Division in the ranks

 Discounting of companies is factoring in the share of products with pricing power, user stickiness and deployment of cash 

 

14 June 2021

 

The worst humanitarian crisis in 100 years is how Prime Minister Narendra Modi recently described the covid-19 pandemic. Contraction in India’s GDP by 7.3% last financial year has not been seen in 40 years. For the stock market, it is the best of times. The benchmark Nifty scaled 2021’s second new high early June, doubling from its multi-year March 2020 bottom. Several companies across market capitalization not only remained profitable during the year but continued to produce record-breaking numbers in January-March 2021 after the December 2020 quarter. Even amid the bleakest period, particularly during H1, companies in India and overseas were successfully raising funds. In India, the third consecutive normal southwest monsoon, competitive and accessible money and staying relatively untouched by infections bolstered rural spending, partially compensating for the caving in of urban consumption. Money shifted from producers of essential output in the early stages of lockdowns to neglected commodities and infrastructure players as restrictions began easing. The rollout of vaccines has now rekindled hopes of the global economy eventually getting weaned away from the life-support of liquidity infusion.  

 

In the absence of innovative tech companies, with the stature of Facebook, Apple, Netflix and Alphabet, investors in India resorted to sifting within sectors. Health and hygiene products supported the lack of interest in beauty products of FMCG players. Entry-level two-wheelers and cars were bought to avoid public transport. Drug makers with a higher share of active pharmaceutical ingredients turned star performers in search for niches. Fertilizers and insecticides makers surged as an above-average rainfall and cheap credit boosted sales. Differentiation based on demand is not new. Earlier, the backing was for those achieving scale. Higher revenues, it was believed, implied market share gain. The theory has evolved, with those commanding better margins, implying pricing power, bagging better discounting. What were informal distinctions for stock-picking even within thriving industries consolidated during the breakout and recovery from the outbreak. Companies tilted their portfolio in favor of premium products in the same category to squeeze out more realization. The strategy will pave the way to pass on increased cost of inputs as consequence of quality. If so, it will indeed be transformation of the marketplace. From pushing value for money gratification -- as amplified by sachets, beginners’ range discretionary consumer products, low-cost airlines, and budget hotels to woo ex-metro buyers -- to targeting discerning users is indeed a gamechanger. Valuations will also account for consumer engagement rather than relying primarily on the number of users. The trend has been visible for some time. The covid-19 upheaval has hastened its acceptance. The regulatory moratorium on servicing loans during the lockdown nudged investors to examine collection efficiency and composition of the assets instead of getting bewitched by the size of sanctions and disbursements. Holdings of mutual funds are getting closer scrutiny as safety supersedes risk reward. The attraction of financial institutions with a higher share of the low-cost current-account-savings-account deposits is not a secret. Also emerging is the preference for lenders servicing home mortgages and gold collaterals. Defaults are negligible when compared with borrowings against credit card limit and to finance purchase of consumer durables. A new order is emerging from the chaos.       

 

The frenetic rush to take advantage of the cheap funds to strengthen the balance sheet by reducing debt is another outcome of the medical emergency. The discounting separating companies from peers will factor if the preparation is to face future disruptions or to cater to the pent-up demand by ramping up capacity. Cash pile cannot be hoarded. If not used for organic or inorganic opportunities, it will have to be returned to the shareholders as dividends, capitalized as bonus shares or deployed for buybacks. The equity base of many companies has ballooned from private placement of shares at moderate valuations with institutional investors. Of the many implications, the prominent is the confidence of servicing the investment due to the low bar. Second, employing the inflows to deleverage the balance sheet will allow funneling the revenue stream into operations instead of interest payment. Third, the reserves can be used to fend off unwanted suitors, attracted by the low return on assets stemming from mobility restrictions, by shrinking the outstanding capital. For investors, all the possibilities will unlock value. 

 

 --Mohan Sule

The coming third wave

 

If the rebound rode on growth stocks and reopening boosted value plays, vaccination is set to prop up services

 

 The March 2021 quarter results were always expected to be an improvement over the low base of a year-ago period. A 21-day nationwide lockdown from 25 March last year had disrupted economic activity. An inkling of the coming boom was visible in Q2 and Q3 of FY 2021 numbers, reflecting the five-phase unlocking from June. The market, too, anticipated a healthy outcome. The Nifty scaled a lifetime high on 15 February of this year. Release of the bunched-up demand cannot be the only explanation for the record revenues, volumes, and profit by many companies. Several other factors converged to produce a memorable January-March 2021 period. The impact of the Union government’s cash transfer to farmers and rural and urban poor became visible in the marketplace. Focused spending on agriculture, healthcare, education, and infrastructure and reforms to ease doing of business were the other cornerstones of the aid package. The central bank, simultaneously, was lowering the cost of funds and undertaking targeted lending to sensitive sections with the capacity to magnify the assistance. Staring at credit crunch after the collapse of infrastructure financier IL&FS in September 2018, the gushing liquidity was a turning point for lenders to home buyers, farmers and MSMEs. Also emboldening banks was the implementation of the Insolvency and Bankruptcy Code from September 2020, freeing resources tied up in bad loans. Peak corporate tax was cut 22% from 30% in September 2019. Coinciding with the man-made efforts, a second consecutive average southwest monsoon improving rural purchasing power.

The two other catalysts, both in January 2020, were the thawing of the two-year-long US-China tariff tiff, with the phase 1 trade agreement, and the UK formally leaving the European Union, three-and-a-half years after a referendum. A deal for an orderly exit was finalised before the year-end deadline. The transition to BS VI norms from April 2020 cleared another overhang since 2016, contributing to spurring consumption and investment that had got stalled in FY 2020.  If MSMEs were able to tap low interest rates, institutional investors were snapping the downsized shares of large and medium corporations. The decline in input and overhead costs provided flexibility to deleverage, strengthening the balance sheet for funding growth. Tinkering the output mix towards premium products increased realization. Establishing a digital presence offset the drop in physical footfalls. Besides the need to meet higher usage, the coverage of production-linked incentives encouraged many companies to look for ramping up capacity as utilization touched the optimum level.  Gains made their way from growth to value counters, punctuating the market’s overheating. A vibrant primary market signalled risk-taking.

 

If the escalating benchmarks foretold Corporate India getting into shape, their current movements offer hints of outlook. The Nifty P/E has slowed to around 29 from a high of 41 mid- February. Apart from spurt in earnings, the contraction in the premium over the historical average of about 22 suggests a slower pace of returns as raw materials turn expensive and logistics issues persist. The Nifty IT index lagged over the past month on fears of recoiling inflation leading to tapering of prime pumping in the US and the EU, the major markets. The Nifty Auto index’s outperformance, despite down from its peak, captures the struggle to obtain chips as well as hopes of CVs catching up with PVs and two-wheelers on normalcy. Tie-ups to churn out covid-19 vaccines and medication are once again propping the Nifty Pharma index after a brief hibernation, when the first wave had started receding in H2 of FY 2021. The Nifty Bank index has doubled from its year-ago bottom, coming out of correction. Provisioning and capital collection are supposed to facilitate higher credit flow. The Nifty Metal and Commodities indices are touching new tops due to the revival of capex and prospect of another season of bumper harvest. They might plateau as central banks end their loose monetary policies early 2022.  In the run-up, attention will shift to the third orbit comprising frontline sectors including aviation and hospitality. The leaders in the entertainment and retail space are up from their pandemic lows and holding on to their gains. Services is consolidating the comeback of the US, initially fronted by tech and then by manufacturing, with outdoor masks no longer required for those inoculated with two doses. The sharp drop in caseloads and estimates of all Indian adults getting two jabs by December 2021 are setting the stage for funds to move into the next upcycle.

 

 --- Mohan Sule