Churn at the top

The travails of HUL, Infosys and Dr Reddy’s capture why large caps are getting poor discounting compared with their smaller peers

By Mohan Sule

The results season never stops to surprise and amuse. Titans numb investors with poor numbers even as dark horses stun with awe-inspiring performance. The period also marks a turning point for the equity market. Companies dissect past performance and lay the roadmap for the remaining year. Inevitably there is a feeling of change in the air as no two quarters are alike. It will be tempting to write off the June 2016 quarter as yet another showcase of the competently reliable and the notoriously unpredictable. This would be a mistake. For one, the period was the last phase of the impact of the rural distress. Second, Corporate India was operating near mid-point of a new government’s tenure, with enough time to absorb its past policies and assess future direction. Third, the global economy continued to be in a flux as never before: China’s slowdown looked inevitable, US recovery fragile and the financial markets uncertain about the fallout of the two-year of UK’s disengagement with the euro zone. Amid the turmoil stood India, displaying vulnerability about its export earnings and at the same time exhibiting confidence about its domestic economy. If the enabling environment was so full of concerns as well as excitement, could companies remain immune? The tough period of the last few years exposed fault lines. First, the era of crony capitalism is slowly but surely grinding to a halt. Auctions of natural resources, cleaning up of bank balance sheets and the commodity meltdown have knocked off the market cap of quite a few magnates.

Second, certain boom industries seem to have had their run or losing steam. Teflon-like sectors are increasingly being linked to global and local factors just like many other Old Economy cyclical industries, while some are facing the winner’s curse. As long as the US was undergoing a bull phase, the major worry of IT companies was the dent in income in the third quarter due to the longish Christmas break. The focus of the consumer disposable segment was coaxing buyers to upgrade to achieve better margins. If the 2008 mortgage meltdown burst the tech bubble, the two consecutive deficit monsoons of 2014 and 2015 pulled down the lifestyle sellers.  If a repressive regulatory regime was suffocating their well being in the licence raj era, intensifying competition is pinching formulations and intermediate producers. Capturing the essence of the headwinds are three Nifty constituents: HUL, Infosys and Dr Reddy’s Laboratories. They are still the flag bearers of their sectors, steadfastly sticking to their knitting and not foraying into unrelated businesses. Minority shareholders have been amply rewarded through capital appreciation and regular payouts. Yet their numbers for the June 2016 quarter have confirmed a trend noticeable since the last couple of years. They are ageing, are increasingly becoming indistinguishable from their peers and even ceding ground to new entrants.

Once a leader, HUL has become a follower, trying to ape entrepreneurs riding on the desire of Indians to go back to their roots in contrast to the yearning for Indian-made foreign goods during the pre-reforms era. Infosys is encountering growth fatigue. There is limit to geographical expansion if the world looks like a fiery red globe, mid-tier companies snap with low-pricing deals and the forex market turns into a foe. Dr Reddy’s formed one of the two pillars of the pharmaceutical industry with Ranbaxy Laboratories late last century. Ranbaxy promoters, perhaps sensing the shaping of the industry into a first-past-the-goal post during a limited window, sold out and a relatively newcomer, Sun Pharmaceuticals Industries, has assumed the pole position, with the pure domestic play turning attention to exports to stay in the race. Investors would have got better post-tax yield from one-year fixed deposits of public sector banks than from the troika. Facing pricing pressure, they are dispersing their band-with by chasing every growth avenue. The tech sector controls 20% of Nifty’s balance, with financial services and energy being the two other segments enjoying near parity. HUL has twice the weight of Asian Paints, the only other consumer disposable player. If ITC, slotted in an independent category, is included, the FMCG sector has the highest share in the benchmark. Financial services have turned volatile with even private banks bogged down with NPAs, ferrous and non-ferrous metals facing a slump in demand, telecom weighed down by capital expenditure, automobiles waiting for demand pick-up and power and capital goods limping, the large-cap index is being driven by cement, two-wheelers and refineries. No surprise, therefore, for the poor discounting compared with the mid- and small-cap compatriots having domain focus.

Conventional wisdom

Time to shed the historic view that low P/E, soft inflation and weak rupee create investment opportunities

By Mohan Sule

The financial markets are divided into two camps: optimists and pessimists. Those with confidence in the economy note a silver lining to every dark cloud. On the other side are those who forecast bubbles ready to burst. The markets need both types of participants to discover value in neglected assets and effect correction when prices run ahead of the underlying strength of the asset. Yet the increasing volatility in global markets reflects the confusion of investors on what constitutes the threshold of opportunity and pain. The decision of the British that the UK will be better off without carrying on the burden of weak EU members despite many heavyweights weighing in favour of continuance as the path to prosperity is another illustration of the increasing doubts about traditional wisdom. The historic view that the boom in IPO issuance co-exists with resurgent equities is also being challenged: bubbly stock prices are contagious and the virus can lead to the collapse of both markets, leaving investors with pricey duds and putting them off investing. Retail investors seeking quick and massive returns through new offerings contributed to the near 20% plunge of China’s secondary market a year ago, requiring the authorities to suspend IPOs to control the fall. Conventionally, a low P/E indicates value buy. On the other side, the miserable valuations might be due to the scepticism about the stock’s revenue visibility or corporate governance. Conversely, a high P/E suggests earnings not keeping pace with the price. A contrarian might see the figure as the market’s validation of a stock’s growth potential. The smart investor gets out of the stock when earnings hit or miss estimates, resulting in a correction. If investors were to latch on to these stocks on moderation of P/E, they might have to be satisfied with a slow trot.

Also, there is no consensus on what should be the P/E to consider a stock a value ‘buy’. Many monopolies and MNCs are quoting at many times the ideal range of 15-20 and still sought after by investors for their business model, steady pace of growth, payout policies and corporate governance. Ultimately, the choice boils down between stocks with a consistent track record of corporate actions and those that compensate for the absence of dividends with rapid capital appreciation. The investment strategy cannot be uniform across the listed universe. Investors have to pick stocks as per their ability to absorb risk or objective: seasonal or all-weather, large caps versus mid and small caps, mid caps with and without transparent operations. There cannot be one-size-fits-all sort of an approach. Another contentious issue is inflation. It has been embedded in the collective conscious of investors that prices should remain static to attract low interest rates and encourage companies and consumers to borrow money to climb up. Capping inflation, however, comes at the cost of growth. Even mature economies are finding virtues in triggering inflation: the European Central Bank and Bank of Japan are following the US Federal Reserve in making available plenty of cheap credit in the hope of spurring consumption. A country is said to be emerging when its population with purchasing power expands. This sort of an economy does not have a ready-made infrastructure on standby, poised to meet the galloping demand. In the interim, the spurt in usage can strain existing supplies, causing prices to jump.

The third issue for tempers to flare up is the foreign exchange rate. Weakness benefits exporters but hurts importers. The currency of open countries moves as per demand and supply stemming from the cost of money and policies on deficit. In India, the rupee is convertible only on capital account. As a result, the finance ministry and the commerce ministry are constantly at odds on the currency’s value. India imports more, particularly crude oil, than it exports due to its inward-looking economy. To finance imports, the country needs foreign fund inflows. If the emergence of the IT and pharmaceuticals sectors as major exporters offered solace to policy makers, it also put them in a fix. Though the dollar remains strong due to its safe-haven status as well as the recovery of the US economy, the Indian currency has appreciated in relation to its competitors in overseas markets, largely because of the gush of foreign direct investment on the back of the Make-in-India initiative. Foreign investors prefer countries with weak currency but want better returns from their investment when it is time for repatriation. Recognizing the limits of depreciation as a tool to boost growth, the market seems to be marking down valuations of export-oriented stocks.