The Hindu Business Line : Riding the wealth generation theme

IN MARCH 2000, fund managers at DSP Merrill Lynch were excited about the launch of DSP ML Opportunities. This fund set out to spot trends in the stock market and invest early. Sold on the idea, it said such theme-based investing would catch on globally. And, indeed, it has. Themes have become important, especially for India, with the stock market grappling with one idea or the other. While the latest craze is infrastructure, several themes are promising from a long-term perspective.

Business Line suggests six themes, and five stocks in each, that you could add to your portfolio. These are: domestic spending, infrastructure development, outsourcing, services, commodities and banking. They were chosen because of their strong fundamentals. They do not appear to be fads, and promise to deliver value over the long term.

There are, however, two major underlying assumptions: One, industrial growth has moved into a higher trajectory and will stay there for a few years, at least. Two, global economic growth will not falter. Even if it does, there will be no meltdowns. With these caveats in mind, let us consider the six themes:

Domestic spending: This is the original India draw. It is this and the promise of the great Indian middle-class that drew foreign institutional investors to India in the early 1990s. This is also the theme that took even many a savvy investor by surprise.

For instance, Mr Vivek Reddy, Chief Executive Officer of the erstwhile Kothari Pioneer, the first mutual fund to launch an FMCG sector fund, was admittedly stumped by the turn of events in the consumer goods sector.

He said in end-2000: "If we look back to March 1999, there were reasonable grounds to expect that the penetration levels of FMCG and pharma which were low, would pick up and that people would buy more soaps and medicines. It is amazing it is not happening that way. In fact, Lever is looking at a flat volume growth, which I am not able to understand."

What confounded industry-watchers in the early years of this decade was the seeming lack of brand power. Investors were switching from high-price brands to low priced ones. Brands seemed meaningless, and consumer goods companies found themselves with little or no pricing power.

Things are different now. The pricing power and, with it, the promise of this sector, appear to have returned. Over the past decade, the per capita income of Indian households has increased steadily. The rising affluence of the middle-class is beginning to make an impact. We think these stocks could take advantage of their brand strengths and make the most of the rising spending levels.

Our picks: ITC, Maruti Suzuki, GlaxoSmithKline Pharma, Pidilite Industries and HCL Infosystems.

Infrastructure development: Over the past five years, the internal accruals of Indian companies have risen sharply. Their capacity utilisation level has also increased steadily. There is no option for them but to start investing in fresh capacities. On the other hand, Indian infrastructure is in bad shape. It is straining to keep pace with the rising economic activity and there is little option but to improve and expand it. Any way you look at it, capital spending by industry and the Government is set to rise.

The earnings of companies in the infrastructure and capital goods sector are already growing at a frenetic pace. The order-book position is more than healthy — the value of orders is now several times the annual revenues of almost all companies in the engineering and construction space.Incidentally, select companies in this sector delivered value to shareholders even during the dog-days of 2001 and 2002. Many firms were then paying attractive dividends and do so even now. The dividend yield now has, however, declined to significantly low levels, signalling their emergence as growth stocks. Earnings growth of these companies continues to be impressive.

Our picks: ABB, Larsen & Toubro, Gujarat Ambuja, Bharat Earth Movers and Thermax.

Services: This theme has delivered spectacular value over the past decade. In the mid-1990s, the Indian service sector's contribution to the economy was less than one-fourth. It is now touching 50 per cent. Many pundits suggested that the service sector cannot keep growing without support from industry and agriculture. The service sector growth has, however, defied such predictions.

Our picks: Bharti Tele-Ventures, CRISIL, Indiabulls Financial Services, Container Corporation of India and NDTV. Most of the service sector companies are not listed. Over the next few years, many are likely to get listed. The service sector portfolio would then need to be revamped.

Outsourcing: For long, outsourcing in India only meant software services. Now, however, outsourcing covers many segments. A growing number of multinationals are looking to use India as a manufacturing hub. Many companies have already started sourcing from India.The most promising segments, apart from IT, are auto ancillaries, healthcare and textiles. Exports of auto ancillaries, for instance, grew at 33 per cent for the year ended March 2005. Textile exports, too, are beginning to look up after dismantling of the quota regime.

Our picks: Infosys, Bharat Forge, Strides Arcolab, Ranbaxy and Arvind Mills.

Banking: Banking stocks have had a terrific run in the past 30 months. They have led the rally, and the average increase in stock prices has been close to 300 per cent — double the rise in indices such as the Sensex and the Nifty. Many public sector bank stocks have risen 4-6 times.

Given this background, most would conclude that the banking story is almost over. Many, however, believe that the best part is to come.

For instance, consider this assessment of McKinsey: "At about $900 billion, India's stock of financial assets — including bank deposits, equities, and debt securities — is one-fifth the size of China's." The article goes on to indicate that several ills plague the Indian financial system, and suggests that sans these ills, the banking sector, which accounts for 2.5 per cent of GDP, could increase its contribution to 7.5 per cent. If that were to happen over 10 years the value generated by banking stocks would be phenomenal.

Our picks: SBI, HDFC, IDFC, Union Bank of India and Karur Vysya Bank.

Commodities: As a theme, commodities have flourished in the past few years. And, by consensus, there is a long way to go still, thanks to the Asian demand, particularly triggered by India and China.

Central banks of many countries have begun inflation targeting. Notwithstanding the rising interest rates and the consequent decline in activity, commodity prices are not expected to decline in a hurry. Particularly, crude oil, sugar and coffee are expected to sustain their bullish trend.

This sector is also the least expensive segment in the stock market. Many stocks are available for multiples of less than five times their latest 12-month earnings. For instance, GE Shipping is trading at about three times its earnings. Such valuation indicates that the market expects a sharp slump in the earnings from these stocks. That expectation, however, is not supported by the outlook for commodity prices and the expected growth in the economy. In addition, valuation is low even if we assume earnings growth to be flat or slightly negative.

Our picks: ONGC, Tata Steel, GE Shipping, Sesa Goa and Balrampur Chini.

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