Avoid Leveraged Companies

Daljeet S Kohli
Head of Research
IndiaNivesh Securities

A TEPID QUARTER

• The Q2FY14 corporate results were in line with expectations, with no major surprises on either side. Topline growth for the domestic segment of most of the companies was muted, though the companies managed well overall in terms of profitability.

POTENTIAL STIMULI

• An international trigger will come from the tapering of the bond purchase program by the Fed. On the domestic front, we expect a lot of noise due to the impending general elections in May 2014.

Speaking of the state of the Indian markets in the current scenario, the one word that comes to my mind is ‘indecisive’. The markets are moving higher due to global liquidity, which in turn, is on the back of stimulus from the US Federal Reserve. Any talk of tapering by the Fed is throwing the global markets into jitters. Although the current rally is more on the basis of ‘risk-on’ trade and foreign inflows, we have not witnessed any significant increase in India-dedicated fund flows. Whatever flows that are coming into India, I suspect are due to allocations towards the emerging markets.

While there has been some easing on the CAD front due to strict controls on gold imports and the positive impact of rupee depreciation on exports, there is still a problem on the fiscal deficit front. The internals of balance of payments suggest that the good work done on the current account front is being negated by muted net flows (foreign outflows minus foreign inflows) on capital account. Also, the Q2FY14 GDP data shows a clear deferment of subsidies, which effectively means that in order to achieve the budgeted fiscal deficit target, the government will have to either cut down on expenses or pass on the subsidies to next year. Thus, we cannot say with any confidence that the macro picture on the ground has improved, albeit the sentiment has improved a lot in the past few months.

The Q2FY14 corporate results were in line with expectations, with no major surprises on either side. Topline growth for the domestic segment of most of the companies was muted – it was slightly better than that in the previous quarter, but still far away from decent growth.

In terms of profitability, Corporate India managed well overall. Companies have followed strict cost controls in order to maintain their margins. Raw material costs were under check. However, the interest expenses still remained high. Since rupee volatility was much lesser in Q2 as against in Q1, the incidence of huge mark-to-market (MTM) losses on forex was much lesser this time around. Earnings growth is likely to remain muted over FY14 and FY15.

Pharma and IT were big gainers of rupee depreciation, and witnessed significant expansion in margins. Banks managed to maintain their Net Interest Margins (NIMs) by efficiently controlling the cost of funds as well as operational costs. Most of the banks underplayed provisions and reduced coverage ratios substantially to maintain their net profit. Had the banks maintained their previous provision coverage ratios (PCR), their profitability would have been much lower than reported.

The government’s efforts on gold imports and the RBI’s continuous measures have helped the rupee to stabilise. Innovative schemes from the RBI on swaps for banks have yielded fantastic results. Exports have also shown marked improvement in the past couple of months. At the same time, non-oil, non-gold imports have remained stable to muted. All these efforts have brought the rupee down from the Rs 68 levels to Rs 62. While the risk on rupee volatility is much less now it was than three months ago, we still remain cautious on the INR and expect it to range between Rs 62-64 to a dollar. The best upside could be upto Rs 60. Anything below Rs 60 would be a major surprise for us.

An international trigger will come from the tapering of the bond purchase program by the Fed. We expect this to start in Q1CY14. Depending upon the quantum of tapering, we believe that the emerging markets will underperform the developed markets. Within emerging markets, India is likely to be a marked underperformer.

On the domestic front, any reforms agenda initiated by government in the short window of a few months post the assembly elections and before the general elections may provide a positive impetus to the markets. However, we have doubts on this because of the tendency of incumbent governments in any election year to go more after populist measures than reforms. We expect a lot of noise due to the impending general elections in May 2014. The markets may poise themselves in favour of one or the other political party.

At this time, we are optimistic on the Oil & Gas and Energy space. We also expect Pharma and IT to continue outperforming the markets. We have a positive view on the agri-related space too.

We advise retail investors to remain in the equity markets, and have designed three types of portfolios for our clients based on their risk profile. Since volatility is expected to remain at elevated levels, investors should position themselves in fundamentally strong companies. Avoid stocks that have a high beta, move on news flows and are speculative in nature. Stick to quality managements, high cash flow generating companies, and avoid leveraged ones.