INDIAN GROWTH STORY – WAS IT A BUBBLE?

There is a big question raised on the fundamentals of our economy. For the economy, how soon the financial problem reflects on businesses? The way the news are floating around, it seems the impact is quite instantaneous and pretty fast for the speed of financial world. It is difficult to presume the speed to be so fast. The asset bubble had been happening for quite a few months and in all probability is older than a year.

In my analysis there was a marked shift in value of the companies listed on the exchange. From a period 2004-2007 the growth in most industries had been phenomenal. In other words there was tremendous value in equities beginning 2004. These equities got fairly priced as time went by and there was still value left in Indian equity. The problem precisely began when optimism was overriding all possible practical understandings. From 2007-2008 the value of stocks (not the market price) remained same and in some cases even saw a marked drop. There could be many explanation for this and the one most plausible is the effect of inflation on raw material inputs. The biggest hit was to metal industries. Metals were undervalued when the bull run began a few years back and in spite of the drop in their share prices now, they are still undervalued. Metal had its run in profitability before 2005, up to this period the returns or profits on capital employed was healthy. As capex increased the capital base increased which is yet to show on profitability and therefore explains the lower return on capital.

Right now there is a view that stocks are undervalued. These statement needs lot of introspection. I am unequivocal and say all equities are still not trading below value, even in this falling market there are equities which are trading above value. There are quite a few equities which are trading below their value and these are corporate which had a good increase in profitability through 2007-2008. I have advised my clients to invest in them.

I am still optimistic of our economy and the nascency of this belief is that we as a nation can’t help it and need to boost investments and though the cost is inflation it cannot be held back for long.

Let me give an example, the growth in cement industries has been around CAGR 7% from 1994-2007 and for the same period Heavy goods has grown 25%, Steel and Aluminum at 3% each. Now there is an anomaly here. There is something about the growth not being similar across industries. This leads to imbalance in growth in dependent industries and therefore we find some equities are overvalued and some undervalued. This will be, invariably rectified albeit with strong policy recommendations.

There is demand which is latent and riding the waves of business cycle. The cycle is at low ebb now and will soon take a ride upwards. The current liquidity crunch is hampering growth and could further dampen investor confidence; the fact is we are aware there will be unprecedented growth but the bet is the timing of when the cycle turns and policy changes the government is ready to dare in the times to come.

- by Santosh Shetty

Realty and Retail

Though India’s GDP projections look good as made by World Economic Outlook (WEO) released recently by the IMF, India is likely to register a Gross Domestic Product (GDP) growth of 7.9 per cent in 2008-09, which may slip to 6.9 per cent in 2009-10; the effect of inflation and credit crunch is now highly visible in two sectors; realty and retail.

In Mumbai most of the developers have discovered credit route from private financiers at a very high cost of borrowing varies from 36 to 48% in last one to two months. This is in anticipation of better comeback of property demand. However the recent property expo was disappointing for such developers. The prices depend on demand which is most uncertain. Bangalore and Gurgaon prices have seen significant corrections and Mumbai it is expected soon by a minimum 20 to 30%.

The other sector affected by inflation and market volatility is retail. Several stores are closed down in last few months. Most of the expansion plans of major group are either delayed, postponed or partially done. The procurement model from low cost manufacturers like china is also getting big hit by rising dollar prices, making situation even more worsen. Downsizing in employment is also become highly visible in this sector now.

Some RBI intervention in the form of rate cut and a good recovery of market today is news to think positive. However; on the claims of decoupling Indian economy from global players, sentiments are still coupled. And so the global direction of financial and equity markets can not be ignored to asses our equity market’s health.

Santosh Srivastava

Why fundamentals of Indian economy is in question?

One financial crisis in US and the equity market in the whole world shaken up with significant decline. Fundamental equations of various industries are questioned and depression took over. How safe is Indian market? All analysis indicates no fundamental error but global depression and rumors have sufficient potential to prove these analysis wrong. I should be positive but negatives can not be ignored in sudden panic environment all across.

Can you estimate how much a panic environment may create a damage? Recent rumors on ICICI bank followed by crash of its stock price is just one of the several such examples. Deposit ratios and leverage of Indian banks are much healthier than that of several top performing banks of US and Europe and still the prices are falling. Again fundamentally nothing is that bad as it is reflected in falling stock prices. Another potential damage is redemption pressure on mutual funds creating a negative cycle of further depression by killing the option of Indian MFs to use their liquidity to invest in declining market.

Let us park rumors and depression aside for a moment and try to analyze some of the fundamental issues of Indian equity market which may affect future of market after stabilizing from current turmoil.

1. First and foremost is the question of decoupling of Indian economy from US. Is it really possible? In one of the interview with Uday Kotak, director of Kotak Mahindra bank recommends that India should stop depending on global flows and start relying more on its domestic savings and domestic ability. The only question to address is the future of globalised Indian industry like IT which triggered Indian GDP growth to more than 8% in past few years and attracted most of global inflows.
2. Second is actual estimate of GDP growth. If the current situation stays for some more time, it will affect the demand. Maintaining more than 7.5% growth will be a challenge. If it drops below 6.5% which is very unlikely as the fundamentals are still okay, the global inflows will be affected.
3. Third is competition with other emerging economies especially China for preferred investment destination. Both economies are having various strengths. The differences to asses are types of governance, service vs. manufacturing capabilities and fiscal deficit vs. fiscal surplus.
4. Fourth is monetary policy. On one hand; RBI announcing further rate cut by 150 basis point, on the other inflation is still above 11%. Further cut in CRR and SLR is expected to manage the current liquidity crisis with some boost to GDP. Monetary policy will be interesting to watch if the objective is to decouple Indian economies from developed countries as I discussed in point no one above. The challenge for the policy makers is how to address issues of both Inflation and growth together.
5. And finally Upcoming union elections and the result.

Santosh Srivastava

Is equity still good?

When the markets were rising all analysts concluded, how robust and strong our economy is and how investors are missing an opportunity to create wealth if they were not buying equity. It took a fortnight of incessant fall in various indices and the facts have reversed. Now, there is liquidity crunch, bad loans, defaults, falling demand, rising interest rate, depreciating Rupee. Well, all possible reasons and some even unheard of have cropped up explaining the demise of equity. To call it demise is perfunctory. Yes, a semi temporary but a deep correction could be the right phrase.
The irony of retail investors or rather the dilemma is, he invests when market as risen considerably or sells after it has fallen considerably.

A retail investor with a perspective of more than a year should invest in this falling market, at least at these sub 12000 levels (Sensex) and do not bother even if the markets corrects further down from here. Large investment houses are under pressure to show profits or need revenues; they will ride the volatility. In these attempts of theirs, market might correct further. The long term retail investor should stagger his purchases in smaller quantities and average is buying price at every fall.

Equity of the day: HCL technologies
Last week I came across articles on HCL Technologies being a good buy. It may be, but my evaluation puts the equity at Rs.220 FY09, so see what percentage profits you need and discount it to arrive at your comfortable buying price. I would recommend sub Rs.180 level.

Their acquisition of AXON group would give them new business of enterprise solutions which, is competitive enough and in these times of cost cutting an established player in this segment is a better bet as there is acquired learning and cost advantage. Anyways an opportunity to enter into new product segment where one is week doesn’t mean instant success. So it is advisable to wait and watch how the deal unfolds and how the business scenario is changing. I wouldn’t know the impact of this acquisition on HCL technologies’ books. If the acquired companies ROCE is same like HCL then it is not a big achievement and the price of Rs.220 FY09 is good. But I seriously doubt this given the cost of acquisition. They are already in talks for raising a debt of 400 million pounds (Rs.3400 crore approx). Therefore, a sub Rs.180 level in this falling market for HCL Technologies makes me comfortable.

Santosh Shetty

SUB PRIME or DEPRESSION

This past few weeks had been turbulent for stock exchanges across the world. India had its own share of problems which is a spill over of what is happening in the west – now this is what most analysts are saying and so I do not want to disagree on the spillover effect. A point to ponder is can we pass the blame completely to the sub-prime crisis in the US of A. A little more thinking and I feel a big NO.

The Indian story is as true as it was a few years ago and in fact more robust for the coming years. The financial crisis in the west had a deprecating effect here and it was expected as the FIIs had to average out their capital losses with gains some where or at least protect assets from depreciating further. Even at 12000 levels the FIIs are major not in red in Indian market as they brought the market here in the 1st place from sub 5000 levels and had booked profits intermittently. So they still have cushion to avoid cash losses if they haven’t suffered yet. The Indian Institutional investors are in same situation albeit with redemption pressure looming on their otherwise sales counter. Apart from this, we need to accept that we had reached a point where assets were getting overvalued, which was a supply issue especially lower supply of food grains, energy, industrial capacities, good equities, good assets etc. and oversupply of money. And what we had was an asset bubble. Asset price bubble is not without reason but it was only ahead of time. Therefore, I say this is a time when investment assets are getting rationalized. We might see a same rationalization in property assets too.

The bigger or core crisis is a financial crisis and not a business crisis though the repercussions are on businesses. The prognosis is therefore a financial prognosis and playing with elements which might tweak or imbalance consumer demand could be unpredictable in its direction. A play in interest rates especially a reduction or reduction in CRR requirement could stoke inflation and could push interest down temporarily and over a longer period push it up. Even as a financial crisis it is not a liquidity crisis across markets. Banks have money as the loan disbursement figures show. The cash is not going anywhere especially risk associated assets in this volatile time, it is only breeding no confidence in the system. There is some interest pressure in inter bank call money market now this indicates some banks are in bad shape and requires quick addressing by RBI. The percentage of savings to GDP is still strong. There has been some loss of liquidity due to capital flight. Capital flight form secondary market has a lesser impact gradually as more units/assets are offloaded at lower price.

There are instances across publications where the current crisis in US is compared to the great depression of 1929. This is not right and complete wrong interpretation of the situation and could be dangerous as wrong diagnosis could lead to a wrong prognosis. The 1929 depression was marked by serious fall in demand and fall in employment thereof. Keynes’ antidote was appropriate and unparalleled. Do we need measures to curtail or resolve the crises? If it is to curtail, then a temporary infusion could lend some confidence to the market but recovery could take same time but with less shocks. To resolve we need another round of banking reforms so a larger section of the population is protected and off course regulatory measures are required. The contagion effect of financial adventures in globalized world is quite new for most analyst and central banks, and therefore calls for more research and understanding.

Santosh Shetty

Performance Indicators of FMCG Industry

Tons of technical analysis is available online on ways to pick a stock. I considered few and got confused. Why investment decisions are supported with too many technical analysis and forecasts? Interesting thing is that the rules of the game are variable and so it is not so simple. Still I dare to find some simple ways and try to understand rules of the game. To start with I’ve taken one of the largest industries, the FMCG industry. The basic question I tried to answer about the variables affecting the industry performance. Stock pick would be automatically in place if the performance indicators are known.

First and foremost is changing market dynamics with fluctuating crude oil prices and inflation. Last few months were terrible. On one side input prices are increasing resulting in thinner margin to manufacturers. On the other side the share of wallet of consumer is decreasing. Overall decrease in category demand is now become visible. Companies with better brand equity are successful in transferring this burden to consumers. However with high competition already in place every time price increase will not be a viable solution.

Second emerging market dynamics is the emergence of organized retail. In this new format, relatively weaker brands also get equal opportunity to place their products and offerings along side a stronger brand. Two things will distinctly visible in such situation. Either exclusively differentiated product or the most cost effective product will get lead in the battle. In high inflationary situation consumer would tend to choose second option in order to control the outflow from their wallets. So brand loyalty earned by various major players will be at stake. Product with very high brand equity could maintain their position till the situation improves. Weaker or moderate brands will be the target of new cost effective products or brands.

Third is the cost leadership. A company’s pro activeness towards innovation, rationalization of cost structure, capabilities in manufacturing and in outsourcing gives a long term perspective of their approach towards cost leadership.Take the example of shampoo in which a crude oil derivative is used in packaging shampoos, while PET, a petroleum-based plastic product, is employed in manufacturing hair oil bottles and packaged water bottles. Crude oil derivatives account for almost 17 per cent of the total cost of corrugated boxes. Which company is working towards other innovative solutions? Another cost iscost of distribution which is very high in FMCG sector. So efficiency of supply chain and logistics adds significant value to cost leadership.

Fourth is competition with unorganized sector and regional players. Their overhead costs are much lower than a company with national presence. Being ‘local’ gives them a very cost effective advantage of distribution and logistics. Their presence can be felt at remote rural level. But since they are small the effect of inflation are even bigger for them. Poor management and poor cash flows are other prominent concerns. So a comprehensive consolidation can also be seen in next 2 to 5 years. The companies with better cash will take this.

Let me summaries the performance indicators to address health of a FMCG company in following parameters:

1. Brand equity with competitive advantage
2. Operating profit margin to understand cost advantage
3. Distribution efficiency by evaluating rural presence
4. Proportion of outsourced manufacturing
5. Cash in hand

I personally feel Marico and ITC as good buy. However; feelings apart, I will post my next blog on qualitative analysis of various FMCG companies on above parameter coupled with some technical analysis to recommend my picks in FMCG sector

By Santosh Srivastava

First blog from my last week diary

Recently there was a report on change in employment structure in Mumbai. And it was a surprise to know that though there was a moderate increase in public sector job, there was a considerable drop in private sector jobs in last two decades. In 1981, 6.45 lakh people were employed in the public sector and 6.29 lakh in the private sector. By 2007, while the public sector employment rose marginally to 6.6 lakh, the number of those with private sector jobs dropped sharply to 3.39 lakh. Report also says that Self-employment is clearly becoming a dominant form of employment. Self-employment (age group 15-59) in city has increased from 15% in 1993-94 to 19% in 2004-05.

This significant drop in private sector jobs can be understood with fall of textile industry which used to be one of the largest employers during 80’s. The fall was ignited political revolution in the name of labor reforms. The win- win situation could have been a healthy textile industry with reformed living conditions of labor. Neither of these happened. Maharashtra government policies, tax structured aggravated the problem to an extent where closing down the textile mills become more viable than to running it. Ultimately who benefited? This happened for several other manufacturing industries as well.

When an industry develops, multiple allied industries get opportunity to develop in its surrounding. This helps in creating multiple jobs. Take Tata motors’ nano case. If it moves out of Singur, opportunity for multiple allied industries in periphery of Singur and in west Bengal will be killed. The problem is we can not expect the protester to be visionary enough to set the direction for their future. Can we expect our politicians to be? I am doubtful.

Coming back to labor reforms, I can think of few of my favorite movies devoted to labor issues in bollywood language and style during 70’s and 80’s. One of those which left some impression on me was “Namak Haram”. The story of the movie revolves around two friends representing two class of society; rich and poor and living conditions of labors.

Shockingly this generation’s politician’s focus is on division of society and not the uplifting poor. That is why Hindu vs Muslims, Hindi vs Marathi seems to be more prominent than employment, health, education, infrastructure, poverty etc in their agenda. According to another report published in TOI a strong correlation is observed between communal riots and terrorist attacks in any state. Between 2001 and 2007, over 71% of all communal incidents in the country took place in the very same states where these terrorists hail—that are Gujarat, Karnataka, Maharashtra, MP and UP. Who will take responsibilities of damage already done?

Santosh Srivastava

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