Linking Sectors to Companies-A 4 Grid Approach

In one of my previous post, I argued for the need to distinguish between good sectors and bad sectors in portfolio investment. However, in the Indian capital market context, the availability and popularity of sector indices/ETF’s is still developing making it difficult to implement a sector based portfolio strategy. As an extension of that research, it may be worthwhile to see the link between sectors and companies. In simple terms, you may have a bad company in a good sector or a good company in a bad sector. How do you reconcile such conflicts?

Why Sectors matter?

Source: Reuters Eikon

BSE has 19 sector indices. If one tracks their annualized performance for the period January 2008 to September 2015, we can see that there is wide variation in their performance. While healthcare was the best performer (20.1% compounded return), Realty sector was the worst performer (-24.6% compounded return) with Sensex performing at 3.8% annualized. Out of the 19 sectors, 8 outperformed Sensex while others underperformed Sensex. Hence, sector performance matters.

Source: Reuters Eikon

While the annualized performance shows huge variation, even within a sector we see wide variation in performance as captured in the graph that depicts median performance. The best example is that of Healthcare, where the best performer clocked an annualized performance of 43.1% while the worst performer clocked an annualized performance of -29.1% with a median performance of 21.4%. Hence, it may not be enough to just bet on good sectors as even within good sectors we notice wide variation in performance.

 The 4 Grid approach

Here is the dilemma while choosing companies. We may have good companies in bad sectors (like Castrol in Oil and Gas) or bad companies in good sectors (Financial Technologies). Hence, it may be worthwhile to regroup the index constituents across these four dimensions and assess their portfolio performance (based on market cap weights):

            1.     Good companies, good sectors (A)

            2.     Good companies, bad sectors (B)

            3.     Bad companies, good sectors (C)

            4.     Bad companies, bad sectors (D)

   The definition of a good company/sector is that it outperforms the Sensex returns and conversely a bad company/sector is the one that underperforms the Sensex.

Here are the findings:

Grid A (Good companies, Good Sectors)

Grid A companies (67 of them) have outperformed both their sector and the wider Sensex with the highest performer clocking an annualized performance of 85% (Indiabulls Housing Finance) while the lowest performer clocking an annualized performance of 3.8% (Mphasis) still better than Sensex. All the more, when you group them as a portfolio (market cap weighted) the portfolio performance is an impressive 17.5% annualized compared to Sensex performance of 3.8%.

Grid A-Top10

Sl. No.	Name of the company	Annualized Return (2008-2015)
1	Indiabulls Housing Finance	85.1%
2	TTK Prestige	46.5%
3	Lupin	43.1%
4	Jubliant Food Works	42.7%
5	Aurobindo Pharma	40.8%
6	Vakrangee	37.7%
7	PC Jeweller	37.6%
8	Strides Acrolab	37.0%
9	Whirlpool	35.7%
10	Cadila Healthcare	35.6%

Grid B (Good companies, Bad Sectors)

Grid B companies are drawn from sectors that has underperformed the Sensex but whose constituent companies have outperformed the wider Sensex and contains 24 companies with the highest performer clocking an annualized performance of 63% (Eicher Motors) while the lowest performer clocking an annualized performance of 4.4% (Siemens) still better than Sensex. All the more, when you group them as a portfolio (market cap weighted) the portfolio performance is 14.9% annualized compared to Sensex performance of 3.8%

Grid B –Top 10
Sl. No.	Name of the company	Annualized Return (2008-2015)
1	Eicher Motors	62.8%
2	Shree Cements	32.3%
3	Asian Paints	30.0%
4	Pidilite Industries	25.5%
5	FAG Bearings	25.4%
6	Castrol	23.1%
7	Havells Inda	18.0%
8	BPCL	16.4%
9	AIA Engineering	14.9%
10	Indraprastha Gas	14.0%

Grid-C (Bad Companies, Good Sectors)

Grid C companies are drawn from sectors that has outperformed the Sensex but whose constituent companies have underperformed Sensex and contains 19 companies with the highest performer clocking an annualized performance of 1.2% (ICICI Bank) while the lowest performer clocking an annualized performance of -33.4% (Financial Technologies) far worse than Sensex. All the more, when you group them as a portfolio (market cap weighted) the portfolio performance is -5.0% annualized compared to Sensex performance of 3.8%

Grid C-top 10

Sl. No.	Name of the company	Annualized Return (2008-2015)
1	ICICI Bank	1.2%
2	SBI	0.8%
3	Dish TV	0.4%
4	Punjab National Bank	0.1%
5	Sun TV	-1.5%
6	Jagran Prakashan	-1.5%
7	Union Bank of India	-2.1%
8	Canara Bank	-2.2%
9	DEN Networks	-4.6%
10	Blue star	-4.7%

Grid-D (Bad Companies, Bad Sectors)

Grid D companies are drawn from sectors that has underperformed the Sensex and whose constituent companies have also underperformed Sensex and contains 65 companies with the highest performer clocking an annualized performance of 3.6% (ACC) while the lowest performer clocking an annualized performance of -43.1% (Unitech) far worse than Sensex. All the more, when you group them as a portfolio (market cap weighted) the portfolio performance is -7.9% annualized compared to Sensex performance of 3.8%

Grid D-Top 10

Sl. No.	Name of the company	Annualized Return (2008-2015)
1	ACC Ltd	3.6%
2	Gujarat State Petronet	2.6%
3	Adani Port and SEZ	2.2%
4	Pipav Defence	1.8%
5	Alstom	1.6%
6	IDEA Cellular	1.0%
7	Aditya Birla Nuvo	0.8%
8	Lakshmi Machine Works	0.7%
9	Grasim Industries	0.7%
10	Larsen & Tourbo	0.7%

Key Takeaways

         1.     A strong look at the sector to which a company belongs is key to identifying winners

      2.  There may be good companies in bad sectors and vice-versa. Hence, a sector bias should not cloud out opportunities.

       3.     In general, good companies come from good sectors. That is a killer combination to have in your portfolio (Remember Grid A)

        4.     In general, bad companies come from bad sectors. This should be avoided at all costs. (Remember Grid D)

The author thanks Rajesh Dheenadayalan for data analytics and support

Oil prices now go beyond the supply/demand equation

Interview with MR Raghu, Head of Research, Markaz by Peter Duke, Sales Director, Fidelity Worldwide Investment

Peter Duke: Good morning welcome to the Fund Forum Middle East. My name is Peter Duke from Fidelity Worldwide Investment. I am delighted to be joined today by Mr. MR Raghu, Head of Research, at Markaz. Raghu Welcome!

Raghu: Thank you

Peter Duke: Your special subject today is oil so of course we kickoff with the basic question around demand and supply and how you see those dynamics in your market at the moment

Raghu: Sure! You know at a very broad level, any commodity is always impacted by demand and supply. Price is always a function of demand and supply and this works very well for oil as well. In the past when we have demand slackening, the supply gets adjusted and therefore the prices defended. Now that model has broken down and we have a double whammy now if I may call it. So we have a weak demand and we have an oversupply , so this is killing the price, obviously. Now the question to ask is “why is supply not getting adjusted to a weak demand to defend the price?” ok that’s where I feel the politicscomes in to play and that’s why I said there is a shift in the way we have to think about the oil market in the current context of the simple “demand – supply –price” equation.

Peter Duke: Raghu you said that argument about politics must be the role of Saudi Arabia is key here. How do see that and how do you judge that policies on internationally working, do you think that it will stabilize away.

Raghu: Yes it was very surprising the way I understand how Saudi has acted at this time around, because traditionally OPEC which is “Saudi Arabia” always had this defend price strategy in place. But they have observed that unconventional oil has come to the market in a big way and the traditional price driven response may actually backfire on them after some time. So they have decided to play the gamble and the gamble is,  “don’t defend the price but defend your market share” which means keep producing rather produce more you know to get more market share and they know the consequence. The consequence will be a lower price and we all see that today. But the thing is there is an inflexion point to this gamble.They want to play this till they get the high cost producers out of the scene and then go back and play their original equation of defending the price. Now, the thing is “who is going to blink first?”, that is the question now. So the way we understand unconventional producers,  it’s a very hazy picture because there is a technology angle to it, there is a price angle to it and the player profile is different, the conventional oil is controlled by national oil companies for example, backed by huge sovereigns, unconventional oil is controlled by small players who are mostly in the just bond market,  such a completely different dynamics. So we don’t know the jury is still not out and we hope the Saudi gamble pays off and the oil market comes back to at least $70-80 as they wanted to be in the medium term. But right now we are in the scene, so we don’t know the climax.

Peter Duke: Well that might be the answer. But have you been surprised by the resilience of Shale produces in the US

Raghu: Absolutely, not only the resilience but the continuous downward estimate of the cost of production, because I remember Goldman Sachs were predicting the cost of unconventional oil about $80 to start with about two years back. But today they are talking about $60 and they are estimating it to go down. So as the cost of production goes down then you know both sides may not blink for a long time.So that is big event to watch. So it’s not happening, you defend your market share and people just go out of the system, they are just not going out of the system actually.

Peter Duke: We have new people coming in to the system like Iran what’s your view

Raghu:Iran is not a big thing as people make it out to be. But definitely in about three four years they will even contribute to the oversupply situation. But not only Iran, we have to talk about Iraq, we have to talk about Libyaall hotspots where we thought supply could be constrainted, are never constrainted . So they are actually adding to the glut of the supply and then demand side is getting bad and therefore we have a double whammy effect on the price.

Peter Duke: if you see this oil crises at these level may be increasing in the medium term. What is the impact in terms of the GCC economies, the stresses that may come out?

Raghu: I feel that the impact is more negative for MENA economies rather GCC Economies. Why because GCC Economies are sitting on huge reserves and they have the fire power to withstand this low oil price environment for a considerable period of time. All this tension about Saudi’s reserves dwindling very fast, it’s over blown in my view. Saudi’s definitely have amassed huge reserves that can stand them today in good stead compared to where they were in 1998 for example when oil prices were very low. But it will hurt MENA economies much more than GCC economies obviously because the breakeven oil price for MENA economies are much higher compared to GCC economies. For exampleIran requires an oil price of $135, Saudi Arabia requires oil price of $100, Kuwait requires an oil price of $50. So the comfort zone is definitely much better in the GCC compared to MENA economies. So it’s the MENA economies that will start putting pressure to the extent they are in OPEC cartel to really stop this defending market share game and at least give us some price that we can breathe.

Peter Duke: One final question that I wanted to put on the spot in terms of oil prices at the end of this year what you think is the reasonable number

Raghu: That’s an easy question to answer because we are already close to end of the year, so I am fine to take a call on that! You know oil prices are now range bound between a band of $40 to $60 and I think that’s going to be there for some time. The $100 oil price era is simply gone. But we are not definitely in to the $20 oil scare as well. So $40 to $60 is a world comfort price but whether that is the “Comfort price” for GCC I don’t know.

Peter Duke:Raghu thank you very much for your insights. You heard this for Fund Forum Middle East. Thank you.

Raghu: Thank you, it’s a pleasure talking to you.

How to Tackle Subsidies in the GCC?

This Article was Published in Arab Times, Gulf News, Akhbar Al Khaleej, Al Qabas, Zawya

Subsidies are easy to roll in but difficult to roll back. The vexed issue of tackling subsidies comes to the fore in difficult times and hence this topic assumes importance in a low oil price situation. According to IMF estimates, GCC countries will spend roughly USD 60 billion on energy subsidies in 2015. While subsidies are offered under various categories, the major one is always energy subsidies. Very high amounts of energy subsidies in the GCC have led to wasteful consumption, which is reflected in the high per capita burden of these subsidies.

This issue is a topic of importance not only to the GCC, but also to the wider MENA region. Arab countries spend nearly 7.2% of their GDP on energy subsidies (pre-tax), while the comparative figure for advanced economies is just 0.03% and about 0.9% for emerging markets. Hence, the scale of subsidies is relatively too large to ignore. Also, given the high subsidy rate in the GCC (averaging nearly 70 to 80% of the cost), it often promotes wasteful consumption and encourages energy intensive industries rather than labor intensive industries.

Before we tread the subject of how to reduce the impact of subsidies, it is important to understand the context of subsidies in the GCC vis-a-vis other Arab countries. In the GCC, subsidy is a form of “wealth distribution,” while in other Arab countries it is more a form of support to poor people as a poverty alleviation tool. Therefore in the context of the GCC, where subsidy is more of a wealth distribution mechanism, the factor of demography plays an important role. In economies like the UAE, where expats are super dominant as a share of total population, the role of “wealth distribution” takes a back seat while that may not be the case in other GCC economies where the share of expats is more or less balanced.

Hence, it is no wonder that UAE recently launched the bold initiative of ending the energy subsidies. In July 2015, the UAE announced linking gasoline and diesel prices to global oil markets staring August 2015. It became the first country in the GCC to remove transport fuel subsidies. The move is expected to result in a savings of about $7 billion for the UAE. Given the large expat population (of over 90%), the burden of such roll back on nationals can be minimal. Hence, we must not assume that all other GCC countries will also follow a similar path.

While the intention behind energy subsidies is to relieve the burden on the poor, such an argument may not be valid for the GCC given the high per capita income and the classification of the GCC as rich rather than poor. It is important to note that in the context of other Arab countries, though subsidies are directed to help the poor, it is often the rich that benefits from them.

What steps should the GCC take now?

It is not a question of “If”, but rather a question of “how” to reduce subsidies and gradually lessen its impact on the fiscal situation. The following can be proposed as ways to tackle this  this vexing situation.

     1. Find alternative methods to distribute wealth: Since in the context of the GCC, subsidies are more of a “wealth distribution” mechanism than a “poverty alleviation” mechanism, it may be a good idea to come up with alternative methods of wealth distribution and replace such methods gradually over time to reduce the burden of subsidies. Direct cash transfer is being proposed by some scholars as an example of this route. The main advantage of such an idea is that it shifts the burden of rational decision making from the State to  individuals and families directly.

     2. Introduce innovative strategies: GCC states can think of introducing various concepts surrounding the subsidies rather than a strait jacket approach of providing the service almost free of cost. The concept of “Tiered subsidies” linked to consumption (low price up to a certain point and high price thereafter) can reduce wasteful consumption. “Smart subsidies” can link subsidies to certain KPIs like national employment or training new graduates. The idea of “Targeted subsidies” can also be tried when promoting certain sectors (say SMEs) becomes more important and therefore can be linked to subsidies provided. Innovation in subsidies can produce better results.

     3.  Aim for efficiency in production: The subsidy burden is simply the difference between price and cost of production. While the suggestions in introducing innovative strategies can work on the price side, it may also be a good idea to focus on how to reduce the cost of production by improving the efficiency of the production of energy. Development of alternative sources of energy fits nicely into such a scheme of thing.

      4.  Launch effective communication: The factor of high subsidies in the present time can disproportionally increase the burden onto future generations. An effective communications strategy that explains the long-term burden of high subsidies and how it crowds out investment in infrastructure can go a long way in gaining support forthe idea that subsidies should be reduced over the long term. 

Chinese Crisis: 3 Questions for NRI’s

This Article was Published in Indiansinkuwait.com

Sensex fell by 1,624 points (5.94%) on August 24, 2015 to reach 25,741 in what is now termed as Black Monday. That was unprecedented given the normal movement of say 100 to 200 points in a day. Though Sensex subsequently recovered to 26,392, the unease continues amongst many of us. So, what has caused this sudden panic and how should we (NRI’s) prepare ourselves. The following questions may be appropriate to answer.

      1.       What is this crisis?

The Chinese stock market has been on a roll since November, 2015. The Shanghai index increased from 1,924 to 4,098, representing a gain of 113%, within a matter of 8 months. This was due to easy money available through banks which lured retail investors into the market. Everyone from fishermen to laundry cleaners were busy making money in the stock market. However, as we all know, such a sudden increase in the market through mindless buying can only go on for some time and not for ever. Companies have become extremely over valued and smart investors started exiting the market. This created a panic among retail investors and they were rushing out of the market creating further slide. The government tried to intervene and prop up the market but it failed. The Chinese stock market fell 35% within a span of 2.5 months. On August 24 (Black Monday), the Chinese market fell by a whopping 8.96% and immediately on the next day all global markets fell including India.

But the question is why a Chinese stock market collapse should cause such a global panic. This is because there is a larger worry among global players than the Chinese stock market. That of Chinese economy.

Since 2008 when the last financial crisis hit the world, there have been fears about slowing global growth. While USA has been trying to recover, Europe is in shambles with only Asia left to support. China is not only a significant part of Asia but also the world. It contributes heavily to the global growth in terms of trade (exports and imports). Before 2008, Chinese economy was growing at the rate of over 10%. Today, the growth has slowed down to 6-7% with fears that it will be even lower. When economic growth is low, countries will find it difficult to create employment which will lead to social unrest. It will also find it difficult to attract foreign money which will hamper investments. Business confidence will fall and businessmen will not make any new investments. Hence, it is important for any country to enable economic growth.

China was predominantly depending on exports for its growth. After 2008 financial crisis, the overall growth of trade (exports and imports) reduced thereby reducing China’s growth. Hence, this panic all over the world. In short, today when China sneezes, the world catches a cold!

      2.       How is India affected by this?

The impact on India is more symbolic than real. Many emerging markets (Indonesia, Brazil, and Russia) are highly dependent on China as commodity exporters. China is one of the largest consumers of many commodities to run its global factory. When China signaled a slowdown in growth, many emerging markets (dependent on china) started feeling the heat and this heat has spread to all other markets including India. Even countries like Germany and Australia (not part of emerging markets but part of developed markets) fell as they have strong links and dependence on China.

India’s economic link with China is very limited. India is not a commodity exporter (like Russia). The only risk India faces is that it can be swamped by cheap imports from China that can threaten local companies. With Yuan devaluation, this threat is real.

The main impact on India will be through its currency. As a fallout to Chinese crisis, many emerging market currencies hit their lows during 2015. (Brazilian Real -26%, Turkish Lira -20%, South African Rand -13%). India is among the least affected currency where the INR fell only by 4% so far in 2015 against the USD. If the Chinese crisis deepens, it will further impact emerging market currencies and we can expect India also to feel the heat in terms of further depreciation of INR.

On the positive side, continuous strain on China can open doors for India as one of the fastest growing economies in the world with least linkages to external world. With America not showing any great signs of economic rebounding and Europe in a limbo state, only very few destinations for investments in the world are left and India can definitely count as one.

      3.       What should NRI’s do?

In this Chinese crisis, NRI’s experienced both good news and bad news. The good news came in the form of lower currency. For eg., the Kuwait Dinar spiked to Rs.224/KD and seem to be hovering around Rs.217/KD now. NRI’s that remit money regularly back to India will certainly be smiling and would hope for even more depreciation of the Rupee!

On the other hand, the steep fall in Sensex/Nifty caused their stock portfolio values to plummet and they were left worried on what the future course of Sensex could be.

For NRI’s, the following observations can be helpful:

     a.       The current Chinese crisis is not just a China issue but a global issue that can affect all markets including India.

     b.      If China slows down (as is feared), it will result in global slowdown, and may negatively affect stock markets and currencies.

    c.       However, India’s fundamental strength (Strong economic growth, ample forex reserves, less linkages to outside world, new government that is reform minded, and a prudent RBI) will make it as one of the safest destinations for investments for foreign investors

      d.      The long-term story of India remains solid

     e.      NRI’s should benefit from the depreciating rupee by regularly remitting money back home and invest in various avenues.

      f.        Diversify your investments by spreading your savings among risk-free fixed deposits/bond funds, and volatile equity funds with some exposure to gold (as insurance). The RBI governor is likely to decrease interest rates in response to lower inflation and hence presently FD rates are looking attractive. Also, when interest rates come down, bond funds will do well. In equities, for those that do not have time to follow markets on a daily basis, invest regularly in well performing diversified mutual funds. If you have the time to select sectors/stocks, favor healthcare, auto, FMCG, infotech and banks. Avoid Realty, metal, power, PSU’s and small cap.

One final note of caution to NRI’s in the Gulf. GCC has more linkage to West than to East. Oil prices have fallen from a high of $140/barrel some years before to $40/b now and are expected to remain at this level for some time. Hence, government spending on projects will likely come down which will put pressure on many companies. Hence, restructuring, cost cutting and job retrenchment can be expected. Job security for NRI’s can come only through increased training and further qualifying. Job security should not be based on the hope that oil price will rebound.