The four musketeers

 

Pharma, IT, auto and commodities gain amid unusual circumstances, hoping they will benefit in ordinary conditions

24 August

Undoubtedly, Reliance Industries led the market recovery from the pessimism of end March lows. The apparent ease with which the petrochemicals-to-retail conglomerate amassed over Rs 2 lakh crore from more than a dozen big-bulge investors and own shareholders within three months paved the way for other Indian companies to issue equity and debt. Importantly, domestic investors felt confident of the Indian economy’s outlook. After all, Facebook, Google and the Saudi Arabia and the UAE governments will not be taking exposure to India’s largest company by market value if they did not see growth visibility. In the ensuing euphoria, the contribution of several wealth creators did not get adequate attention. Those not enamored by the leveraging of the telecom platform to connect farmers with consumers through mom-and-pop grocers looked majorly at four sectors benefiting from being at the right place at the right time, turning of the wheel and having nothing further to lose. The coronavirus outbreak opened up an opportunity for one, while cash injection in export markets supported another. Clearing of regulatory overhang and anticipation of recovery following the easing of lockdown restrictions propelled the others. Ironically, a return to the pre-pandemic period might disrupt the dream-run of these outliers.

 

The current medical emergency enhanced the visibility of drug producers. Interest in sanitizers and malarial antidotes surged. Many were quick to develop and launch anti-viral remdesivir to treat covid-19 patients. The margins got inflated on dollar earnings, aided by a weak rupee. Not only is the pharmaceutical sector one of the three to provide positive returns in the current calendar till date, its appreciation has been the highest. Intensifying competition in the regulated generics markets and US President Donald Trump’s order to import drugs for senior patients with the lowest prices from economically comparable countries are potential disruptors. Several players are looking to Latin America and Africa, where demand is plenty but scope for the upside limited, to diversify risk. Not only that, the overarching FDA blocks imports from plants falling short of its exacting quality standards. Lengthy and costly litigations for patent infringement have concluded with millions of dollars in settlement. The sustainability of the current business model is uncertain just as it was for tech solution providers prospering on back-office work.  Shift to work-from-home and contactless selling have hastened the transition up the value chain. Their future appears bright as the reliance on the digital mode for communication is likely to be the new normal as captured by the bumper earnings and soaring valuations of US internet properties. Revenues of investment bankers in America and local brokers got a bounce as restless investors took to online trading. The downside will be pressure on operating profit as more players enter the fray and dip in consumer confidence if an effective vaccine is not available soon.

The pain of piled-up inventories on automobile manufacturers in the run-up to the BS-VI emission regime has disappeared. Expectation of increased footfalls to snap up new models was dashed after the nationwide shutdown end March. Two-wheelers and tractors, riding on rural prosperity following a good rabi crop and timely arrival of southwest monsoon, are showing traction but not commercial vehicles.  Despite localized lockdowns making transportation challenging, investors betting on buying to catch up going ahead pulled up the Nifty Auto index to third-best performer, beating the benchmark from July till date. Similarly, the upturn in commodities is discounting consumption coming back as the mortality rates drop. From below US$20 a barrel level in April, Brent crude has more than doubled. Metals are crackling as the US and China signal slow but gradual rebound. Hike in MSP and ease of credit to farmers have bolstered profit of fertilizer and pesticide makers, with the Nifty Commodities outpacing the mainline indicator over a month. What is common with these sectors is their lackluster performance before March. Now they are basking in an extraordinary situation in the belief that they will get their rightful dues on the restoration of the old world order. With pharmaceutical stocks slowing down over the past few days, what will be keenly watched is whether they will be able to maintain their momentum or return to their traditional roles as cyclicals and defensives as other laggards pick up speed.

.  

 -Mohan Sule

 

 

 

 

A new order

 

Making of a welfare state, disruption policy by companies and cash getting better discounting

 10 August

 

The pandemic has not altered the world. It had already begun to change a dozen years ago. What the outbreak of coronavirus has done is to make the transformation irreversible. From turning unmistakably risk-driven, when China opened up its economy in the early 1970s and early 1980s, more and more countries are becoming welfare societies, acknowledging the limits of market forces. The 2008 global securities meltdown was triggered by reckless lending. Instead of turning tight-fisted, the US central bank’s remedy was giving away money at practically no cost to keep companies running. In 2020, the Federal Reserve’s bond-buying has been supplemented by the US administration’s direct transfers to substitute pay cheques. Pump-priming is now set to become a precedent of what to do when faced with an economic disaster that could be man-made, as in 2008, or a medical emergency as in the present day. Differences in US Congress or the EU are not about the need but on the quantum of support. The concern of monetary authorities is not their balance sheets but keeping the credit pipeline open. The initial scepticism of asset bubbles has given way to grudging recognition of the effectiveness, when nearly all the employable people in the US got jobs. Not surprisingly, stakeholders expect the second act to replicate the first, despite an uncertain timeline for the availability of vaccine. A bull-run is set to be the new normal irrespective of the reality of the economy. The new-age of socialism is with capitalist characteristics.

As developed nations watch helplessly the surge of patients overwhelm their healthcare system, businesses, too, have to reckon the reality that covid-19 is here to stay. Strategies that produced results in the past will not necessarily have the same outcomes going ahead. Huge capacities to achieve economies of scale for competitive pricing are likely to be a disadvantage if the site is in an area that has borne the fury of the calamity. Backward and forward integration, a favored recipe for cost-effective production, will be meaningless if distribution of finished goods poses a logistical problem. Proximity to raw materials or markets to circumvent poor connectivity can be a winning strategy only if the back- and front-ends of the value chain function simultaneously. To overcome, a smaller but self-sufficient presence across regions might emerge as a preferred option. Outsourcing will accelerate as niche suppliers will have the agility to keep ticking. Work from home, contactless shopping and home delivery will be an opportunity to become asset-light. An important challenge will be ensuring working capital at a time revenues have decreased or disappeared. The decline in the cost of borrowing accompanying the economic turmoil will be used to pad up treasury. Rationalising overheads will be the method to maintain or even expand the margins instead of pricing power. Of course, soft input expense on drop in commodity prices will be a major contributor. Cash and equivalent will assume a prominent position. Debt issuance and equity dilution will be frequent to suck in the liquidity sloshing around, without being a source of worry for the impact on profitability. Growth expectation will also have moderated as real interest rates become practically non-existent.     

Besides governments and companies requiring a new vision to prepare for unexpected shocks, investors will have to re-examine their strategies. They will have to scrutinize revenue streams to determine segments vulnerable to discretionary consumption. The distaste for lots of reserves, signalling lack of opportunities, for dragging down the return ratios will have to be muted. How fixed expenses are managed when sales dry up will be a topic of interest. The pressure for ramping up dividend pay-outs has to be tempered as a trade-off for remaining a going-concern. Priority to survival over capital spends will be lauded. Valuations will be pegged to access to cheap funds than earnings growth. The government could even impose capital adequacy on the lines of banks. Despite protests, investors have come to accept the 2% spend of the three preceding years’ profit on corporate social responsibility. The buffer might even act as collateral for short-term loans. It will not be surprising if the DRHP of IPOs spell out how much of the proceeds will be kept aside as security. The market might even be willing to assign higher discounting to such prudent issuers. Importantly, enterprises will be expected to spell out in the annual general report policies and systems in place to cope up with future disruptions.

 

 -Mohan Sule

 

 

Making up for lost time

After being left out of the 2010s global equity boom, the Indian market does not want to miss Bull Run 2.0

27 July 2020

Equities have rebounded swiftly and strongly from the end March lows. There are enough clues to suggest it is a making of a V-shaped recovery rather than a dead cat bounce before the beginning of a bear phase. India missed participating in the over-decade-long bull-run enjoyed by the US, fuelled by near-zero interest rates and the six-year long US$4-trillion bond-buying by the US Federal Reserve after the collapse of Lehman Brothers in September 2008.  India was grappling with its demons. The Supreme Court in February 2012 cancelled the allotment of 2G spectrum, leading to a policy paralysis in the run-up to the Lok Sabha elections in May 2014. Coal block nominations, too, were held invalid in August 2014. Reserve Bank of India governor Raghuraman Rajan in December 2015 ordered banks to undertake asset quality review, with the threat of 5% provisioning for under-reporting. Lenders became risk-averse after they were told to keep aside 15% of their deposits, instead of 5%, for bad loans, whose classification was narrowed to 60-day default in servicing. The Real Estate Regulatory Act in May 2016 pushed the largely unorganised industry into turmoil, affecting demand for housing-related products including aluminium, steel and cement as well as for home loans. The recall of high-value notes in November 2016 and the bumpy transition to the goods and services tax era in July 2017 followed by the apex court in October 2018 ruling that the automobile sector had to transit to a new, fuel-efficient era from April 2020, slowed down private investment. The   collapse of infrastructure player and financier IL&FS in September triggered a liquidity crunch that lingered well into Q3 of FY 2020. Green shoots of recovery visible in January and February were nipped in March following the covid-19 outbreak.

In a strange coincidence, the Fed is mimicking its 12-year-old act as it scrambles to contain the damage to the economy from the pandemic. Interest rates are back to near zero. Bond-buying has resumed and will continue, at least well into the next year. The US government has provided US$ 5.5 billion of cash through two stimulus packages, in March and May. The stage has been set for Bull Run 2.0. In India, the overhang of the past disruptive measures has faded. The low corporate and individual tax rate regime has come into effect from the current financial year. The Rs 21-lakh fiscal and monetary support may be low on direct cash transfers but has opened up easy and cheap credit to the important components of the economy such as farmers, small and medium businesses and the home, auto and consumer durable buyers. The entire economy has been opened up. There has been no better time for risk-taking than now. The capital-raising being undertaken across the spectrum suggests that companies are feeling emboldened despite lack of revenue visibility. Not many are undertaking capital expenditure at this juncture. What is important is the confidence of issuers that money is available and the optimism of investors that it will be put to good use in the near future. The cash chest built at low interest rates will be an advantage when normalcy returns.

The readiness to part with funds is a useful guide to big-ticket investors’ calculations. RIL raised nearly Rs 2 lakh crore in less than two months from a clutch of foreign companies, equity funds, sovereign funds and internet properties to service the domestic digital and fuel markets, and not for exports. It suggests the bets are on India to regain its title as the fastest-growing economy in the world. That it will be the only major economy, excluding China, to record the lowest GDP de-growth in the current fiscal year points to, apart from a low base, resilience even in the most adverse environment. Right now, rural consumption is supporting the Old Economy and partially offsetting the absence of the urban buyer. It will not be surprising if Mukesh Ambani has used the presence of   Reliance Retail in tier 2 and lower centres to attract funds for the creation of a virtual marketplace that aims to replace the brick-and-mortar model. Only RIL can pull off this seemingly contradictory achievement. In the process, the buoyancy in the secondary market as India’s most valuable company turned debt-free has embraced sectors with physical assets such as automobiles, capital goods, infrastructure and commodities, positioning them to be beneficiaries when normalcy return. It is a welcome departure from the previous experience of demand drying up for all goods and services, save for the sluggish defensives, during a recession. A virtuous cycle is being created. Every secondary market rally will see renewed fund-raising in the primary market. The correction in listed stocks will afford an entry into reasonably valued counters.

-Mohan Sule