A man who would make you laugh like a child

A man who would make you laugh like a child

Dr Kallam Anji Reddy, founder of Dr Reddy's Laboratories and a stalwart of Indian pharma industry in his own right passed away on 15 March 2013.

It is personally a sad moment for me. You do not meet too many people in life and come back thoroughly inspired. Five occasions I had the privilege to meet with this truly modest and humble son of an Andhra turmeric farmer, were some of the most memorable moments of my life – the moments which are firmly ingrained in your memory for life.

Though I would meet him as part of the team of private bankers that managed a part of his wealth, we never talked about money and investments.

The thing I liked most about him was his laughter. He had this amazing ability to laugh like a two year old child on almost everything.

He was always keen to know about the socio-political problems afflicting the country and how he could contribute his two cents to help the wanting. The meetings planned for 10-15 minutes all ran for well over an hour. On one of the occasions he even postponed his lunch to continue the discussions about education for poor girls I was mentioning to him.

After relinquishing his routine responsibilities at DRL, Doctor, as he was affectionately called, had devoted himself to a variety of philanthropic causes, including providing drinking water to rural areas and mid-day meals to school-going children.

Despite keeping a bad health, he was deeply involved and working hard on an Alzheimer drug for past many years. While his modest beginning, hard work, commitment to research and rise to the top rung of fiercely competitive and highly regulated pharma are all well known and documented, very few talk about his innocence and easily trusting nature.

Whenever he would come to Mumbai, he was nostalgic about his graduation days at Mumbai University, when he lived at small place in Matunga and had his food at famous Udupi kitchen near Mantunga railway station.

It may also be not well known outside pharma industry circles that Dr. Reddy Laboratories under his stewardship has produced many successful entrepreneurs who dot the pharma map in India.

For past many years, there had been rumors about him wanting to exit DRL, like Ranbaxy promoters. But he would always laugh out loud and say, “I take my medicines with my name written on these. Why would I want it any other way”.

As reported by a newspaper – “Life did full justice to his enterprising spirit — it threw several challenges his way all of which he gamely tackled. What stood Reddy in good stead were his incurable optimism, his passion, his trust-and-delegate management style, and his ability to continuously seek inspiration.”

Seeking new horizons

Seeking new horizons

As we adjust to a lower pedestal, new horizons would emerge.

The quintessential adjustment phase of the economic downturn is finally catching up. The signs are conspicuous.

Corporate

Companies are selling core assets, acquired in past few years with great hopes (e.g., GVK Australian Coal, GMR Singapore Power, etc.); airlines are cutting fares to compete with railways, hotels, automobile manufactures, realtors are offering humongous discounts to get rid of inventory; IT companies are delaying calling the new hires; telecom companies are not jumping over each other to capture airwaves; road projects that were awarded with exuberant premiums are getting cancelled; sports and entertainment events are finding it difficult to get sponsors; managements are working overtime in cutting corners to save margins.

Consumers

Consumers are not crowding the red sales; household budgets have reconciled to higher energy prices, rail fares, vegetable prices, service tax on every rupee spent and negative return on savings; savings are settling at lower level, and credit outstanding is rising as the spend on health and education takes a hit.

Government

The government has drastically cut budgets for its flagship Bharat Nirman schemes, MGNREGA etc.; taken many unpopular decisions in a pre-election year like raising rail fares, LPG and diesel prices, hiking effective tax rates for corporates struggling with down turn, etc.

Financial institutions

Usually, the financial institutions, especially those in public sector, bear a substantial part of the cost of adjustment. We have seen in past 5-6 quarters that the “restructured” assets of PSU banks have risen significantly. The banks appear to have adjusted to the reality of “restructuring” and hence are conserving capital (by lending less and selectively).

New horizons

Historically, the adjustment phase has always resulted in durable cost efficiencies, higher productivity, smarter consumption patterns, stricter lending norms, better compliance levels and reformed policy framework.

Material (esp. cement and metal) companies, large banks, consumer (both durable and staple) companies and IT companies have come out much leaner and stronger out of this phase.

As suggested earlier we are closely watching Hindalco, Tata Steel, UltraTech, ICICI, Voltas, Havells, HUL, Dabur, HCL Tech, Tech Mahindra, and Exide for signs of new rising.

Lead me to light

Lead me to light

The market reaction to the news flow this week has been unwarranted though not completely unexpected; given the overemphasis on the expected RBI decision on policy rates in the next week policy review meeting.

In our view, the economic news flow, viz., February exports & CPI, and January IIP is important to take note but may not be acceptable as indicator to any change or reversal in trend. Moreover, the data was mostly on expected lines, except IIP which anyways is notorious for its wild gyrations and revisions.

The hypothesis that better than expected (though still extremely poor) IIP numbers and elevated CPI for just one month would impact RBI decision dramatically prima facie appears flawed. In our view, we are fast approaching the breaking point where RBI will have to save its concerns for inflation for a later date. The US Federal Reserve which was focused on inflation for many years is concerned about jobs only. They had the luxury of owning USD printing press. RBI could hardly afford any luxury. In our view, a repeat of 2009 is more likely in 2H2013, when RBI did cut relentlessly to support growth.

The following news flow has drawn our attention recently, which in our view ought to influence the policy formulation in coming years.

(a)   As per a report in Business Standard many small and medium size pharmaceutical manufacturing firms located in Baddi (Himachal Pradesh) are facing the threat of closure. These units were lured into this location 10yrs back by tax concessions and capital subsidy given under special status state category. Despite huge influx of benefit seekers, the infrastructure in this area could not be developed. The connectivity remained poor. As the tax (Excise and income tax) concessions expire next year, many of the 250 odd units would be incurring losses and face closure. In our view, many industrial units in Kashipur and Rudrapur areas of Uttrakhand may also meet similar fate.

We feel, this should initiate a serious nationwide political debate over the efficient allocation of scarce resources vs. parochial regionalism, and even more important “enablement vs. provision”.

Gujarat model of development based on enablement has attracted more investment and hence created more growth opportunities, rather than the model based on “provision” adopted through special status mechanism. Nitish Kumar and Mamta Banerjee might have few tips to take from Baddi instance.

(b)   Chinese government is reportedly considering scrapping some ministries, including the Railways, to check corruption. The Indian government may also want to examine this possibility.

(c)   Yet another failed spectrum auction, CBI status report on Coalgate and changes proposed in defense procurement policy ought to lead to some structural changes in governance structure and make it more transparent and accountable.

Catch - 22

Catch - 22

The current market conditions present a classic dilemma before the investors in Indian equities.

There are reasonable indications to suggest that the global equity rally may extend little further into the summer; and along with the Indian markets may also show strength. However, the trends in macro fundamentals of Indian economy are suggesting a likely deterioration as the summer heats up. The actual corporate performance might also be sub-par in next couple of quarters, leading to another round of earnings downgrades. Even if RBI cuts rates aggressively, it will take at least 2-3 quarters for it to reflect positively in earnings.

In this Catch-22 situation – the investors broadly have two options – (a) continue to remain underweight on equities; wait for the macroeconomic conditions to bottom out and show some signs of recovery; let this rally happen and fizzle out; or (b) participate in the rally by investing in selective stocks that may tangibly and/or sentimentally benefit from the recovery in global economy (mainly US and Japan) and therefore logically participate in the global markets led rally.

In our view, the investors should opt for the second alternative.

To implement this decision, it is important to understand the characteristics and direction of the global rally and identify the likely beneficiaries on the Indian shores.

We feel, the global economic improvement will be primarily led by (a) reduced level of stress in financial system (b) productivity gains through cost savings (mainly energy and wages), & technology innovations, (c) continuation of low rates & benign liquidity and (d) fiscal corrections (austerity in public spending and higher taxes).

These theme shall manifest, inter alia, in lower employment growth (more outsourcing), lower public spending (outsourcing of government jobs, lower defense and security, budgets, lower healthcare budgets etc.,), large scale migration to tax arbitrage jurisdictions (Singapore, Dubai etc.) lower consumption growth and new wave of manufacturing revolution in west triggering a price war with Asian giants like Korea and China.

Thus, the sectors that may lead the rally will likely be – US financials, EM ITeS outsourcing companies, EM pharma, technology innovators, Dubai and Singapore real estate, etc. The losers would include consumers, materials and low productivity manufacturers.

The key risks would include a serious global political crisis leading to failure of economic cooperation seen since 2008; elevated geo-political risks and security threats as defense budget cuts take place in US and Europe, leading to spike in energy prices; and major collapse in commodity world.

We add Voltas, Hindalco, Mind Tree, Siemens, to our Watch List disclosed last week.

We also propose to launch a model macro long short portfolio, with a12-15months time frame, on these assumptions from April 2013. 

Who moved my cheese?

Who moved my cheese?

In past couple of months, our readers have raised more queries regarding currency than equities. The worries on current account are now universal, well articulated and well documented. The economic survey, RBI policy statement, budget speech, rating agencies’ reviews and professional economic and banking research analysts all have expressed concerns over the worsening current account and its implication for the Indian currency.

We have been regularly highlighting the structural issues that make the current account unsustainable. In our view, besides economic and market forces, the confidence of people in their own currency also impacts its value.

Empirically post 1998 we had witnessed strong Indian sentiments towards the rupee. The sentiment did reflect in substantial rise in NRI remittances, NRIs buying rupee assets, and significant rise in investment in real estate – despite all regulatory hurdles and administrative problems.

This trend has definitely weakened, if not reversed. The preference for USD and gold is seen higher as compared to INR amongst most professionals. The unskilled and semi-skilled labor is currency neutral as they continue to remit money to uplift living standard of their family back home. Besides they do not get much investment opportunities in the country of their work.

Many NRI living in US and EU are finding the local real estate more attractive than Indian properties.

Secondly, the energy revolution that is gradually developing in USA and Canada is attracting a lot of attention even from Indian entrepreneurs. The lure of cheap and sustainable source of energy may likely set the clock in reverse order – driving the manufacturing back to Americas. This could have serious implications for India’s trade balance.

-          The technology and process knowledge transfer that had accelerated in past one decade may take a big hit as the manufacturing stays back or relocate to Americas.

-          India’s endeavor to transform itself from supplier of raw material and low cost converter may face serious hurdles. Thus, the reliance on imports may rise, whereas the value addition in exports declines.

-          The FDI flows might slow down further as new investment opportunities emerge in Americas.

-          On the other hand the reverse FDI (Indian corporates investing in overseas ventures) may accelerate.

-          The global carbon market may collapse.

-          The industrial job growth and wages stagnates.

In our view, though it is very early to draw any conclusion from these assumptions, these cannot be dismissed as purely speculative. The investment strategy therefore needs to factor this in as a note of caution of at least.

Hold your fishing rods

Hold your fishing rods

As suggested in some of our recent posts, we continue to believe that Indian economy and therefore the equity market may hit the rock sometime later this year. We may see a gradual recovery over 2014 and some acceleration in 2015.

The down leg of the economy in next six months would likely be led by fiscal tightening, fall in household consumption and savings, and deferment of investment plans.

Rise in consumer prices especially energy, election in key states followed by general election, still high fiscal and trade gap and fall in external demand due to fiscal tightening in US and EU, are some of the key factors that may support the downtrend.

Historically, the market has reflected the bottom in distress. Sale of core assets by the stressed corporates (already happening), large scale debt restructuring (we need to see some substantial write offs rather than cosmetic maturity extension), and capital restructuring to cleanse the balance sheets usually mark the completion of the process. Banks and the stressed sectors (infra, realty and power in current case), are invariably pushed to the wall.

We therefore see a repeat of 1998-99 in the markets, where the recovery will be led by the global economy and the companies that directly benefit from the global demand, especially US and Japan. We therefore OW IT and large pharma and suggest substantial UW on banks and stressed sectors. A normal monsoon and estimated US$10-12bn spending on elections in next 15months may support consumption demand, especially auto and staples.

Strategy

(a)   Over next 6months gradually increase the weight of equity in asset allocation.

(b)   Overweight exporters, especially IT and global pharma. Select auto and consumer staples may also be added.

(c)   Select financials may be considered at appropriate price points.

(d)   Keep a close watch on the stressed companies which have good assets. The completion of three phase restructuring as suggested above would definitely provide a decent investment opportunity in this sector.

(e)   Some of the stock worth considering are:

IT and ITeS (OW): TCS, Mahindra Satyam, Hexaware, HCL Tech, Mind Tree, Polaris

Consumption (EW): M&M, HUL, Dabur, Havells, Exide

Pharma (OW): Dr Reddy, Sun Pharma, Glenmark, Lupin

Financials (Review): ICICI, Yes Bank, L&T Finance, M&M Finance, Manappuram.

Commodities (Review): Ambuja Cement, Ultra Tech, Tata Steel and Hindalco.

Stressed Companies (Review): GVK Power, NCC, IVRCL, JPA, 

…and save my fears!

…and save my fears!

As discussed in yesterday’s post, the best case for Indian equities could be a selective rally, similar to 19

However, this rally should not sustain beyond a point in time, if the domestic economic conditions fail to show substantial pick up. This prompts some thoughts on the worst possible case.

In our view, the worst possible case for Indian equities could be as follows. It is important to note that this is not the base case for us, but nevertheless possible.

(a)   The pre-conditions for emergence of green shoots of recovery that have been taking shape globally, especially in US and China, subside prematurely; leading to abortion of famous “great rotation”.

US spending cuts, scaling down of Chinese growth estimates, gradual unwinding of commodity trades, and 10% fall in US and German treasuries over past one week, suggest that nothing is a given as yet.

(b)   The governments world over are mostly out of fiscal options. The EU, US, and Japanese central banks are determined to back stop any financial or liquidity crisis. However, post Italy election market reaction suggests that the Central Bank Put may not be as effective, especially in case of a political crisis. The much feared “currency war” which is mostly a political phenomenon, could become a reality should the EUR weakens substantially due to political instability, particularly in Southern Europe.

In this eventuality, there could likely emerge new points of vulnerability, especially in commodity world, e.g., Latin America, Central Europe, South Africa and Australia.

(c)   Indian economy fails to grow beyond 6% in next two years, thus worsening the unemployment conditions, CAD grows as external demand shrinks, and lower investment keeps domestic supply conditions tight. WPI eases but the consumer prices remain elevated, preventing major monetary easing. Next general elections throw a fractured mandate with none of the two national parties going beyond 140.

(d)   Corporate earnings stagnate for another 3years like FY09-FY11, and market gets

In this scenario, with Sensex EPS of Rs1300-Rs1400, market trading at trough period average multiple of 12x, the market will be stuck in 15000-17000 range for more than two years, with occasional violations on both the sides.

The worst case scenario in our view thus projects a scenario for Indian equities, where even the nominal 2008-2015 returns could be negative in absolute terms.

However, we may reiterate, this is not our base case outlook. We shall discuss the more likely (our base case) scenario in tomorrow’s post.

As bad as it gets

As bad as it gets

The union budget 2013-14 presented in the parliament today could at best be described as “short sighted”.

Problem identified

From the Economic Survey presented a day earlier, and the early part of the budget speech, it is very clear that the government has precisely identified most of the problems afflicting the Indian economy. Inadequate job creation, skill deficit, infrastructure deficit, current account deficit, fiscal deficit, declining savings and investments, slowing global growth, persistently high consumer prices, disillusioned youth, unsafe women and child, rising social and economic inequalities being the most prominent ones.

Besides, need for consistency and transparency in policies and tax administration are also emphasized.

No cure offered

The budget proposals of the finance minister however do not appear to be offering solutions. Budget just offers some increments in the allocations to the current schemes, which might be mostly inadequate.

To the contrary, the proposals seem trivial in many cases; introduce a fair degree of adhocism; and completely lack transparency especially in case of provisions that could have negative implications for the financial markets. For example, provisions relating to retrospective applicability of GAAR, taxability of entities investing through Mauritius route, higher tax on income for bond and income funds for individuals, 2% surcharge on MAT, etc. find no mention in speech.

Can kicked to July 2014

A second reading of the speech and budget proposal makes it clear that FM has probably presented this budget against his wishes, just to complete a formality, leaving the task of curing the ills plaguing the economy to the finance minister who will present the next full budget in July 2014 (assuming election will happen as per schedule in April –May 2014). The question is what happens if he remains the finance minister in July 2014? Remember what happened to CWG preparations in Delhi in 2009-10!

Gimme some hope!

Gimme some hope!

Now that the euphoria over “Reforms” unleashed by the government after the incumbent FM took over last summer has yielded the way to “Reality” and the market expectations have been mostly aborted, we find it pertinent to find reasons to stay invested in Indian equities. The task is not easy, especially when you are standing at the precipice staring down at the abyss that lies ahead.

As highlighted in the yesterday’s issue of Morning Trekk, we do not see much reason to increase allocation towards Indian equities at this point in time. Nevertheless, the incorrigible optimist in us believe that the current economic phase will not lead to a structural collapse of “India Story”, and the next 5years will see Indian economy’s potential growth rate improving from the current 6-7% to 8-9%. Which essentially implies that over next 5years Indian equities might provide decent returns to investors.

Remember, the five year period between 2008-12 the benchmark indices have given negative (-)4% nominal return in absolute terms. Taking the impact of inflation and dividends, the return would be (-)30% negative.

In this background we tried to work out the best and worst case for Indian equities in next couple of years.

The best case

The best case for Indian equities in next two years would be that:

(a)   The global economy stabilizes, especially US and China, leading to improvement in external demand environment;

(b)   the benign liquidity conditions continue to prevail at least till end 2014, keeping the rates low so that investors keep chasing that extra few bps of yield thus sustaining the flows to India;

(c)   the next general election in India produce a truly coalition governments where the constituents genuinely agree on a common minimum program and such CMP is implemented in right earnest.

The key risk in this scenario could be sharp rise in global commodity prices, especially energy that would strain the macro fundamentals of Indian economy further.

In this scenario, we could have a repeat of 1998-1999, where a large but selective market rally occurred in new economy stocks, following a global trend.

It is however critical to note that such a rally would be very selective and fizzle out as the valuations of selective sectors become excessive soon.

In this case the exporters, especially IT services and large unleveraged pharma companies could gain substantially. The austerity drive in US and EU may also support more outsourcing of public services to cheaper labor and demand for cheaper pharmaceutical products produced in India.

Markets to slither on the last leg down

Markets to slither on the last leg down

Over the last weekend we read 47 budget analyses report, besides the one written by InvesTrekk itself. An overwhelming consensus appears to believe that this budget is inadequate; uninspiring; lacks innovation; and sets too ambitious fiscal target, especially tax collection, deficit and subsidies.

We may outline the likely economic scenario for FY14 as follows:

(a)   We may not witness any substantial acceleration in investments during FY14. The fiscal constraints shall continue to constrict public investment, as evident from unimpressive provision for plan capital expenditure. Besides, traditionally no major private projects are initiated in a pre-election year, as the industrialist wait for the new regime to take place and announce their policies. The only area where investment can accelerate is the faster execution of work-in progress.

We do not agree with the opinions that extension of 80IA and introduction of investment allowance could be immediate motivating factors for investment in power and manufacturing sector. Rs100cr plus plant and machinery investment decision is different from buying in end of season 2day sale at a popular retail store.

(b)   With no credible plan to check consumer inflation, deteriorating job outlook and lower subsidies, the resilience of consumption should also start withering.

(c)    The fiscal tightness, higher consumer inflation, slower savings growth and lower industrial credit demand should continue to impact the money growth. The liquidity conditions should therefore continue to remain tight. The recent hike in deposit rates by banks is a clear indication towards this trend. Even if RBI cuts the policy rates by 25-50bps in next 3months, the short term rates may not react sharply.

(d)   The volatility in Chinese data, persistently poor European economic data and recent US budget cuts shall add to the global economic woes. The external demand situation may therefore not improve dramatically in next couple of quarters. The current account and INR will therefore continue to remain under pressure.

(e)   Under the circumstances the growth shall continue to remain below trend. Though the massive election spending in next 12months may add few basis points to growth, overall it may still be at the lower band of the projected 6-6.5%.

(f)     We may soon see a fresh round of earnings downgrades, especially in banking and industrial sectors.

In our view, the market has definitely completed its up move that started last year. The down move has begun and shall strengthen in coming months as the markets corrects some oversold conditions and short sellers gain some confidence.