Saturday, May 31, 2008

INDIAN EQUITIES 2008 - The Bullish Bear UPDATE

Here it is at last- The MEGA POST on Indian Equities.
The first five months of 2008 have been tough for global equity markets & Indian equity markets continue to struggle.
After justifying a BSE SENSEX Index of over 21,000; buyers seem hesitant to step in to buy stocks after this deep correction.

Once favorite sectors like Capital Goods, Brokerages, Real Estate and Financials, have taken a hit, while Autos, Public Sector Oil Companies, Infrastructure and Cement continue to under perform.

The Corporate sector struggled to maintain its scorching pace of earnings growth in the fourth quarter. As a result, no one’s betting on a quick recovery in markets here. An Uncertain environment in the global economy, slowing growth and rapid inflation at home, and rising Crude Oil prices have kept any attempt to pullback from recent lows in check.
Meanwhile as companies continue to expand to meet larger orders, as a fresh investment phase begins in the domestic market. Rising depreciation and Interest payments will further dent bottomlines in the coming quarters.

For the true long term Investor in India (where long term isn’t 6 months but 3 years or longer), this is a time of consolidation and selective stock picking. Your patience is going to be tested, as the markets continue to be range bound with a downward bias in the near term.

The domestic demand story will continue to propel the economy forward: A rapidly expanding middle class, improving job opportunities, increasing disposable income and consumption and favourable population demographics.

As the capital expenditure cycle rolls on, many infrastructure companies and Capital goods companies stand to gain, an example being companies in the power generation and Transmission space, once fresh capacities come on stream. The Indian Telecom space is said to be the fastest growing in the world, and as these companies penetrate deeper into rural India, the growth in volumes will come, but investors must wait for it.

In my 31st December 2007 post I was cautious on valuations and also said that investor expectations must be reasonable.
Then came the deep correction and a return to reality: valuations are a lot more reasonable today.
When deciding whether to buy or sell or hold stocks, focus on valuations and not on the recent 52 week high of the stock.
Indian Equities will face many hurdles in 2008, as the US and world economy slows. Certain sectors will be hurt more than others and recovery times will vary. While it’s impossible to time the market, it’s also important not to get in too early.

Overall its time to be cautious and be very selective while picking stocks. Focus on the long term, and use a ‘Staggered buy on declines strategy’ to add to positions in your favourite stocks


The sector, a long time market favorite showed some signs of slowing.
Despite growing order books and strong earnings visibility in the fourth quarter, the sector witnessed disappointments on margins and slower than expected order execution.
As companies in this space continue to expand, commencing production of higher value critical products (e.g.: higher capacity boilers and transformers etc); increasing manpower, raw materials (e.g.: Steel and Copper) and depreciation costs are going to put pressure on margins going forward.

This was clearly evident in the power sector recently, where competitive pricing resulted in some power generation companies, choosing Chinese products over those manufactured by Indian companies such as BHEL.
I would wait before any fresh buying in the large cap stocks here, as weak hands may begin to offload stocks, as earnings growth rates moderate.
I am optimistic on a Material Handling Equipment company: Elecon Engineering, a Crane Rental company: Sanghvi Movers. The earnings visibility is good, and valuations have corrected substantially. As new Cement Plants, Refineries, Power Plants, Steel Plants and Fertilizer Plants are built; Elecon Engineering and Sanghvi Movers should see strong earnings growth.
Long Term investors can remain invested; moderating their earnings expectations in the near term as these companies expand capacities

This sector includes capital goods companies, infrastructure finance companies, engineering procurement construction (EPC) companies and earth moving machinery companies among numerous others. Valuations across the space rose astronomically over the past few years and subsequently corrected sharply. Rising cost of finance and rising prices of raw materials have added to project execution risks. Cost overruns and the inability to pass on rising raw material prices, may subdue earnings in some cases. Large players like Larsen and Toubro in the EPC space and IDFC (an infrastructure finance company with excellent asset quality) should do well in the long run. I hold shares in L&T and IDFC.
Long term prospects are extremely encouraging, given infrastructure projects like ports, airports and railways are in an expansion phase.
Smaller players are likely to feel the heat, and I would advise investors to stay with the larger players.
I would advise caution on certain companies with longer gestation periods, like Mundra Ports and GMR Infra. (For Airports). These are clearly VERY long term investments. The returns will come, but involve a considerable waiting period.

After some years of consistent growth, this sector too is facing tough times.
A combination of a buoyant economy, falling interest rates, increased infrastructure spending on roads and highways, and a Supreme Court ban on overloading of freight commercial vehicles, contributed to robust growth over the past 5 years

Cars and Bikes: Model fatigue, rising interest rates, rising steel prices and cut throat competition have resulted in reduced margins.
The buyer is spoilt for choice, as various product segments are getting crowded with overlapping models from competing manufacturers, resulting in no clear market leader in this space.
Trucks and Buses:
A higher base effect coupled with rising rates took its toll. While the freight Light Commercial Vehicle (LCV) and Passenger commercial vehicle space continues to do well, there appears to be a slowdown in the freight Medium & Heavy Commercial Vehicle (M&HCV) space. Freight rates remain robust, as many new players are entering the ever expanding ‘hub and spoke distribution’ logistics space, given the fast improving intra state road networks.
Passenger Transport continued to do well, as State Road Transport Corporations added to existing fleets, especially in the intra state segment.

I am currently researching a Used Truck Finance company: Shriram Transport. The company has reported excellent earnings, even as the new truck market continues to languish. The used truck market has done well. An interesting company, with a management that holds an enviable track record; in this unconventional non banking finance space.

The sector continues to be hassled by news of writedowns, mark-to market losses, and falling treasury income.
ICICI Bank was the first to report mark to market losses and took hits on assets related to the subprime mess, and was later followed by Axis Bank with MTM losses.
Indian banks are also being sued by clients who have reported losses on Forex derivative contracts (used to hedge currency risk).
Meanwhile credit offtake appears to be slowing. Confidence is low, and no one is sure that that we’ve seen the last of the writedowns
So overall, uncertainty has resulted in sharp corrections in the banking sector.

I am keeping an eye out for ICICI Bank. Although they have been worst hit so far and have been known to be too aggressive at times; their businesses span Insurance, Asset Management, Venture Capital, Brokerage (ICICI Securities) and banking. They are among the top3 players in the Insurance and Asset management space. I am holding on to my shares in ICICI Bank, and will wait for more pain before bottom fishing.

For the more conservative investor: HDFC and HDFC Bank are safer long term bets. The management is known to be more cautious and their asset quality is excellent. I also hold shares in HDFC and HDFC Bank.

These were the leaders of 2007, the returns were phenomenal and the valuations were CRAZY in some cases. They have since corrected sharply in some cases by over 50 %. Real Estate prices across the country have halted their relentless surge, and prices in many parts are moderating.
These are two sectors I would stay away from, as valuations in most cases are still not reasonable.
Risks for Real Estate: Execution risk, rising interest rates and overstating the valuation of Land Banks (read: unsold inventory; land purchased at high prices)
Risks for Brokerages: A declining stock market and a fall in volume of transactions post Jan 2008, will impact earnings (i.e. brokerage fees, M&A fees as also fees on the institutional investment side.)

Another two sectors that I would avoid. Rising raw material prices, a prolonged US slowdown, and a volatile Indian Rupee will continue to drag down earnings. Slowing Auto sales in the US will adversely affect Indian auto component manufacturers which supply the US auto industry.

Fears of Supply exceeding demand by FY10, government intervention to cap cement prices, and rising raw material costs, have seen cement stocks fall sharply from their 52 Week highs. The decline in cement stocks began even before the fall in broader markets. As new capacities come on stream, supply is expected to exceed demand, leading to falling realizations for manufacturers. Meanwhile Raw material costs in terms of limestone, coal, and fuel have risen sharply.
While the near term could see lower prices for cement stocks, I am cautiously optimistic over the longer term.
Delays in adding fresh capacities & increased infrastructure investment (Airports, Sea Ports, and Irrigation Projects etc) will lead to renewed demand.
The sector may also see some consolidation, as smaller players are snapped up by the two cement giants –The Aditya Birla Group and Holcim.
I remain invested in Grasim, a company I have held shares in since the year 2001. I do not see any runaway rally here, so I will wait before adding to my position.
Investors will have to tone down their expectations of returns from this sector in the short-medium term.

As was the case with the cement industry, steel manufacturers are battling similar constraints, except for the fact that the industry does not face a near term supply glut. Government intervention to cap prices and rising input costs are resulting in increased margin pressure. Avoid fresh investments for now, and wait for further downside from current prices.

India is the fastest growing telecom market in the world. Ever since the Reliance group commenced its telecom venture- targeting mobile phone affordability (both handset and tariff prices) the volume growth in this space has been exponential.
Ever changing legislation for GSM and CDMA operators has made this a difficult space for the retail investor to understand. Bharti Airtel and Reliance Communications (RCOM) are the two giants here. Once again I would stick with the Big 2, as I feel the changing rules and FDI Limit policies may be too much for the smaller players to cope with, in this volume driven business. While some of the smaller players might be future acquisition targets, for now the risk return equation is skewed against them in this low price – high volume market, where economies of scale is very important.
Another new development is the MTN takeover/merger/acquisition saga. First it was Bharti, and now RCOM has stepped into the ring. While it is too early to know the outcome, successful completion of such a deal would catapult one of these two into the Top 5 globally. It would be amazing to have a Giant Telecom player operating in high growth markets of the Middle East, Africa and India
However the final cost and structure of the deal would be critical to any future valuations of Bharti Airtel and RCOM. For now I am holding on to my RCOM shares. I do not hold any shares in Bharti Airtel.

Fast Moving Consumer Goods: FMCG
The FMCG sector has outperformed the broader market in 2008. Stocks like Nestle, Marico, Godrej Consumer and ITC have done very well.
I am positive on ITC, even though the company reports just a 13% rise in PAT in FY08. There are clear signs of slowing earnings growth across the sector, but the steady cash flow from the Tobacco business and a possible demerger of the hotels and FMCG (biscuits and potato chips etc) businesses could be triggers going forward. Wait for a decline before fresh buying.
Overall I would be cautious on the sector. Valuations are not too cheap, and growth rates may slow as new players enter and competition intensifies.

A strong Rupee and fears of a prolonged US slowdown has finally slowed down the earnings momentum of the Indian IT services sector.
A volatile Indian Rupee (Rs.) that rose to Rs 39 to the USD some months ago has now pulled back to Rs43 to the USD.
The BIG 3: Infosys, TCS, and Wipro; have seen drastic cuts in their stock prices, in a rather difficult business environment.
Given my views on the US economy, and US financials in particular (Large Investment Banks are some of the biggest clients of the Indian IT industry), I would wait before buying into this sector. I would restrict my research to the larger players as I expect some mid cap companies to struggle, given the uncertain business environment: a volatile Rupee, rising wage inflation and possible upcoming billing rate cuts/IT budget cuts/ margin pressure as the US economy continues to deteriorate.
Long Term, the Big 3 should reemerge stronger, but I wouldn’t buy them just yet.

OIL AND GAS & OIL PSUs (Public sector companies.)
While stocks like Cairn India, Reliance Industries, and Reliance Petroleum have done okay, the PSU Oil companies are facing their worst times ever.
The government has refused to raise retail fuel prices (Petrol, Diesel, Kerosene and Cooking Gas) as Crude oil surges to new highs, & losses are mounting on in the Oil PSU’s books. Oil bonds and subsidies are getting messy, and something’s got to give. Upstream majors like ONGC and pipeline majors like GAIL INDIA, too are being forced to bear part of the burden for our subsidized retail fuels. As a result Capex activities are slowing and these companies are being forced to resort to borrowing for working capital.

Coming to the Reliance Group; their new refinery will be commissioned in the second half of this year, at a time when the West is falling short of refining capacity. The new complex refinery has been built in record time, and together with the existing Refinery, will be the largest Oil Refining complex in the world. Also, the gas find in the KG Basin in Andhra Pradesh will commence production later this year, which will be extremely positive for the company.
I am holding onto these stocks, and would use sharp declines when the markets correct to add to these positions.

Cairn India’s large Oil find in Rajasthan was truly a masterstroke. (Especially as Shell, who sold them the same block in Rajasthan, were unsuccessful there.) I would be cautious on Cairn’s current valuations; given that actual production is still some time away.

This is a blog of my personal views on world financial markets, focussing on India in particular. Investors must carry out their own research & make their own informed investment decisions, using qualified independent advice. Always invest with an adequate margin of safety and know your own investment risk profile. Neither the information nor any opinion expressed constitutes a solicitation to buy or sell any securities nor investments.

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