Back from the brink

An important lesson from the stock market’s recent brush with bears is that valuations is a dynamic concept

The near 1,200-point slide in the stock market following the Federal Reserve’s stated resolve to begin the cycle of interest-rate hikes and the eventual recovery have plenty of lessons for investors. The first is that the rules of the game have changed. Equities are shrugging off the control of foreign investors, though the category still has the power to sway the market like the four trading days in September. In fact, companies with high foreign fund holding have become liabilities due to their sensitivity to international events. Instead, mutual funds are the new movers and shakers. Many of them are maintaining a higher percentage of cash to deploy on dips. Their exposure is not limited to index constituents as is of most pension funds from the developed economies because of their investment objective. The second change is the shift of mood.  Investors are tapping players creating ripples in niche platforms, bypassing those with established revenue models. Retailers, pathology labs and fast-food providers have emerged as forces to reckon with in contrast with tech, telecom and banks in the pre-2014 era. The slowing of MNCs in the large-cap space in providing capital gains is the third conclusion. They do surprise from time to time. These occasions are exceptions rather than the rule. Indian peers are seizing the initiative as consumers are shaking off their reverence for established brands. They score with their value-for-money proposition by spotting space in the market that big players have ignored or unable to tap due to the low margins. Some are becoming MNCs in their own right by going to neighboring countries.

The fourth inference is the preference for listing gains, as reflected in the huge over-subscription to IPOs of late, rather than bracing up for the long trot or fluctuations in the secondary market to gather capital appreciation. Some dodgy issues, to be sure, don’t elicit the necessary interest, a display of maturity of the market that prefers quality even if it is expensive. The fifth outcome is the dramatic transformation in the outlook for valuations. The yardstick of using historic P/E to determine if the current prices are over the top is turning obsolete. Fancy for stocks in high double-digits seems to be a reiteration of the understanding that the economy is set to scale up at a faster pace. The sixth observation is that many hot and happening sectors have let down investors unexpectedly. The lukewarm reception to e-commerce properties is in consonance with their de-rating by private equity and venture capitalists earlier. Volumes cannot be a substitute for quality of the earnings is the message of the market.  The seventh noticeable trend is that every phase has some comfort sectors. These continue to perform steadily, irrespective of the internal and external environment. Passenger cars and two-wheelers fit the slot. A range of models cater to different needs, without bloodletting. There is seamlessly adoption of new challenges.

Each bull-run throws some surprises, too, is the eighth fallout. The trigger could be transformation in the market’s taste or change in technology or regulations. Ignored till recently, deregulation of petrol and diesel have made refiners the market’s darlings. The danger here is that just as loosening control permitted PSU oil marketing companies to bloom, any tinkering with norms could also make them wilt.  The eighth footprint is that traditional safe harbors are no longer dependable. FMCG and pharmaceuticals, once considered defensives, are now becoming unpredictable. Sales of personal-care products bob according to rural consumption that, in turn, depends on rains. Drug producers’ fortunes wax and wane as per the observations and clearances by overseas regulators. The ninth marker is that sub-segments can perform in a diametrically opposite fashion. Even as state and some private lenders are fighting off the market’s negative perception in the financial services space, NBFCs continue with their trail-blazing run due to their nimble-footing in customizing to borrowers’ needs. The riddle is if consolidation will make banks responsive or shackle them with more layers of decision making.  There is possibility of hitherto-shunned industries making a dramatic comeback is the tenth inference. Non-glamorous nuts-and-bolts producers are coming out of hibernation. Bearings, components for machines, water and sewage treatment, chemicals and metals are once again meriting a closer look from a market that is fed up of the hype and want India Inc to walk the talk.

Mohan Sule

Silver linings

The huge foreign exchange reserves leave enough room to keep interest rates low and rupee capped

Whether demonetization has resulted in the destruction of the economy or is a much-needed disruption is a polarizing issue. Despite the differences, there is consensus that India needs to widen the tax base. The conflict is how to go about doing it. Opponents such as former governor of the Reserve Bank of India Raghuram Rajan or former economic advisor to the UPA II government Kaushik Basu have no answer other than to point out to the short-term setbacks. The practitioner of coalition dharma, Manmohan Singh, pronounced the exercise as legalized loot, conveniently forgetting the plunder of the national treasury by crony capitalists. A swap of high-value notes mutated to mean their confiscation. How daily wage earners and those with unsteady stream of revenues came to own such a large number of high denomination currency and who was responsible for injecting them into the system remain a mystery. Digital India would have remained a catchy slogan and Jan Dhan accounts with nil balance. Destruction is needed if the edifice is too rotten to be repaired. Disruption results whenever there is change in current status. The sinking of the Titanic in 1912 and the take-off of commercial air travel in 1914 could not have been a coincidence. The outcry system of stock trading got seamlessly converted into online trading without any glitches.  Credit goes to the ease of using the interface as well as the aggressive push by the market regulator. The plunge in telecom data prices should have been the trigger for exodus to cashless transactions. If payment gateways are yet to find widespread usage despite their proliferation, the fault lies with the central bank for not doing enough to push down transaction charges.

The second silver lining is the implementation of the goods and services tax. The entire value chain from the supplier of inputs to the manufacturer to the distributor and the consumer has to become tax-compliant. Not surprisingly, there are complaints about the frequency of filing returns. Much sympathy is being extended to the difficulty faced by micro, small and medium enterprises so soon after DeMo. In a sense, GST is anti-thesis of the socialistic policy of protecting these units with tax exemptions and benefits instead of incentivizing them to grow big. Most of them till recently were reluctant to avail or unable to access capital from financial institutions due to absence of book-keeping. The new regime encourages these units to achieve economies of scale by availing of input tax credit.  Many of them could turn out to be DMart or LalPathlabs by tapping the equity and debt markets. The cascading effect will not only be visible in employment generation but also in boosting consumption. Mutual funds in search of high-quality, low priced offerings will get an opportunity to deploy their subscriptions, encouraging more investors into the market on the prospect of better returns.

A valid point is the number of tax slabs. A uniform tax regime implies a common rate. Enough hints have been given by the finance minister that some of the rates will be merged once the system becomes revenue-neutral. Eventually, there might be just two rates, one for essential and another for non-essential items. No product or service should remain outside the purview. The recent spurt in petrol and diesel prices has provided an impetus to bring them in the GST net, too. The third comforting factor is that interest rates are still high. Recently, the bond market saw turbulence, with yields on government paper rising on talk of an imminent fiscal stimulus. The fear was that increased government borrowing would crowd out private players and strain liquidity, thereby pushing up interest rates.  The concern seems exaggerated. The real rate of interest is near-about 3%. The Reserve Bank of India can adopt a neutral stance for the remaining part of the fiscal even if wholesale and consumer inflation rallies. It can begin the reduction cycle if there are signs of cooling of food inflation as late rains in many parts of the country seem to have nearly wiped out the monsoon deficit. Besides, the high rates have proved to be magnets for foreign funds. Their inflows have bolstered the foreign exchange reserves to a record US$400 billion. The stockpile gives room to the monetary authority to maintain liquidity to keep interest rates soft and to depreciate the rupee to boost exports, thereby ensuring that the withdrawals of the dollars from the treasury are replenished. When the economy begins to recover, inflation will also look up. As long as it does not run away, the development should be welcomed as it will induce risk-taking. Producers will be able to earn better realizations because consumers will be in a position to absorb the prices hikes.

Mohan Sule

What the market knows

The rally in the broad market and the continuing attraction of mid caps indicate the present economic woes might be temporary

Baiters of Prime Minister Narendra Modi have been quick to blame demonetization for the GDP growth slowing to a three-year low of 5.7% in the June 2017 quarter. The trigger seems to be the Reserve Bank of India annual report coincidentally coming around the same time. It revealed only about 1% of the old currency was not returned to banks. There could be two reasons for depositing of most of the cash in circulation. First, only a handful of people might be in a position to generate, store and utilize the liquidity. The possibility is that they are at the top of the pyramid and rented the accounts of their field force. Second, many might have already laundered the loot through a web of channels. The discovery of nearly two lakh shell firms and the restriction on trading imposed on more than 300 listed companies should be counted as major successes apart from the revival of the dormant zero-balance Jan Dhan accounts. There is some quibbling whether 90 lakh new tax payers were added or about 50 lakh as mentioned in the second Economy Survey. The controversy is silly. What is important is the amount of income declared rather than the number of tax payers. The puzzle, however, is why the impact of the swap of currency should be felt after a quarter. The GDP grew 6.1% in the January-March 2017 period over a year ago, when the intensity of the fallout was the highest, with the 50-day period for exchange of old notes closing in the previous quarter.

The disruption in the rural economy could be responsible for the lag effect. Last year’s normal rainfall resulted in supply glut. Prices of many farm produce crashed. The distress of farmers after two consecutive years of drought, therefore, did not ease, affecting karif sowing beginning April. The roll-out of the goods and services tax from the second quarter of the current financial year forced manufacturers to cut production on dealers’ reluctance to restock. Companies were busy shedding off past excesses on fear of being declared insolvent. Construction stalled as new houses now have to be Real Estate Regulation and Development Act-compliant. A strong rupee and the churn in the tech sector hurt export services. Infrastructure initiatives of the government such as Smart Cities and Digital India are at the planning and ordering stage, with execution of many yet to commence. Therefore, the growth in industrial production, at 1.2%, and construction, at 2%, was lower than that of farm output, at 2.3%, in the quarter. If manufacturing has slumped and food inflation is rearing its head due to floods and patchy rains in different pockets, why is the market not bothered? The benchmark index of the BSE once again crossed 32,000 and of the NSE 10,000 after retreating amid a spell of volatility triggered by North Korea’s missile tests. Yet, investors have been selective in their approach to leaders in recognition that many of them have to diversify to bolster earnings, a risky exercise. Only a handful of index constituents are attracting most of the inflows. Interestingly, these stocks get most of their revenues from the domestic market.

Nearly 30% of the NSE Nifty 50 hinge on exports for a major part of their revenues. After capturing a commanding share of the local market, other companies in the index too, have been seeking international orders. The quest for dollar-denominated income made sense when the rupee was depreciating. The acceleration of foreign direct investment since the launch of the Make-in-India initiative and foreign portfolio investors’ increasing interest in debt due to high real interest rates have boosted the Indian currency. Many export-oriented sectors are facing headwinds. Mid- and small-sized companies are getting better discounting despite the general belief that large companies are better placed to absorb external shocks. Domestic funds, buoyed by cash that turned formal, are betting on these counters. Only about 10% of the 100 companies in the S&P BSE Mid-cap Index depend on exports. Many medium and small companies are in nascent sectors or emerging from segments dominated by the informal economy. There is scope for them to run at a faster pace. The low base effect of the GDP growth rate in Q1 and possibly Q2 of the current fiscal could also be a launch pad for recovery going ahead. The spurt in spot prices of electricity points to the bottoming out of the economy. The increase in August in CPI due to food articles and WPI largely by metals implies the slump in demand post DeMo and GST turbulence is fading. Fortunately, interest rates are not so low as to push the RBI to reverse the course. No wonder, the market continues to remain bullish on the India Growth Story.

By Mohan Sule