Why it pays to be sector-specific

This article was published in Global Analyst under the title "Stock Selection Strategy"
This article was also subsequently published in The Industrial Economist (Nov13)
 

The numbers speak for themselves. During the last five years, if you had invested Rs.1 in FMCG sector, it is worth now Rs.3.5 as against Rs. 1.4 for Sensex and 10 paise for Realty sector. In annualized terms, the FMCG produced an annualized return of 21%, Sensex 5.24% p.a while the Realty sector produced an annualized return of -30% p.a. During the last five years, FMCG, Healthcare, Auto, and Consumer Goods produced good returns compared to Realty, Power and capital goods. Isn’t it time to differentiate among sectors?

Even sophisticated investors do not consider sector bets as seriously as it deserves. While the broad market is comprised of many sectors whose performance ranges define the average performance of the index, investment performance can be enhanced significantly by choosing good sectors and avoiding bad sectors.

While the overall market is represented by Sensex which is a confluence of all the sectors, the performance of Sensex will also be balanced by both well performing sectors and poorly performing sectors. Additionally, active fund managers also do not make serious deviations in favor of well performing sectors for the fear of tracking error.

 

The case of investing in a broad based index like Sensex will ensure the presence of both good and bad sectors thereby taking away the benefit of performance in the guise of offering diversification. If academic theory says that it is quite possible to have a fully diversified portfolio with just 10 stocks, then identifying those stocks among the well performing sectors should be the way to go. Hence, investing in broad based index fund or ETF may not be as much a good idea as investing in well performing sectors. Even among well performing sectors, as per traditional theory, the investing should be focused on the index heavyweights whose performance can significantly influence the overall performance of the sector index. For eg., in the case of FMCG, the performance of ITC, Hindustan Lever and Nestle should definitely matter as they have larger share in the index. However, if you look at the leaders and laggards, in most cases it has names not among the heavyweights. Hence, the job is not done by simply investing in sector funds. It is quite possible to improve the portfolio performance significantly by fishing within the sector basket which calls for stock picking. This argument is even more relevant if we consider the divergence in performance of leaders and laggards relative to the sector index performance. For eg., in the consumer durables segment the best performer has been TTK Prestige with an annualized return of 66% while the worst performance in the same sector has been Gitanjali Gems at -16.6% p.a. with the overall sector performance at 9% p.a. Very clearly, the individual stock performance diverges significantly from the mean providing immense opportunity for stock selection.

The good/bad paradox

While the general case is to embrace good performing sectors as against not so good performing sectors, as said before, there may also be cases of good stocks in bad sectors and bad stocks in good sectors. For eg., Sunteck (+26%p.a) in Realty sector (-29.83% p.a.) and Ranbaxy (-5.4% p.a.) in Healthcare (+14.5% p.a). In case where such stocks are index movers, a closer scrutiny may be warranted. However, if they are not index movers, then it may not be worth our time to finely distinguish this aspect. More than selecting good companies in bad sectors, it may be worthwhile to avoid bad companies in good sectors and improve portfolio performance.

More dimensions to evaluate sector performance

Apart from the annualized performance of the sectors, there can be inspection of stocks within the sector in terms of outperforming the sector index as well outperforming the broad market index (Sensex). Companies that outperform both their sector index as well as the broad market index can obviously be classified as superb while at the other end of the spectrum we may have companies underperforming both their sector index as well as broad market index (called poor) and all others falling in between. For example, in the auto sector where we have 11 companies, 8 of them out performed the auto sector index as well as Sensex indicating a larger pool of opportunities to choose from. On the other hand, in the PSU sector where we have 30 companies, 14 companies underperformed both the PSU index as well as Sensex limiting the opportunity pool. In the overall analysis, out of nearly 200 stocks, 69 stocks outperformed both their respective indices as well as Sensex and they mostly belonged to good performing sectors.

What explains sector performance?

FMCG

Increasing disposable incomes, favourable demographics augur well for the resilient consumption theme. Rural India has been a big driver aided by National Rural Employment Guarantee Act (NREGA) payments.

Healthcare

Resilient to macro headwinds and favourable currency tail winds have benefitted the sector. Cheaper manufacturing costs by c.30-50%, abundant talent pool and regulatory expertise have helped in establishing a stronghold in generic space globally. Future driver: series of patent expiry in US.

Auto

Surging aspirations of middle-class, low per capita ownership of vehicles had led to strong 20%+ growth in 2010 & 2011. Headwinds in the form of higher interest rates and fuel prices have taken a toll on volume growth since then.

Consumer Durables

Higher inflation and rupee depreciation had led to constant price hikes, leading to deferment of purchase of items like appliances and other durables, which essentially are discretionary in nature. This is reflected in the Index of Industrial Production. Production in the Consumer Durable sector has consistently been in negative territory.

Banks

Economic slowdown which exposed inadequate appraisal and monitoring of credit proposals and a move to system-driven identification of NPAs had led to increase in gross NPA level for the banks. Implementation of Basel III norms by March 2018 would require significant capital and issuance of new bank licences is poised to increase the intensity of competition.

InfoTech

Spending on technology and related services has grown at a faster rate than the GDP growth. With organizations trying to reduce operational costs amidst competitive business environment, global sourcing has gained prominence benefitting the IT players. The currency depreciation is an icing in the cake!

Tech

Uncertain regulatory environment and outbreak of scams has marred the telecom sector. The ensuing recommendations by the regulator towards spectrum auctions, pricing and re-farming had fuelled the already existing uncertainty and were viewed negatively by the players. Retrospective tax imposed on Vodafone exposed the flip flop approach of Indian authorities to the world at large.

Metal

Capacities which were increased on expectations of higher demand resulted in oversupplied market leading to intense competition amongst domestic suppliers. Mining industry was gripped in a seemingly ceaseless national debate on issues related to illegal mining practices. Iron ore export slumped 69% in 2012-13 from a year ago.

PSU

The deterioration of bank asset quality is more pronounced in PSU banks. Higher crude imports and subsidized pricing of Diesel, LPG and Kerosene has resulted in c.16% increase in under recoveries for the Public Sector OMCs.

Oil & Gas

Weak macro environment and slower growth have led to volatile margin environment causing downward bias.

Cap Goods

Slump in investments across the sectors, particularly in infrastructure space (like power) due to policy uncertainties had led to poor order flow. Orders have become stagnant and competition has become intense as many players chase the few available orders.

Power

Issues of coal linkages, environmental clearances, land acquisition, fund constraints (sectorial exposure limits) and scarcity of skilled manpower have hindered new projects, while on-going projects are on a slow execution mode leading to tight cash cycle. Financial position of State Distribution Companies (State Discoms) is also a matter of concern.

Realty

Realty which experienced unprecedented growth in 2007, post the aftermath of the financial crisis tempered to moderate levels of growth. Demand shifted away from investors to actual end users. Most players are also saddled with huge debt.

The Final Word

It is evident that significant enhancement of portfolio returns can simply be achieved by being sector choosy and within sectors stock choosy. Embrace well performing sectors that are based on solid macroeconomic forces (like demography, consumption, exports, etc.) and avoid sector that suffers from macroeconomic tailwinds (like high interest rates, capital expenditure, regulatory pressures, etc.). While not ignoring good companies in bad sectors, avoid bad companies in good sectors as it may have company specific issues (corporate governance mostly) and may not be in a position to take advantage of favorable sector atmosphere.

The author thanks Rajesh Dheenathayalan for his assistance

What's next? A Credit rating downgrade probably?

This article was published in The Global Analyst

 

Amid all the debates of whether India’s economy is facing a 1991-like crisis or not, what the country’s policymakers is forgetting to understand that it’s not the time for making some announcements here or there or planning some piece-meal solutions, but for some real action. Time is running out for the country’s crisis managers. Their jobs are cut out: deficits are needed to be reined in quickly, while the domestic demand needs to be given a big boost. While there is no denying the fact that attracting greater portfolio inflows and FDI is crucial in the government’s efforts to stem rupee’s dramatic fall against dollar, what is equally important to note is that this could also be utilized as an opportunity to kick-start exports. Can the government get into the action mode instead of calming those drawing similarities between the current situation and the pre-reforms crisis?

An avalanche of bad news hit India of late leading to rupee crash, stock market crash, and investment outflow. Though India does not have any sovereign bonds issued outside the country, a sovereign rating downgrade can trigger many collateral damage. Currently India enjoys a BBB- rating which is the last tranche of investment grade. While Fitch and Moody’s have given a “stable” tag to that rating, S&P has given a “negative” tag. A down move from here means that India will slip to the first leg of non-investment grade from the last leg of investment grade.

Losing investment grade status even for a temporary time could be a severe blow to our ego and psyche as one of the fastest growing economies in the world. Due to lack of sovereign borrowings, it may not create a repeat of 1991, but it will certainly generate collateral damage worthy of note.

 

It is not the purpose of this article to predict when or if at all a credit rating downgrade will happen. However, it will be useful to assess its impact ahead of time to be prepared for a portfolio strategy.

Current take of rating agencies

Fitch maintains its BBB-negative rating with a negative outlook without any changes in its previous estimates on account of slowing growth rate, high inflation and rising fiscal deficit and warned of a possible downgrade to junk status in the next 12-24 months. In June 2013, Fitch returned its outlook back to ‘stable’ from ‘negative’ a year after its initial downgrade, on back of measures taken by the government to contain its budget deficit.

Standard and Poor continues to see one-in-three chance of a downgrade in the next 12-24 months. The rating agency said that, if weak sentiments cause business financing conditions and investment growth to deteriorate further – putting long-term growth prospects at risk – likelihood of downgrade will increase. The rating agency said that “We may revise the outlook to stable if the Government implements initiatives to reduce structural fiscal deficits, improves investment climate and increase growth prospects”

Moody’s reiterated its stable outlook in June, 2013. It cited low levels of overseas government debt and adequate reserves for balance of payment needs in near term as reasons for its stance.

   

By looking at the outlook of different credit rating agencies towards the countries with similar credit rating, we find that most of the countries have stable outlook. Fitch has given the positive outlook to 4 countries, stable outlook to 8 countries and only 1country has been given a negative outlook (India) among the 13 countries it rated so far. S&P and Moody’s also show a similar trend with giving only 2 countries and 4 countries respectively a negative outlook.

 

The company we keep…

Countries with credit rating similar to India

 

Country	Fitch (BBB-)	S&P (BBB-)	Moody’s (Baa3)
India	Stable	Negative	Stable
Tunisia	Negative		Negative
Azerbaijan	Positive	Positive	Positive
Colombia	Positive		Positive
Bulgaria	Positive
Namibia	Positive
Iceland	Stable	Stable	Negative
Uruguay	Stable	Stable	Positive
Morocco	Stable		Stable
Indonesia	Stable		Stable
Romania	Stable		Stable
Philippines	Stable		Stable
Turkey	Stable		Stable
Spain	Negative		Negative

 

The “Worry’ List

Overall, the agencies are worried about the following key factors:

• GDP growth
• Fiscal Deficit
• Current Account Deficit
• Inflation
• Investment Climate

While the first four can be quantified precisely, the last one is a loose description of many things but mainly FDIs.

Let us see the IMF numbers on all these parameters:

Growth Concerns

After clocking Hindu rate of growth for decades (less than 4 per cent), India finally emerged to post growth in the 8-9 per cent band albeit for a short time. It now regresses more or less back to Hindu rate of growth adjusted for today’s times. The IMF forecast of 5.7 per cent in 2013 is a sharp reduction from 6.2 per cent and the recovery expected in 2014 is at best takes it back to 2012 with some silver lining appearing in 2015.

Ballooning Deficit

The fiscal position of India deteriorated dramatically following the global financial crises of 2008 with central government deficit widening to 5.9 per cent for the year ending 2011-12. The country’s current account deficit (CAD) touched a record high of 6.5 per cent of GDP in the Oct-Dec quarter of 2012 and ended for the whole year at 4.8 per cent of GDP as against the government year-end target of 5.1 per cent.

	2012	2013	2014	2015
Real GDPGrowth %	6.2	5.7	6.2	6.6
Fiscal Deficit(% to GDP)	-8.3	-8.3	-8.4	-8.3
CAD(% to GDP)	-5.1	-4.9	-4.6	-4.3
Inflation(CPI, avg.)	9.3	10.8	10.7	9.5

During the first quarter of 2013, CAD was lower than expected and stood at 3.6 per cent of GDP. Data for Q2 2013 would be released by September end.

Inflation Blues

The CPI inflation forecast by IMF points to double digit level of 10.8 per cent stubbornly remaining there for 2014 with a moderate drop in 2015. WPI Inflation which was cooling off due to weak demand, shot up to 5.8 per cent (YoY) in July 2013 (a 5-month high) compared to 4.8 per cent (YoY) last month. Supply side pressures led to acceleration of food inflation to double digits (11.9 per cent YoY) on higher prices of vegetables due to poor arrivals and supply chain disruption. Fuel inflation was under pressure due to weakening rupee.

Investment Climate

Lack of economic reforms and policy paralyses deteriorated the investment climate in the country. Rigid FDI policy and inclusion of retrospective tax provisions in the finance bill were not taken very well by the investors as this might act as a catalyst to already slowed growth of the country. The government came up with some reforms to improve the investment climate. The Finance Minister approved the FDI in retail, aviation, insurance, broadcasting services and power exchanges but was perceived more as a lip service incapable of being executed swiftly due to political factors.

 

Impact of rating downgrade on India

Flight of Capital: Post downgrade, liquidation from funds which have a mandate that prohibits investing in countries with ‘Junk’ sovereign rating would materialize. Outflow of funds from both debt and equity market would lead to further depreciation of currency and the resultant impact of increased borrowing costs is bound to hurt players saddled with debt. Overseas acquisitions fuelled by foreign debt and companies which raised debt through ECB window/FCCB would be affected. Those with foreign debt would face the double whammy of currency depreciation and higher rates leading to increased refinancing costs. Increased costs of capital externally would lead to fight for capital internally leading to crowding out for funds. Domestic liquidity would be constrained. Infrastructure woes (Infra projects were largely funded by Government) would persist and structural weakness in the economy would be exposed.

Increase in borrowing costs for government: Indian government is looking at external debt financing to finance its fiscal deficit. The current gross fiscal deficit stands at around 3.6 trillion and lowering of India sovereign status will increase the borrowing costs on account of higher probability of default, monetization driven depreciation and inflation. With then bonds in junk status, sovereign bonds yield have to be high enough to attract investors and the depreciating currency and high inflation will also put an upward pressure on the bond yields and increase the borrowing costs.

Increase in overseas borrowing costs for Indian companies: Indian companies will also be affected by the country’s rating downgrade. The companies will then shed more money to attract investments and this will considerably increase the burden on them. The recent plunge in rupee against dollar on fears that India may fail to finance its current account deficit led 5-year CDS on State Bank of India to jump to 14-month high of 351bps. (India has no traded sovereign debt outstanding and state-owned SBI is used as a proxy to hedge exposures to India). This is almost 150bps higher than Russia CDS value of 201bps (Brazil CDS: 211bps, China CDs: 117bps; Markit, Values as of Aug 20, 2013). According to a recent research published by India Ratings and Research, 65 of its 290 Indian investment-grade issuers may face a negative outlook or an outright downgrade if the rupee remains weak for a sustained period of time.

India’s borrowing capabilities reduced: Not only will the borrowing costs but the borrowing abilities of India will be reduced. Government will find it difficult to borrow money as investors might not prefer to invest in junk instruments on concerns of default. India will have $1 trillion infrastructure deficit over the next five years alone and with a rating downgrade, it will be very difficult to gain investors’ confidence and attract investments in the country. Also, since 2001, foreign investors have invested almost 3 lakh crore in India and a rating downgrade may prompt the investors to further pull the money out of India adding to the current trend of money moving out of India.

Impact on Stock Markets

Effect of sovereign debt downgrade would be majorly felt in ‘Debt Market’, while ‘Equity Market’ is expected to suffer collateral damage. Sustained sell-off in equities is unlikely as rating downgrade is largely a lagging indicator (Rating agencies look at past data to draw their conclusions), whose effects would have been factored by the market. Nevertheless, the stock market impact depends on three factors:

• Level of foreign debt
• Export surplus &
•  Hedging

In other words, the higher the foreign debt, the greater the impact. Also companies enjoying export surplus (meaning export more than imports) and companies that have hedging in place will be less affected compared to others. Broadly speaking the impact on stock market can be summed up as follows:

 

Falling Rupee

Positve Impact	Negative Impact
Information Technology	Chemicals
Pharmaceuticals	Paper
Textiles	Auto Ancilliaries
Tourism & Hospitality	Power
	Steel
	Banks

 Banks which have a mandate to invest 24 per cent of their deposits in G-Sec would be most affected, as a sell-off triggered in ‘Debt market’ would result in portfolio losses (due to yield spikes) and subsequently drive down the capital base. Power sector which is dependent on imported capital goods would be hit. Energy sector and downstream chemicals which depend on import of crude oil would be exposed to higher business costs. While on the flip side, export driven businesses such as IT, pharmaceuticals and textiles could sustain the impact and possibly gain. Tourism & Hospitality sectors would benefit. Amid this tumultuous scenarios, preference for Gold as an investment would gain prominence within India and exacerbate the existing current account deficit problem.

However, for export-oriented sectors like IT, Pharma and Textiles, it should not be assumed that rupee depreciation will directly benefit them. Companies may be subjected to price renegotiations and hedging restricts the potential upside when rupee is depreciating. Similarly, import-heavy sectors need not be fully hit if they have import price parity or cost pass through contracts. However, Chemical companies usually do not enjoy the benefits of import parity or cost pass through. As a portfolio strategy, it is best to focus on zero-debt companies.

 

Can India bounce back?

From being a tiger economy a few years back, India is now facing the daunting task of avoiding a rating downgrade to junk status. Piecemeal handling of the problem by RBI coupled with lack of progress on reforms by the government has exacted its toll on the economy and its image. A rating downgrade will bring India on the global center stage for all the wrong reasons. The silver lining in this is the lack of sovereign foreign debt, though Indian corporates have huge exposures and will suffer immediately post the downgrade. Like the USA, now being used to AA+ rather than AAA, India will eventually reconcile to the fact of being junk rated with political parties blaming each other for bringing the situation to this pass. We all wish that it does not get this messy.