP growth and rise in input costs tend to look attractive when the cycle is favourable. So if you were shocked to see the commodity and financial sector stocks that were in cold storage in 2013, lead the rally since May 2014, here is an explanation. Any improvement in GDP growth is expected to have a direct and benign impact on the demand for these commodities and credit from financial sector. So, while the GDP growth should lead to better industrial output as a whole, the cyclical sectors could see the maximum earnings growth.

However, one factor that you cannot miss out while looking at cyclical stocks, particularly commodities, is the level of capacity utilization in the industries. For if the existing capacity is almost fully utilized, it will take years for the industry to create new capacity to absorb the higher demand. Plus the incremental capex will mean additional cash flow and higher debt in some cases. This is exactly the case in the US where capacity utilization has gone back to 2005-06 levels, which happens to be at the decade high. And by the time companies create new capacity, the demand growth could dwindle.

In the case of India Inc, however, capacity utilization is almost at a four year low. For sectors such as cement, automobile and steel , the utilization levels are at a decade low! Hence any upturn in economic cycle and demand could be absorbed very well by these industries, without any balance sheet strain. The higher utilization levels in turn will lead to economies of scale and help companies fetch higher margins. In other words, most of the volume gains will flow directly to the bottomline and shareholder returns!

Thus while Indian companies are overall well placed in the economic cycle, their 'capacity utilization levels' will allow select sectors to make hay while the sun shines. Make sure you do not lose sight of this number while looking for companies to invest in from these sectors.

The upside in volumes without balance sheet strain

Which cyclical sectors according to you will be the biggest wealth creators over the next decade? Let us know your comments or share your views in the Equitymaster Club.

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Now, economic buoyancy does not mean there are no risks for Indian companies in the medium term. In fact, the biggest financial risk that is staring at us is being ignored by the RBI, leave alone the government. We stand by our opinion that the RBI is one of the most conservative and proactive central banks around. However, it seems to be deferring measures to hedge this massive risk for too long. And this could have a huge impact of corporate stability in the longer term.

With inflationary pressures ebbing, and the stress on our balance of payments easing, RBI has built up currency reserves over the past year. Yet, the rising external debt situation is something that the reserves may not be able to tackle. The turbulence in currency markets reflects increased investor anxiety. And India remains very vulnerable to both currency crisis and global liquidity tightening.

So far many Indian companies have enjoyed foreign funds at dirt cheap rates through their external borrowings. Many firms have abandoned hedging altogether, just to save costs. Others have made innovative use of loopholes in foreign debt regulations to raise money through related offshore entities. Such corporates pose a great risk to India's financial stability. India's external debt-to-gross domestic product (GDP) ratio has steadily risen from 18% in FY11 to 23% in FY14. This has in fact surpassed the pace at which forex reserves have grown. And without RBI waking up to the gravity of the problem, India Inc can expect enough pain on the leverage cost and currency losses front.

There is one country that has been in the news for all the wrong reasons these days. And while it may be looking silly right now because of what is happening to it, what many don't know is that it is this country that not only knew what may have been in store, but had also began preparing for it well in advance.

Yes, we speak to you of none other than Russia. In fact, Russian president Vladimir Putin had indicated in November itself that he is prepared to face a "catastrophic" slump in oil prices. How was Russia preparing for this? One of the ways was to stock up on gold. So while the July to September 2014 period saw the world's central banks add about 93 tonnes of gold to their reserves, a whopping 59% of net purchases in this period were made by Russia alone! And this aggressiveness in buying gold has not been limited to just this recent period. Reports suggest that over the past decade too Russia's central bank has been the most vigorous buyer of gold. So much so, that Russia has now overtaken China in the amount of gold held by its central bank.

As per The Guardian, gold now makes up 10.6% of Russia's total reserves. With Russia needing an oil price of about US$ 105 to balance its budget, it is not surprising to see why Russia thought it fit for it to hedge its reserves from the falling prices of oil. If the country has indeed built in and prepared for the situation it now faces, it may very well not be long before Russia is able to crawl back out of the hole it now finds itself in.

And while Russia has tried desperately hard to stem the slide in its currency by substantially increasing its interest rate from 10.5% to 17%, another country out there has gone to the very opposite extreme. The Swiss National Bank (SNB), the central bank of Switzerland, introduced yesterday a negative interest rate. The SNB has said it would impose an interest rate of -0.25% on sight deposit account balances of over 10 m Swiss francs. Further, it is going to expand its 3 month Libor target range from -0.75% to 0.25%.

Why is it doing this? Because it wants to discourage the buying of Swiss franc investment by investors who have become anxious over the crisis in Russia. It hopes that the introduction of negative interest rates will make it less attractive to hold Swiss franc investments, thus arresting an excessive appreciation of its currency. Unlike its Russian counterpart, its decision has indeed achieved the desired result with the franc falling after the announcement to its lowest against the US dollar since May 2013.

The Indian stock markets were trading strong today on the back of sustained buying activity across most index heavyweights. At the time of writing, the BSE-Sensex was trading up by around 350 points. The biggest gains were being seen in metal and oil and gas stocks.

 Today's investing mantra
"Our best ideas haven't done better than others' best ideas, but we've lost less. We've never gone two steps forward and then one step back - maybe just a fraction of a step back" - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Tanushree Banerjee and Taha Merchant.

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