Dec 30, 2005|
Stock markets: Play it safe!
Skeptics and non-believers were proved wrong for yet another time in 2005. The Indian stock market rallied, led by increased flow of money into the country (thanks to foreign investors) and significant level of money mobilisation in the domestic primary market by both mutual funds and public issues. It was yet another year of abundant liquidity. The concerns that loomed over the markets in 2004 (the key being the Congress-led government at the helm) were a non-issue, barring occasional flicks, as far as the stock markets were concerned in 2005.
The BSE Sensex gained 44% YoY in 2005 and has appreciated at a CAGR of 40.3% since December 24, 2002 (the YoY gain in 2003 and 2004 was 68.3% and 15.2% respectively). This has been despite crude prices rising to record high levels and interest rates in key developed economies (read, the US) hardening. The ruling Congress-led coalition seems to be in hibernation, with occasional news flow with respect to disinvestment and opening up of the retail sector, without any major decisions (barring petrol, diesel and LPG price hikes).
As far as financial performance of Quantum Universe (300 companies) goes, while net sales in the first half of the fiscal year 2006 grew by 20% YoY, net profit growth was much slower at 13.5%. This was largely on account of higher input cost pressure and to some extent, dismal performance by the steel sector. To put things in perspective, the combined profit of steel companies as a percentage of total net profit of the Quantum Universe declined to 6.3% in 2QFY06 as compared to 11.6% in 2QFY05. Mid-cap and small-cap stocks from across the sectors were also in limelight during the year.
| What we said at the start of 2005?|
FIIs and stock market: If interest rates in the US were to increase significantly next year (which is expected), the FII inflow could reduce.
Investment cycle to kick in: We believe that a strong investment cycle is in the offing over the next three years, which is a positive for the economy and the stock markets. Perhaps, this is the strongest reason to invest in equities from a three-year perspective.
Valuation: We believe that the Indian stock markets are not really a 'value play' from a medium-term perspective. At the current level, investors need to have long-term horizon (3 to 5 years) while investing in Indian equities. An investment with a year (or less) horizon is fraught with high risks. Secondly, it is better to stagger your investments at these index levels.
As against our expectations of a slowdown in FII inflow into the country, actual inflow has neared US$ 11 bn. Interest rates in the US have touched 4.25% and a further hike is expected. But this has not deterred money flow into the Indian equities.
As far as the investment cycle is concerned, around June 2005, we met with around 5 banks (private and public sector) to gauge whether the capex cycle is a reality. From what we gathered, while most of the corporates have tied-up working capital by then, the actual implementation was expected to start at the start of 2006 and beyond. Considering the 28% YoY growth in non-food credit offtake in 1HFY06, it seems to be on the right path. Capital good imports have also showed a marked increase, which is one of the lead investment indicators.
As a matter of practice, we do not upgrade valuations of stocks just because the market is bullish or bearish, as we understand that fundamentals of sectors/companies do not change in line with market movements. Our valuations continue to remain conservative and to that extent, our view has been proved wrong. But this is a call that we are happy with.
In terms of sectoral performance, BSE Capital Goods index has outpaced Sensex by 2.1 times. The Indian infrastructure story has clearly played a critical role in propping up share prices. In our view, while much has been said about the scope for infrastructure improvement, at the ground level, the pace of implementation has been far from impressive (15% the Golden Quadrilateral project is yet to be completed). As far as the power sector is concerned, yes, there are pockets of significant progress. However, to sustain growth over the long term, the availability of natural gas is an issue, which needs to be addressed for the generation capacity expansion to take place at the expected rate. We suggest investors to exercise caution considering premium valuations of stocks from the sector.
| Sector leader: BSE Capital Goods |
While the reasons for the underperformance is clearly known, which includes adverse ruling in cases of some generic drugs and price decline in the US market, it remains to be seen how far it is justified. More importantly, if one looks within the sector performers, while select MNCs have gained, Indian pharma majors have lost out. In our view, the prospects of the likes of Ranbaxy and Dr. Reddy’s are not tied to one or two drugs. We believe that these companies are in the right direction and have visionary people at the helm. Of course, pharmaceutical is a high-risk sector, but investors have to have a long-term horizon to capitalise on the upside.
Pharma lags, while FMCG is back…
| Sector laggard: Pharmaceuticals |
The company’s turnaround strategy that started with the restructuring of its overseas operations and simultaneously, improving the working capital equation paid rich dividends in FY05 and in 1HFY06. With both the key division improving on profitability, the stock price has also appreciated. With the rights issue in the horizon, the balance sheet is likely to be strengthened even further. This will also enable the company to invest for future growth. While we are convinced about the long-term prospects of Titan, when it comes to valuations, we are apprehensive.
Smaller companies dominate…
When Dr. Reddy’s was performing badly prior to FY05, stock market participants hailed Ranbaxy as the best managed company. And when the latter itself posted poor numbers in FY06, the decline in the stock price was not surprising. The risky side of the Indian pharma companies (which emanated with the price erosion in the case of generic drugs) was fully reflected in Ranbaxy’s numbers. In our view, the fortunes of Ranbaxy are not dependent on one or two drug and it is therefore important for investors to align their expectations with the management’s growth plans.
||865 / 155
||497 / 130
||713 / 187
||1,057 / 274
||3,698 / 1,225
||817 / 265
||217 / 73
||533 / 165
||1,440 / 555
||202 / 83
||650 / 340
||755 / 453
||547 / 300
||243 / 146
||104 / 66
||382 / 230
||82 / 55
||63 / 40
|ING Vysya Bank
||220 / 134
||641 / 409
Interest rates and the stock market: While we have been believers of the fact that hardening of interest rates will have an impact on emerging markets like India (in terms of money flow), it has failed to reflect till now. But we continue to believe that this is a risk, which any investor has to keep in mind. We can clearly see valuations of stocks/sectors being upgraded just because there is a demand for Indian equities. We do not subscribe to this strategy and therefore, the risk element doubles. FIIs, without doubt, have played an influential role on the Indian stock market and this is unlikely to subside. Given the demand for money domestically and the global liquidity scenario, we see interest rates rising in the domestic market. Typically, increase in interest rates tends to have a negative impact on stock prices.2004 in perspective
Past performers may be laggards: While one agrees about the ‘India infrastructure story’, at what price one is buying this story is a cause of concern for us. We have seen many times in the past that the underperformers of yesteryears have actually been rewarded very well (like FMCG in 2005), once fundamentals support them. We believe that 2006 will not be much different. The graph above indicates the outperformers and undperformers in the calendar year 2004. If one compares the same with the performers in 2005, one can conclude that things can change fast as far as the stock markets are concerned.
Equity returns are high, but so are risks: Our view on equities, as an asset class, has not changed. But, upon careful analysis and systematic approach, we believe that equities have a positive role to play in one’s long-term investment plans. The graph above highlights the returns on the benchmark index across various time horizons. In hindsight, the stock markets returns, over the long term, have been rewarding. However, it has to be mentioned that between February 1992 to July 2003, the BSE Sensex, on a point-to-point basis, was at the same level! While it has not been a one-way ride, surely, what the graph highlights is that equities can provide decent inflation adjusted returns in the long term.
Wishing you all a very happy new year!
To read our thoughts on year 2005 and our view for 2006, click here - Reflections 2005.
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