Let's begin by talking some of the things that will or will not certainly happen in 2007. First for the things that are certain. It will not be a leap year. It has been designated as the International Polar Year. Most of the 2007 will overlap with the 'Year of the Pig' in the Chinese calendar. Dates from the 1st of January 2007 until the 17th of February 2007 will be in the 'Year of the Dog' in the Chinese calendar.
Well, that's for China. What about India? For us, 2007 will be a year of taking stock. For the economy, the government and policymakers, it marks the end of the 10th five-year plan, thus raising the need to reassess the targets set in 2002 versus actual performance at the end of the plan period. For the stock markets, unlike the Chinese pigs and dogs, 2007 will most likely mark an intense tug of war between the bulls and the bears. These things are certain!
Now, for things uncertain! Considering the current tight balance, there is less surety on the way the Indian economy will fare in 2007. As for the stock markets, will they be able to repeat their performance of the past two years in 2007 as well? Our answer, "Maybe! Maybe not!" That's the uncertainty!
After a 44% YoY rise in 2005, the BSE-Sensex repeated the performance to the tee in 2006 as well (another 44% YoY rise). This strong performance from the benchmark index has been broad based considering that only 2 of the 30 index stocks closed the year with a decline in their market capitalisation. The Sensex surge was despite rising global imbalances and vibes of a domestic overheating. The year 2006 also saw crude prices rising to record high levels and interest rates in key developed and developing economies hardening.
As far as financial performance of Quantum Universe (350 companies) goes, while net sales in the first half of the fiscal 2006-07 grew by 29% YoY (22% YoY in 1HFY06), net profit grew at a stronger rate of 34% YoY (15% YoY in 1HFY06). More importantly, the net profitability of this sample improved from 9.6% in 1HFY06 to 10.1% in 1HFY07, indicating better pricing scenario and lower input cost pressure.
FII activity: As far as Foreign Institutional Investors (FIIs) activity was concerned, the year saw US$ 8.3 bn of net inflows into Indian equities (US$ 10.7 bn in 2005). While the quantum of investments was low when compared to the previous year, it still played a significant part in the Sensex rally. Another indication of FIIs considering India as an investment destination, apart from the FII investments, is the ever-increasing number of FII registrations with the stock market regulator, Securities and Exchange Board of India (SEBI). The same have increased from about 500 in early 2003 to 993 as of today.
The solid economic performance of the Indian economy in general and India Inc. in particular has played their part in the country getting more mind-share among foreign investors. Apart from this, lack of enough growth opportunities elsewhere and a weakening US dollar (owing to the superpower's burgeoniong current account deficit) has also been prompting foreign investors to invest in non-dollar assets, which is partially responsible for FII money flowing into emerging markets. However, any signs of reversal in any of these fronts would be viewed negatively and investors must remain alert, as this reversal would force FIIs (especially the momentum guys) to reallocate to better opportunities.
Interest rates and the stock market: Our belief that hardening of interest rates in the developed world (the largest suppliers of capital) will have an impact on emerging markets like India (in terms of money flow), was vindicated in 2006. At the beginning of 2006, we had warned investors of this risk, which reared its head during the year.
| What we said at the start of 2006?|
We clearly saw valuations of stocks/sectors getting upgraded just because there was a demand for Indian equities. And if the crash of May 2006 were any indication to go by, speculators/punters/tippers would have learnt their lessons the hard way. As far as long-term investors are concerned, we had indicated that the crash presented them with an opportunity to allocate (more) money towards equities, while sticking to their respective risk-return profiles.
If investors are to remember, the pressure on Indian equities (and those of other emerging markets) in May 2006 was a knee-jerk reaction to the US Fed's hawkish stance on interest rates, led by its own excesses and indicated by inflationary pressure on the world's largest economy. While it was difficult to predict when the Fed will stop hiking interest rates (it finally did it in June 2006), we remained firm believers of the fact that any further rate hike would have an adverse impact on FII inflows into India. Our reasoning was that a further rise in Fed funds rates could have reduced the risk premium between the US and emerging market equities, thus leading to a U-turn in the movement of capital to safer US T-Bills and bonds.
Past performers may be laggards: Our concerns with respect to prime valuations of capital goods stocks did not reflect in their stock market performance as these maintained their outperformer status during 2006 as well (reasons mentioned below). On the other side of the spectrum, pharma maintained its underperformer status in 2006, as it had in 2005 (reasons mentioned below). However, FMCG, Auto and IT indices, which had outperformed the Sensex during 2005, turned out to be relative underperformers in 2006.
While the scale of outperformance was significantly lower, the performance was a repetition of what we had witnessed in 2005. During 2006, the BSE Capital Goods index returned 9% more than the benchmark Sensex. And why not! The sector has been a witness to tremendous growth over the past few quarters, owing to large scale infrastructure spending that has directly flowed into companies' order books and topline. And the financial performance has been rewarded by the stock markets. The major beneficiaries have been those who are focused on the power (generation, transmission and distribution) sector.
| Sector leader: Capital Goods |
As far as the other segments of capital goods are concerned - infrastructure construction, hydrocarbons and process industries - growth will be a factor of greater capacity addition and increased private-public participation.
Outlook for capital goods: World-class infrastructure has emerged as one of the most important necessities for unleashing high and sustained growth and alleviation of poverty in any economy. And with poor infrastructure to support other growth initiatives, the Indian economy continues to be a laggard when compared to its developing peers. From a policy perspective, however, there has been a growing consensus that a private-public partnership is required to remove difficulties concerning the development of infrastructure in the country. The realisation finally seems to be setting in. Considering these factors, we expect the sector to grow strongly into the future. However, scale and execution capabilities will be the key mantras for success for the engineering companies.
I. Pharmaceuticals: While adverse ruling in cases of some generic drugs and price decline in the US market had led to the underperformance of the healthcare sector in 2005, in 2006, the pressure was on the back of some serious price erosion in the US generics market (due to rise in the level of competition and lesser number of drugs going off-patent) and slow growth in product launches from MNC companies in the domestic market.
Outlook for pharmaceuticals: While the fundamentals driving the generics market continue to remain strong, the brutal pricing environment is a cause for concern. It must be noted that the competition has tremendously increased, escalating the extent of price erosion. Having said that, while the competition most probably will show no signs of abating, a considerable rise in the patent expiries of blockbuster drugs in the coming years is likely to provide a breather to generic companies and boost revenues. The ability to manufacture drugs at the cheapest cost and leverage one's marketing and distributing network to increase reach will be the key to survival.
We also believe that partnerships are likely to play a crucial role in driving growth. This could be in generics (contract manufacturing, authorised generics) or research (R&D collaboration, contract research, out-licensing of molecules) or custom manufacturing for innovator companies. In the domestic market, with the introduction of the patent law and subsequent slowdown of product launches, albeit at a gradual pace, companies entering into in-licensing agreements with innovator companies will have the upper hand. This will ensure a steady flow of product launches in this market. For MNC companies, while new product introductions from their parent's folio will be the key to success going forward, in our view, it is unlikely to be a cakewalk for them. This is because prices of these patented products will most likely be subject to 'price negotiation'.
II. FMCG: After a year of outperformance in 2005, the BSE FMCG Index grossly underperformed the benchmark Sensex during 2006. For every Rs 100 invested in the FMCG index at the start of 2006, yielded Rs 116 (16% returns) at the end of the year (against Sensex returns of 44%). The problem for FMCG companies was not in terms of growth. In fact, 2006 saw strong volume growth numbers from most of the sector companies, largely on the back of robust economic performance and consequently higher consumption spending. Even the rural demand kicked in during the year. The issue that plagued the sector pertained to declining brand strength due to intensifying competition across categories, and added pressure on profitability owing to rising input costs. Even in cases where companies resorted to price hikes to take care of rising raw material costs, the instances were few, indicating a fear of loss of market share. This led to increased volatility in performance of the companies from the sector, and the consequence was seen in their stock prices.
Outlook for FMCG: In 2007, the environment will no doubt be competitive for FMCG players. However, growth will remain a factor of 'volumes'. Product differentiation and innovation along with technology and processes will be the critical aspects for growth. Also, the leading domestic FMCG players, who have started to spread their wings in the overseas market, will see a greater global shift during 2007. The bottomline from investors' perspective is to have a balanced portfolio in the FMCG sector (large and niche players) to reap benefits of the consumption story going forward. More importantly, investors need to understand that FMCG is not a high-return sector and to that extent, expectations have to be realistic.
Volatility, uncertainty, and more of the same! We believe that the Indian and global economy, interest rates, and stock markets are more tightly balanced as we near the end of 2006 than these were anytime in the near past. Let us see where these are headed in 2007.
Indian economy: We believe that the three key macro factors of demographics, globalisation and economic reforms, which have led India's strong economic performance during the past three years, shall continue to pump up the economic activity in the country going forward as well. However, there is a caveat to this assumption. While we believe that these factors will aid the economy's strong performance in the coming years, the fact that a part of growth in the past has been a result of the sharp rise in capital flows (in response to an increase in the global risk appetite), which has allowed the government and the RBI to pursue relatively loose fiscal and monetary policies, puts the economic growth to a test of risk. In our view, the government needs to implement measures to stimulate the supply-side by investing in infrastructure, implementing labor reforms, improving the management of its finances and strengthening the institutional and administrative framework.
As reported in the Economist, "The shining dreams evoked by the world's recent recognition of India as a great emerging power have always seemed at odds with the messy reality of the country itself. In 2007, dream and reality will collide in each of India's three claims to greatness: as a country of more than 1 billion people that remains a vibrant democracy; as a power accepted at the global high table and at peace with its neighbours; and as an economy enjoying almost Chinese rates of growth. All three claims will survive the collision, emerging not so much tarnished as strengthened by a new sense of realism."
Interest rates: We believe that the days of cheap money are near to over. And if the vibes from the Reserve Bank of India (RBI) are an indication, we shall see more action on the Mint Road. The first week of 2007 will see the cash reserve ratio (CRR, or an indicative rate for broader interest rate scenario in the economy) being raised by a further 25 basis points to 5.5% (already announced; effective January 2007). Considering the globalisation of the international financial system, formulating an independent monetary policy is expected to become more complex in 2007. The RBI will have to take into account, among other issues, developments in the global economic situation, the international inflationary situation, interest rate scenario, exchange rate movements and capital flows while formulating its monetary policy for 2007-08.
Stockmarkets and valuations: At the current juncture, Indian equities, on a broader basis, are trading at almost 19 times one-year forward earnings. While this looks expensive on a peer comparison basis (relative to other emerging markets in Asia and South America), considering our bottom-up approach to stock selection, we still find value in stocks from a long-term perspective. As for our view on the Sensex is concerned, we never had one in the past, and do not intend to have one in the future as well. How does that matter when one is following a stock-specific approach?
We, in fact, hope that the BSE Sensex loses some of its relevance in 2007. There have been innumerable instances in the past when gullible investors have drowned in the sea of stock market uncertainty just because they jumped on their experts' advise that the 'Sensex will touch XYZ,000 in 1 or 2 months time!' It is for this reason we hope for 2007 to witness an increasing irrelevance of the Sensex. And this is what we are asking readers of this article to do. Block the noise! Stop listening to the paranoid experts! Sleep easy!
We believe that one of the biggest downside risks to the performance of Indian equities in 2007 will be a reversal of global capital flows from emerging and developing economies in the case of realignment of global interest rates. Also, slow investment growth on account of higher domestic interest rates with the tightening of monetary policy stance by the RBI will only add to the pressure.
These factor, however, do not alter our view on equities as an asset class from a 3-5 years perspective. While it might not be a one-way ride for stocks in 2007 and beyond, what is more important to note is that equities will provide attractive inflation adjusted returns in the long term. You just have to be rational in your choices and not follow the herd, and you need to value stocks not beyond any accurate or rational reflection of their actual worth. This is not to say that your (equity) investments cannot legitimately enjoy a huge leap in value, but this leap should be justified by the prospects of the underlying companies, and not just by a mass of investors following each other.
The unreasonable belief in the possibility of getting 'rich' quickly is the primary reason people burn their fingers in market crashes. One tends to neglect the fact that there is a direct correlation between high risk and high returns. While the history of market crashes does not in any way foretell anything dire for the future, the best thing that you, as an investor, can do in 2007 is keep yourself educated, well informed and well practiced in doing your homework.
"Trust no future, however pleasant! Let the dead past bury its dead! Act, act in the living present! Heart within and God overhead." - Henry Wadsworth Longfellow, Psalm of Life
Wishing you all a very happy new year!
To read our thoughts on year 2006 and our view for 2007, click here - Reflections 2006.