Spoilt for choice

On offer are small caps with governance issues, mid caps taking debt to grow and large caps prone to missteps in using cash  

Investors are in an enviable position. There is an array of old economy sectors to explore: The dependable FMCG companies, private banks, NBFCs, automobile assemblers and pharmaceuticals producers. The fading of the disruption due to the recall of high-value notes and roll-out of the goods and services tax and the turning of the commodity cycle riding on the recovery of global economy have put into play oil and gas explorers, refiners, metal miners, capital goods and cement manufacturers, construction companies and providers of housing-related products. PSU banks are getting capital infusion and being empowered to drag defaulters to insolvency. The basket of emerging industries, too, is expanding, with the addition of small lenders, asset management companies and life and non-life insurers. Large-cap laggards are waiting to be picked. Mid and small caps beckon after many shed 30% and more flab. The market regulator has turned hawkish in monitoring stock movements. Policy makers are pump-priming the economy by a series of steps to provoke consumption, particularly in rural areas. GST has widened the tax base as the beauty of input tax credits motivates every tax payer to ensure that his supplier is compliant with the new regime. The arbitrage of price advantage to gain market share is disappearing.    

At the same time, investors today are a pitiable lot. Only about one-third of the more than 3,000- listed stocks trade regularly. Small caps celebrated for spotting niches are also susceptible to headwinds of macro-economic trend reversals, revision of policies and changes in market tastes. The other side of a booming economy that lifts airlines is surging prices of inputs.  The tight grip of the promoters that gives flexibility to change directions without much outside interference can be misused. An e-governance facilitator is now being probed for buying shares of a jeweller. Disclosures can be sketchy. A promising packer of fruit pulp went into a free fall on allegations of divergence of its plan on paper and on ground.  Corporate actions such as bonus shares and stock-splits can be deceptive as there is no outflow of cash. More information is available about mid caps. Their outlook is enticing but can become outdated quickly. An air-conditioner maker unexpectedly skidded in the June 2018 quarter after a `bad summer’. If the upside is survival bias in once-emerging sectors, the downside is sluggish growth. Presence of domestic and foreign institutional investors does offer comfort about their numbers and practices. The concern is the constant need for capital to achieve scale. A builder of airports, a sunrise opportunity, has a debt-to-equity ratio of 46. Ironically, the revenue visibility coincides with the economy heating up and the cost of raw material and money beginning to rise.

Large caps have the strength to withstand economic instability. Yet they are not immune to company-specific issues. Overseas buy of a domestic steel giant that seemed like a masterstroke turned a cash guzzler after the global meltdown. The boards of those that have dispersed ownership are prone to dither over resolving issues that can affect stock prices. In contrast are promoters who do not want to let go and make a mockery of price discovery. The price-to-earnings of a discount retailer with just 20% float is above 100. Opaque acquisitions, bumper compensation packages and accusations of conflict of interest have tarred brands in the private banking and technology services spaces. Usage of reserves becomes a lightning rod. Buybacks to shore up prices result in limiting liquidity and loss of interest among institutional investors. Unrelated diversifications are typical gestures to flank the core activity. The market is unsure if the primary business of tobacco should get more weight or the unevenly performing portfolio of hotels, foods and paper. A petrochemicals conglomerate has been re-rated not because of the cash that its refinery is producing but because of the promise of capital gains from telecom services. A personal-care MNC dependent on rural income is darting from indigenous solutions to frozen desserts to stay attractive. An infrastructure player’s subsidiaries providing financial services and software solutions are getting more interest. The shareholders of a quality private bank are figuring out the next move of the smart founder to dilute stake without causing destruction of wealth: offload shares, enhance the capital or undertake an expensive merger. Those who bought into a legacy LCV and M&HCV owner’s bet on top-of- the-line luxury passenger vehicles to capture China’s growth story are stumped as the local market is showing more potential. When it comes to side-stepping risks, investors do not seem to be spoilt for choice.        

-Mohan Sule

Liquidity injection

Capital infusion into PSU banks, hike in MSP for kharif crops and cut in GST rates lift large caps

A striking feature of the recent rally in large caps that took the benchmarks to lifetime highs is the role of domestic institutional investors. Foreign portfolio investors are reducing their exposure to equities since August 2017. More stocks were liquidated by them than bought in the first six months of the current calendar year after being net buyers in the previous three years. In contrast, mutual funds’ net equity investment was up 30% between January and June over the same period a year ago. As the US and China respond with tit-for-tat import duties, countries are going to look inward. The trend of subsidizing home producers even as import barriers are being pulled up is pushing out overseas investors, who will prefer to operate within their boundaries rather than risk taking money outside. Countries will be left no choice but to manipulate their currencies to achieve growth. How they do so will depend on their orientation. China intends to loosen money supply to depreciate the yuan to make exports attractive even in the face of higher duties. India wants to prop up the rupee to slow down the flight of capital to pay the import bill. The US Federal Reserve has taken a pause from hiking interest rates. A strong dollar will push American exports out of competition.

Mutual funds do not seem unduly perturbed by the macro-economic headwinds. Equity scheme folios have increased 30% and those of exchange traded funds ex-gold 60% over the June 2017 quarter.  Cash has to be deployed. Many large caps had yet to participate in the rally and looked moderately priced compared with their smaller peers. The first wave of June 2018 quarter results underlined their capabilities and outlook. The reorganization of market-cap groupings, as per the Securities and Exchange Board of India mandate, has resulted in the downsizing of several stocks. Schemes whose selection is based on the criterion of market value had to shuffle their portfolios. With the shrinking of availability, the search has intensified for value buys by large-cap funds that had become lighter after many of their picks became mid caps. Big-sized companies are ready to run after spending most of the last year ensuring that their distributors and suppliers become GST-compliant to claim input tax credit. The capital market regulator’s increased surveillance has put off investors from small caps. A portion of the profit booked by exiting from these counters is making its way into large caps. A massive fiscal stimulus has been pumped into the economy. The minimum procurement price of crops that will be sown in April-September will be 50% more than the cost of production. Karnataka is the latest state to waive farm loans, writing off Rs 34000 crore. The depletion of the treasury of states can be expected to be made good by the buoyancy in tax revenues as the rural economy embarks on a spending spree.

With the worry about recovery vanishing, banks will have to make lower provisions and will have more funds to lend. Alongside, the clean-up of books by tightening the bad loan recognition norm, shepherding defaulters to the insolvency process, initiating corrective action against worst-case-scenario banks and infusion of capital by the Union government are shaping up PSU lenders to meet the increased demand for credit. Creating a favorable atmosphere for consumption is the latest round of reduction in the indirect tax rates. In a year since implementation, cement, air-conditioners and large screen televisions are the only mass-based items in the highest slab of 28%. Trends suggest the economy has not only recovered but is picking up momentum, too. The services sector recorded a 21-month high growth in July. The thrust on infrastructure and housing segments has spurred demand for steel (output up nearly 3% end June 2018 over a year ago) and cement (12% increase). Monthly electricity generation is the highest ever. Sales of passenger cars rose 8% to an all-time high of 3.3 million and two-wheelers 16% to cross 20 million. The good response to recent IPOs suggest availability of funds for investing. The tailwinds of the festive season are around the corner. The US-EU accord on tariffs has bolstered hopes of cooling down of the trade-war rhetoric. Oil prices look unlikely to climb up any further, having lost over 5% in July. The downside to the upbeat mood are corporate governance issues that might crop up, surging valuations of large caps and intensification of the panic selling of mid and small caps by retail investors, hurt by the recent brutal correction.

-Mohan Sule