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What Should Your Strategy Be?

Despite major global setbacks, the markets eventually come back strongly, making the present state a buying opportunity…

The global economy could well be on the brink of another crisis owing to the state of affairs in US and Europe. As has been witnessed during past crises, sentiments have taken a knocking. Investors (including FIIs) have begun pulling money out of high-risk investments such as equities and moving to lower-risk assets (such as cash). Yet, one must remember that markets do bounce back in due course. Says Anup Maheshwari of DSP Blackrock Investment Managers: “As we have seen in previous crises — the Russian default or the Asian crisis — eventually markets come back strongly. That is the view we are going with.” If you view the current crisis from this standpoint, then the current state of the markets presents a buying opportunity to investors who have a long-term horizon of three to five years.

Besides the many valuation tools used to decide whether to buy a stock — price to earnings ratio and price to book value, discounted cash flow method, and so on — one fail-safe indicator of equities being available at attractive valuations is insider buying. Company insiders tend to raise their stakes in their companies only when valuations are dirt cheap. And insiders are buying now. “This is a good sign,” says Maheshwari. “This signal works well over a six-month to one-year period.”
Consensus opinion holds that Sensex earnings will grow at 12-13 per cent this year to close FY12 at the `1,180-1,200 level. If one goes by this estimate, then the Sensex is currently trading at 14 times FY12 earnings. This is an attractive valuation compared to the uber-optimistic 20x level that it was trading at prior to the 2008 crisis.

According to Sivasubramanian KN, chief investment officer, Franklin Templeton Investments, “Indian equity valuations are currently below their long-term averages and look attractive vis-à-vis long-term fundamentals.” Echoes Navneet Munot, chief investment officer, SBI Mutual Fund: “At present valuations are favourable with the Sensex P/E at about 14x.”

All eyes are currently glued to Q2 corporate results, which will provide an inkling of how companies are likely to perform this year. One thing is for sure: the years of very high revenue and profit growth are out. In fact, according to some pundits, profit growth in this quarter could be at the lowest level seen in the last six-seven years. High commodity prices and high interest rates are expected to take a heavy toll on corporate bottomlines.
Sector-wise performances are likely to vary. While FMCG, IT and auto are expected to do well, PSU banks, oil marketing companies, construction and non-ferrous metals and mining may perform below par. According to Sivasubramanian, “A key factor to watch out for is the extent of escalation in interest costs due to the recent rate hikes.”

What is smart money betting on?
A common refrain among fund managers is that in these uncertain times one should go for a bottom-up strategy and invest in quality companies with high returns on capital (ROCE), irrespective of sector. Next let us turn to the prospects of individual sectors.
FMCG. Structurally, FMCG still has a lot going for it — favourable demographics, rising income levels, and low penetration. Though valuations are at near 10-year highs, no other sector provides the comfort on earnings visibility that FMCG does.
Some fund managers derive comfort from the fact that the sector’s current valuations are still lower than their historical 15-year highs. Compared to that benchmark, FMCG still offers a potential upside of 30-40 per cent.
Investors must, however, be aware of the potential risks to this sector. Prices of a number of inputs have risen significantly, for instance, that of milk, eggs, and palm oil. Moreover, at current valuations the sector does not offer much margin of safety.
To beat the impact of inflation, some fund managers are scouting for companies that have pricing power. Godrej Consumer for one has indicated it will raise prices further. Telecom companies too have upped their rates in recent times.

Discretionaries. Pricing power is more evident in consumer discretionaries (non necessities) as compared to staples. Companies selling two wheelers, watches, jewellery, clothing, restaurants and high-end clothing are the ones you could consider.

Two wheelers.
At 15-16 times one-year forward earnings, the sector looks interesting. Both the frontline majors — Hero MotoCorp and Bajaj Auto — beat market estimates with their Q2 numbers and are expected to maintain their momentum. Additionally, points out Munot: “The sector has, over the years, become less interest-rate sensitive as the number of vehicles being financed has declined.” That accounts for why the two-wheeler sector continues to notch up record sales despite high interest rates.

Pharma. Like FMCG, pharma has robust growth prospects and trades above its long-term average. But Indian pharma today is well positioned and is still not as expensive as FMCG.

Information technology. Information technology (IT) has seen its fortunes turn and how. The industry bellwether has turned from much reviled to much loved: Infosys is up 25 per cent from its mid-August lows while the Sensex has inched up barely 5 per cent over the same period.
The falling rupee has turned IT into a desirable sector once again. But it’s early days yet. Though demand from abroad for IT services remains robust, Munot of SBI MF cautions: “Worsening of macro conditions could have a quick impact on business confidence and IT spending.”
Maheshwari likes sectors such as ports, airports, merchant-based power, fertilisers and agri-chemicals. However, he cautions: “You may have to wait till there is serious macro growth before valuations go up.”

<Out-of-favour sectors
Infrastructure. Among the sectors that aren’t finding favour with fund managers currently, infrastructure tops the list. Even though the CNX Infra is 60 per cent lower than its 2007 highs, fund managers are shying away from this sector. Says Maheshwari: “The markets will still remain with cash generating companies like FMCG and utilities rather than with infrastructure companies where there are just no cash flows.”
Realty. Another sector that remains out of favour is realty. Huge debts, overpriced products, and lack of strong demand (due to high interest rates) will keep profits deflated.
Four-wheelers. After years of robust performance, the slowdown has finally caught up with vehicle manufacturers, again due to high interest rates and high input costs.
Banking. In the current high interest rate scenario, credit offtake and net interest incomes are shrinking while non-performing assets are rising. Expect banks to remain under pressure till the rate cycle turns.
Metals and mining. Commodity prices are declining globally while several domestic mining companies have got enmeshed in corruption scandals. Hence the sector will remain out of favour for a while.
It would be naive to expect an early resolution to the economic problems in the US and Europe, so the Indian markets could also remain choppy for a while. Investors should therefore dig in for the long haul. For those looking for safety of capital, FMCG and pharma are sound bets. Those of a more aggressive bent may go foraging for stocks in sectors like two-wheelers and consumer discretionaries. Contrarian investors may selectively pick up stocks from the unloved infrastructure sector.
Finally, in these turbulent times stay away from debt-ridden companies and those with even a whiff of scandal about them. Stick to players with low debt, low working capital requirements, and a high return on capital.