The Hindu Business Line : Verdict 2004: Catalyst for a market makeover

MAY 1996: The election verdict had thrown up a hung Lok Sabha. Sensex shed about 3.5 per cent in the first ten days of the month and then moved sideways for the whole of May. The politics of coalition had taken roots in India and uncertainty was about to rule. The market recovered but after a while. Forget stability, it did not improve dramatically thereafter. So the received wisdom is: Stay invested whatever the uncertainties.

The advice has indeed worked wonders. An investment in a scheme such as Franklin India Bluechip has delivered annual returns of about 25 per cent in the eight years from May 1996 to May 2004. That is, an investment of Rs 10,000 would have grown to about Rs 60,000 in the ten years.

This has been repeated again and again in equity markets, in India and across the world. If a country's economic growth is going to be healthy, equities will outperform all asset classes over the long-term. It was true for the Indian market then and it is true of it now.

Structural shifts

However, this is only part of the story. While, from the outside, the flow of the market over the long-term may appear relatively smooth, regardless of its ebbs and flows, the view from within is seldom that orderly or even logical. Structural changes are constantly happening. Sectors and stocks win the vote of the investors only to be unceremoniously dumped in double quick time when something else catches their fancy.

Of course, these structural changes do not happen suo motu. They need a helping hand — a catalyst.

For instance, between April 1996, when the then Congress government was about to demit office, and April 1999, when a broad-based bull run in stock prices started, the IT sector stocks soared in value. The February 1997 Budget presented by Mr P. Chidambaram was the catalyst for the IT sector.

Similarly, the sharp decline in interest rates in 2002 set off the bull run of 2003. Several stocks, including of many public sector units and banks, had remained under-valued for long. But the decline in interest rates proved to be the catalyst that would set right the valuation anomaly.

And it is happening again. The market-wide shake out following the uncertainties thrown up by Verdict 2004 too appear to be catalysing structural changes.

The shape of the change is none too clear at this point. And there will be other triggers too, such as the Budget. The odds are, however, stacked against the continuation of a market-wide bull run.

From January to May, the market has corrected gradually and the interpretation before the elections was that the stocks would resume their upward run after the new government is in place. Now, going by local factors and from global indicators, the bull run is probably over.

In this context, we can look at the trends of the last week and those in the period April 1996 and April 1999 for clues on what the market may have in store.

May 13-21

Trends within the downtrend

The market was witness to a number of trends apart from the swift decline in prices of public sector stocks. These trends were:

BSE FMCG and BSE Healthcare indices outperforming all other indices

IT sector also outperforming, though in relative terms

Among non-PSU stocks, BSE Capital Goods is a major loser led by stocks of power sector companies

Nifty underperforming both CNX Midcap 200 and S&P CNX 500

Dividend plays in non-public sector hold their own

Auto-component, telecom and automobile major stocks are the outperformers. The outperformance of FMCG, Healthcare and IT sectors is in a way a repeat of the trends in earlier years.

Uncertainty tends to drive money into defensive and liquid stocks. FMCG stocks are defensive while IT and healthcare are relatively more liquid. IT and healthcare company earnings are a lot more dependent on exports.

In contrast to earlier years, however, the outperformance of FMCG, Healthcare and IT sectors was not symptomatic of a larger trend of a flight to safety. This is evident from the fact that CNX Midcap 200 outperformed Nifty.

If it were a classic `flight to safety', it would have been the other way around. Investors still seem hopeful of a number of mid-cap stocks.

On the other hand, the market seems to have given up on reforms-dependent sectors. Thus, power sector stocks were cut to size. Reliance Energy, Emco, Alstom Power, BHEL, Jyoti Structures, ABB, CESC and Siemens lost more than 15 per cent.

Profit growth of the power sector is heavily dependent on reforms. The return of `free power' in Andhra Pradesh and Tamil Nadu appears to suggest that power sector reforms, already the most contentious issue in the country, may be even more difficult to pursue.

Similarly, sugar sector stocks, also dependent on reforms, notched larger losses.

By and large, however, hopes that drove stock prices in 2003 seem set in place. For instance, dividend plays in the private sector continued to attract market interest. Stocks such as Infomedia India, MIRC Electronics, Carborundum Universal, Chambal Fertilisers, Hero Honda, GE Shipping, Thirumalai Chemicals, Blue Star and Omax Auto did much better than the market.

Kochi Refineries, the most attractive dividend play in the public sector, lost the least among PSU stocks.

In addition, stocks from sectors such as auto-component (Bharat Forge and Munjal Showa), automobile (Tata Motors and Maruti Udyog) and telecom (Bharti Televentures) continued to be outperformers.

April 1996-April 1999

Carnage in the market

Between April 1996 and April 1999, unstable coalitions ruled the country. During that time, the following trends were evident:

The market was dominated by sector themes — IT, FMCG and Healthcare ruled the roost, delivering exaggerated returns

Valuations of companies dependent on the domestic economy were relentlessly cut down. The low industrial growth was a factor. Even stocks such as Grasim, Raymond and Ashok Leyland lost about 80 per cent

Stocks from sectors such as power, hotels and banks suffered large losses

Commodity stocks were the worst hit. Some stocks such as TNPL and Ballarpur Industries lost about 90 per cent. They had to bear the brunt of a drop in commodity prices as well as a decline in economic activity The picture has changed much between April 1996 and now. Industrial growth promises to be healthy at about 6 per cent now in contrast to between4 and 6 per cent then. Interest rates are at all-time lows now and unlikely to rise in a hurry. The competitiveness of the Indian industry has also improved considerably now.

Getting ready

The carnage seen between April 1996 and April 1999 is unlikely to be repeated. While political instability could be a factor this time around too, there are certain positive features unlike then.

Healthier commodity prices and soft interest rates — two factors referred earlier — are reason enough to hope that there will not be a repeat of crashes. Nevertheless, the trends between April 1996 and April 1999 indicate that if the market moves side ways or trends downwards, sectoral themes would dominate.

In this context, the following strategies may prove suitable to deal with the trying times that may be ahead of us:

Preference for sector themes. The two most prominent sectors appear to be auto and healthcare. Textile too could emerge a favourite theme. Mutual funds may load with stocks from such sectors.

A move away from commodity sector stocks. Commodity prices may decline since the Chinese economy is slowing and such stocks could under perform the market.

A move away from stocks dependent on domestic growth, particularly that of capital goods and cement.

IT may still not emerge as a predominant theme. Slower global growth will affect IT as much as other sectors.

Rising importance for dividend-yield stocks. In the absence of abnormal returns, the relative safety afforded by dividend-yield stocks may prove alluring.

Avoidance of high P/E stocks within sectors.

The trends in the stocks from banking, power and sugar will, however, have to wait for the Budget. If the Budget pronouncements do not prove detrimental to these sectors' interests, then market interest would revive, especially in bank stocks.

The emergence of such themes is, however, predicated on the assumption that Indian economic growth too will cool down. The oil price rise, the decline of the rupee, the slow down of the Chinese economy and the rise in US interest rates do not augur well for economic growth that is higher than that achieved in the past. In this backdrop, a move away from commodity and capital goods sectors appears preferable.