DSIJ Mindshare

Fab Four - The 4 sectors to watch out for

With rising interest rates, inflationary pressures, geopolitical tensions, declining GDP growth rates, a gloomy global economic scenario and what not, the market is presently surrounded by all kinds of negatives. So much so that even a good set of numbers from India Inc in the March quarter failed to act as a trigger for its next leg up. As it continues to grapple for a meaningful direction, a good monsoon season is now being looked upon to act as the much-needed next big trigger for it. But aren’t ups and downs an integral part of the market? The smarter investors will always be on the look-out for avenues to park their funds even in uncertain times so as to reap the benefits of higher returns when the tide turns over. After all the equity markets are known to offer decent normalised returns over a longer period of time.

Having said that, the million dollar question is: Where should one invest during such uncertain times? There are many in the know who are suggesting that investors should adopt a stock-specific approach in the current times. However, as a first step to safe investing in such times when the market is just about trying to come to terms with larger macro-economic issues such as rising interest rates and burgeoning inflation it would be better to apply a top-down approach. Figuring out the sectors that are worth investing in the current market scenario particularly with an eye on the longer term prospects of your portfolio would be a much sensible thing to do.

Why do we think so? It is the top-down approach to stock-picking which will help in factoring in the larger macro economic factors currently afflicting the market in a much better manner. Selecting the correct sectors and then narrowing down to stocks within these sectors is sure to help investors create a correct balance between the risks and rewards going forward.

Now, coming to the core of our discussion, which are the sectors that one should invest in with a one-year perspective to earn decent returns? Though the recent results point towards a good performance from India Inc, there are many sectors which are reeling under pressures thrust by factors like rising interest rates, higher inflation, rising commodity prices, etc. For instance, many would be expecting the automobile sector to be a part[PAGE BREAK]

of our favoured four for the next one year. However, the current environment in which the sector is operating puts it out of favour. Auto companies have been riding the wave of higher volumes for quite some time now. However, those days are behind us.

Volumes are not expected to be a major growth driver for companies in this sector going forward. Moreover, rising commodity prices will put the margins under further pressure. One of the most important factors that goes against this sector is the rising interest rate. Mortgaged-backed sales of automobiles will surely be hit thanks to higher interest rates. Thus, auto-mobiles as a sector to invest in would probably be the best to avoid. Though FMCG is considered to be a defensive bet especially when a normal monsoon is expected to perk up demand from the large rural market, recent trends suggest that on the ground level companies have been struggling to clear their inventories even in some high-value products in this sector. Higher commodity prices again play a spoil-sport for margins here and higher product prices may not go down well with the consumers.

Real estate has anyways been in the doldrums and the sentiment for this sector is likely to remain bad for some time going forward. Moreover, rising interest rates will keep the demand for housing on the lower side with consumers not wanting to borrow at higher interest rates. Cement, whose fortunes hinge to a large extent on the demand for housing and construction, has anyways been a gross under-performer for quite some time now. The next quarter would be a low-demand quarter for companies in this sector. Pricing power has been limited in this sector and the future is quite opaque.

Would you want to invest in the telecom sector? Here too there are issues which have been plaguing the players. Rising competition and price wars have been hurting mar-gin expansion. There is a very little chance that the scenario will improve going forward. Moreover, players who have bid and won 3G licenses have paid huge amounts for them. This is another factor that will create a pressure on their balance-sheets. Considering all this it becomes important to pick up those sectors which are likely to be neutral to such worries as the rising interest rates, higher inflation, etc which are currently afflicting the market.

We have selected four such sectors which we believe should do well going forward. Banking, infrastructure, pharmaceuticals and IT are the four which form a part of our elite sec-tor selection for investors to park their funds with a one-year perspective. The primary reason for the selection of these sectors is that all of them are showing a good amount of clarity in terms of future growth. IT is probably one sector that is completely insulated from the vagaries of rising interest rates and higher inflationary pressures. Pharma has traditionally been considered as a good defensive bet in uncertain times. There are many other factors which go in favour of this sector such as the expected demand likely to arise from a large number of drugs going off-patent in the developed markets.

Infrastructure has underperformed for quite some time now but its future looks to be on a sound footing particularly with the added government thrust that this sector is likely to receive going forward. Banking is probably the only sector which looks like a contrarian bet to take in the current situation. However, there are reasons why we believe this sector would do well going forward. We have also put out two stocks from each of these sectors which are worth investing in. Our recommendation of these four sectors is from a one-year perspective.[PAGE BREAK]
BANKING - MINTING MONEY

It may surprise many to see this sector finding a place among the promising sectors for the next one year. In a scenario where interest costs are rising, the banking sector remains one of the most vulnerable. However, we have compelling reasons to believe that in the next one year this sector will see its fortunes turning and outperforming the broader market. First, there are concerns that the rising interest rate will deteriorate the asset quality of the banks. But the latest report by S&P on the banking sector states just the opposite. It says that the asset quality of the Indian banking sector is going to improve in FY12. The average gross non-performing loans of the Indian banks are likely to improve from 2.6% in FY11 to 2.4% in FY12.

The reason for this is that currently the low and moderately risky loans account for 81% of the Indian banks’ asset portfolios, while only 19% are within the high-risk category. The second concern is that credit growth will be impacted due to an increase in the lending rates. Nevertheless, if we see the order book position of some of the largest Indian infrastructure companies, we find that they are growing, albeit at a slower rate and are currently over three times their FY11 revenue. The segments that will primarily drive this credit growth within the infrastructure sector are roads and ports. Certain other sectors that are likely to help credit growth are metals and mining within which steel and aluminum where a huge capacity expansion is going on will be the main drivers.

Therefore, we believe that though the RBI in its recent policy has projected a credit growth of 19%, it will be more than that. Even last year the Indian banking industry’s loan book grew by 21.4% in fiscal 2011 - higher than the RBI’s projection of growth of 20%. To fund this loan growth the public sec-tor banks will use the re-capitalisation route and the private sector banks will mostly use their internal accruals. In the budget for 2011, Finance Minister Pranab Mukherjee has made a provision of Rs 6,000 cr for capital infusion in certain public sector banks which have low equity capital.

Another major trigger for the performance of the banking stocks will be the financial sector reforms. These will fundamentally change the landscape of the banking sector. The granting of licenses to new players, draft guidelines of which will be out soon is some-thing that is being keenly watched. The entry of new and bigger corporates will definitely push up the M&A activities in the sector, helping some of the banks to be re-rated. We believe that the new licensees might pitch for acquiring the smaller banks to make their presence felt.

Though the old private sector banks are likely to be bigger beneficiaries, their public sector counterparts too have something to look forward to. What will change the scenario for the public sector banks are recommendations of the committee for the financial sector reforms. These recommendations will allow them to gain more autonomy in their functioning and hence are expected to improve their efficiency and thereby trigger their re-rating. In addition to the above mentioned factors, what currently makes the banking stock looks attractive is their valuation. Despite showing a robust increase in their topline and bottomline since the past four quarters on a yearly basis, the BSE Bankex has underperformed the Sensex.

From the start of Q3FY11 the Sensex is down by 9% whereas the Bankex is down by 13%. This has made the valuation of the banking stocks look attractive. The BSE Bankex at the end of May was trading at 0.75 times of the Sensex PE, down from 0.81 times at the end of October 2010. We believe that some of the headwinds for the banking sec-tor as a whole such as the contraction in margins and the moderation in credit[PAGE BREAK]

growth will remain there for at least another quarter but things will improve thereupon. What is important to note is that the banking stocks will start discounting the improving conditions earlier than the actual improvement. Two companies to watch out for in this sector are HDFC Bank and Oriental Bank of Commerce.

Oriental Bank of Commerce is one of the public sector banks available at a very attractive valuation of price to adjusted book value of just 1.1 com-pared to its peers trading at more than 1.5 times. Going forward the bank expects to grow its loan book by 20-22% for FY12. Even its asset quality remained better than the industry average at the end of Q4FY11. HDFC Bank, our second choice in this sec-tor, is one of the best managed private sector banks in India as reflected in its ROA of 1.8%, one of the highest in India. In a rising interest rate scenario its high CASA ratio of 51% will help maintain the margins. Moreover, superior asset quality and negligible restructured loans offer comfort.

INFRASTRUCTURE - BUILDING STRENGTH

Infrastructure forms a part of our elite group of four sectors for the next one year which may baffle some. But the way infrastructure companies have underperformed on the bourses, they have every right to be surprised. There was too much of a buzz about the infrastructure sector, but the sec-tor as a whole has not managed to live up to the expectations. It has always been said that if India needs to sustain a decent GDP growth rate, infrastructure development will have to play a major role. But certain factors like monetary tightening leading to higher interest rates, margin pressures due to aggressive bidding and rising commodity prices, high working capital requirements, lower availability of funds for long-term projects and some amount of political instability resulted in the underperformance of the sector.

However, we are of the opinion that most of the factors are expected to improve and bring the infrastructure sector back in the reckoning. The first and the most important factor is the strong order book of the companies. On the overall front it is around 3x of the FY11 revenues. So it clearly indicates good visibility in forward revenues. Further, according to CMIE’s data, the order backlog is the highest since September 2008 with a continuous improvement in every quarter. As regards the new order flow, it is on the upsurge and after witnessing a sharp decline in the June 2010 quarter it has continuously witnessed an upward movement. We are of the opinion that usually the government’s public spending increases in the second half of its tenure.

It is true that the government is currently busy with non-core issues but once those matters are sorted out, the focus will be on the growth front. For instance, NHAI has a target to allot 59 projects amounting to Rs 56,939 cr till January 2012. Rather, NHAI has already allotted projects to the tune of Rs 18,458 cr in just the past three months. We expect the process to pick up momentum going ahead. While this is on the road front, L&T in its recent analyst meet mentioned about the railways, domestic and international airports, metro rails in Tier II cities and ports expansion as good opportunities for growth. Even water projects (urban, rural and private) are slated for a big push in the next one year.

On the margins’ front, the average EBITDA levels are about 9% for the Indian construction companies and with more than 35% of sales tied up in working capital, this has meant that free cash flow generation is low. As mentioned earlier, the non-availability of funds for the projects has been a source of worry for the infrastructure players. Further, the rising cost of funds has only added to their woes. Here we are of the opinion[PAGE BREAK]

that funding is available but at a price. So if there are viable projects, funding will be available. In addition to that, many large players are also looking for opportunities like external commercial borrowings. IRB Infrastructure recently mentioned that it is looking for ECB avenues as that would be cheaper compared to Indian funds, even with the inclusion of the hedging cost.

Another reason why we are bullish about the infrastructure sector is that the interest rate cycle is peaking out and the one hike which is expected seems to be already priced in. This could prove to be the most advantageous factor for the infrastructure companies. On the margins’ front, the volatility in the commodity prices is also likely to diminish. Rather, no substantial increase is expected in the commodity prices. In fact, any fall in the commodity prices, mainly cement and steel, will be beneficial for the sector. Last but not the least, it is said that no company is good or bad but it is its valuation that makes it so. On this particular front, after an under-performance for a long period most of the companies are available at better valuations.

The risk-reward ratio is currently favourable towards rewards and hence there is hardly anything negative from these levels. Therefore, taking into consideration such factors as a strong order backlog, better expected flow of orders, interest rate cycle peaking out and the expected stability in commodity prices, we believe that the infrastructure sector is expected to show a better performance going forward. Two companies to watch out for in this sector are Larsen & Toubro and Nagarjuna Construction Company.

IT/ITES - RIGHT CODING

The next on our list of elite sectors for investing in FY12 is IT. Renewed concerns over slower than expected recovery of the US economy does cast a shadow of doubt on this selection of ours but before concluding that our selection is ambitious there are reasons you should know why IT as a sector should do well and why it makes sense to keep it on your radar. While concerns on the US economy have been there for some time now, what one doesn’t pay attention to is the consistently improving performance of the IT sector, especially in terms of the bottomline. From a muted 3.3% growth in Q1FY11, the growth rate improved to 7% in Q2FY11, followed by 14% in Q3FY11, ending the fiscal on a very high note with a bottomline growth of 25%.

What this indicates is that the IT revival is right in place and though it has taken its own sweet time to arrive here, the revival is there and is happening for sure. While volume growth continued for the sector, the last fiscal also saw the return of some pricing power for the domestic IT players.

When we look forward there is certainly good optimism seen amongst the IT companies about the business outlook. In fact they appear to be quite upbeat about the business that they have not only currently won, but also about the business pipeline they see for the coming period. This is evident from what some of them have said in their recent interactions with analysts.

IT biggies such as TCS and Infosys continue to add new clients, new business and are speaking about a strong inflow of deals for the coming period. This provides assurance about two things. First, the volumes are still intact. Second, the clients are coming forward to spend on their IT needs. In fact while most of the clients’ IT budgets would be finalised by the end of June, we expect these budgets to be marginally higher than what they were a year ago. The Indian IT companies are well aware of this and have been recruiting in huge numbers to[PAGE BREAK]
drive their growth. TCS, which has posted a stellar performance in FY11 and carried out a gross recruitment of about 70,000 in FY11, is already looking at another gross intake of 60,000 in FY12. Infosys too has recruited 45,000 in FY11 and is looking to add another 43,000 in FY12.

In fact some of the global IT majors such as IBM, Intel, and Cognizant have posted strong numbers for the first quarter of the calendar year 2011. The good part is that IBM and Cognizant have also raised their profit estimate upwards for the full year. According to Gartner sales of server systems are seen increasing, a sign that technology firms are spending again. They say that server systems sales precede spending on other technology products and software. Even International Data Corporation (IDC) estimates that worldwide IT spending will top $1.5 trillion in 2011, with spending on PCs, servers, and storage and net-working gear expected to soar. This is a clear indication that business is good and would continue to be so going forward. If that is not enough, figure this out. What makes this sector even more attractive is that this is one sec-tor that is neutral to the current macro economic concerns. It should be noted that while interest rates and commodity prices continue to rise and are seen affecting sectors across the board, it will hardly have any impact on the IT sector. Most of these companies are debt-free companies and hence there is zero interest outgo for them. This should help these companies keep their margins healthy.

A rising interest rate scenario would actually benefit IT companies as these cash-rich companies would earn better returns on their liquid investments. It would also help them push their other income. There are two companies that are looking quite good. One, of course, is TCS which has exceeded expectations in FY11 and is available at a PEG ratio of 1x and the second is Persistent Systems which is available at a PEG of 0.81x.

PHARMA- HEALTHY RETURNS

In uncertain and volatile times it pays to play safe and when it comes to parking funds in the equity markets, any form of investment in defensive sectors such as pharmaceuticals seems to be a wise move. If we see the year-to-date performance of the BSE Healthcare Index, it has outperformed the Sensex by 5%. It is not only due to the defensive nature of the sec-tor that the index has outperformed but also for the fact that pharmaceutical is also one of the fastest growing sectors in India. For the five years ending FY11, the Indian pharmaceutical market has grown at a CAGR of around 13% and is currently valued at approximately USD 16 billion. We believe that, going forward, it will increase further.

The first reason for such optimism lies in the number of drugs that are going off-patent in the next few years in the world’s largest pharmaceutical market, the USA. In the current year (CY11) alone drugs with a market worth of USD 10.76 billion in CY10 would be going be off-patent and the figure for CY12 is around USD 13.63 billion. Most of the Indian pharmaceutical companies have a very strong presence in the US market. These companies have many ANDAs (abbreviated new drug approvals) filed with the USFDA which include more than 50 FTFs, highest by any country. Indian firms produce about 60,000 generics brands across 60 therapeutic categories and edge out their global peers in terms of cost efficiency as Indian generics are 15-25% cheaper than those manufactured by other companies elsewhere.

It is not only the US market but Japan, the world’s second-largest pharmaceutical market, which is also throwing up new opportunities for the Indian generics players after India and Japan signed a free[PAGE BREAK]

trade agreement in February. This agreement puts India’s generics firms on par with Japanese drug makers. Japan has clearly mentioned that they need to increase the generics penetration from the present 18% to 30% within the next couple of years. As of now the share of generics is just USD 8 billion. Various companies like Dr Reddy’s Labs, Alkem, Ind-Swift Labs and Elder Pharma are planning to enter this strictly-regulated Japanese market, while those already present there, such as Lupin and Zydus Cadila, plan to expand their presence.

In addition to the opportunity in the generics space, there are huge prospects in the contract research and manufacturing services (CRAMS) segment. This is because Indian companies provide a unique proposition to drug innovator companies. India has the highest number of USFDA approved plants outside the USA which number more than 150. Moreover, Indian companies offer potential cost advantage of 60% in outsourcing end-to-end research and development to India. The low R&D productivity has put intense pressure on global innovators to generate growth and we believe that a large portion of this outsourcing business is likely to come to India. Currently the total size of the CRAMS market is USD 1.5 billion in India and this has been growing at a CAGR of 65% from 2007.

We expect this momentum to continue and its market share in the global contract manufacturing business likely to more than double to 7% by the end of CY2012. Some of the Indian companies that are active in this field and who derive maximum revenue from CRAMs are Divi’s Laboratories (50% of the revenue), Dishman Pharma (70% of the turnover), etc. These companies have shown good sales growth in Q4FY11 on a yearly basis with good momentum in the CRAMS business. The above must not be misconstrued to indicate that the domestic pharmaceutical industry is dull and dry.

Domestic sales still constitute a little more than 50% of the total turnover of the Indian pharmaceutical companies and the growth is at a CAGR of around 13.5%. With increasing affordability, shifting disease patterns and an increase in the total consumer spending on healthcare products and services, it can be assumed that this growth will continue. Hence we are of the opinion that this is one sector that investors would do good to stay invested in with a perspective of a year or even more.

There are two companies that are looking good in the current scenario. First is the DIVI’s Lab that has major presence in the CRAMS, the market of which is reviving. Next one is the Lupin Pharmaceutical that has major presence in both the major markets that is USA and Japan.

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