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Stability or reforms?

SI Team in Mumbai | May 17, 2004

If something has to go wrong it will, predicts Murphy's law. After a dream run in the stock markets for the past one year with the Sensex almost doubling before giving away some of its gains amid election uncertainties, it was time for something to go awfully wrong. 

Savvy investors should have guessed the 2004 election results when everyone on Dalal Street without exception voted for the NDA-led government. 

As far as stock markets were concerned, an NDA government was a foregone conclusion -- only its composition was a matter of opinion. 

The Smart Investor survey of 56 investment professionals in the first week of April revealed that 100 per cent of people surveyed were confident that the NDA would come back to power at the Centre. 

Seventy-two per cent said a BJP-led government would be best for the markets. 

When asked about the pace of reforms, 20 per cent said the reform process will be faster with a Congress-led government, 40 per cent said it will progress at the current pace and the balance 40 per cent said it will slow down. 

So when counting began and numbers started looking weak for the NDA, the stock markets cracked and the Sensex wilted 230 points in 15 minutes flat. 

But as the margin for victory for Congress pierced a certain threshold, markets reconciled to a Congress-led government and regained lost ground, citing a stable government as a welcome relief. 

After a gap of nine years the Congress is set to come back to power at the Centre. The Congress-led alliance added up to 219 seats in the Lok Sabha; the Left parties bagged another 64 seats, the highest tally in their history, and the Third Front, which includes the Samajwadi Party (36) and Bahujan Samaj Party (19), has 68 seats. 

So Congress now needs to choose between the Left and the Mulayam Singh Yadav or both to help in the formation of the government. 

From a stock market point of view it is really a choice between stability and reforms. Either way, it may not be best for stock markets. 

If Samajwadi Party and Bahujan Samaj Party are notorious for their fickle approach, the Left may well prove to be an impediment for economic reforms. 

The industry and stock markets are already assuming a Congress-led coalition with support from the Left to form the government, even as the formal decision on whether the Left would join the government would be taken only on Monday. 

Some observers say that Congress is in a much better position this time around in terms of bargaining power since they have close to 230 seats. 

"Pushing economic reforms may not be much of a problem. The Left has also benefited from economic reforms in the states they are ruling. I don't think these governments can afford to ignore reforms at the expense of their own electorate," says Nimish Shah, chief executive, Parag Parikh Financial Advisory Services. 

But the popular belief is that if the Left lends support to a Congress-led coalition, it may want to force through some of its ideologies. Hence, the future of economic reforms is worrisome. 

"We believe that the new government (Congress-led coalition with support from the Left) has a reasonable chance of providing stability over the medium-term, though the reform agenda -- especially in oil and gas and power could be an immediate casualty," says Nikhil Vora, vice president (research), SSKI Securities. 

There may not be a U-turn but economic reforms could definitely slowdown. 

"It is important to look at how the policies are guided by the Congress government in conjunction with their partners as such. Neither the Congress or the Left parties would want a re-election in the next six months," says Nimish Shah. 

The immediate concerns of the stock markets pertain to divestment, capital market friendly moves and taxes. 

Can the Congress push through divestments at all? Will sops for capital markets in the form of lower capital gains tax, etc. continue? Would corporate taxes be raised? The voices from the Congress and the Left are not quite encouraging. 

Market participants are already getting ready to face a populist budget. "Populism could be the agenda in the first budget of the new government. This could be detrimental to the economic growth prospects of India," says Gurunath Mudlapur, head of research, Khandwala Securities. 

Congress is not in favour of strategic sale of profitable PSUs, while the Left front demands stopping all divestment in profitable PSUs. 

The fate of several PSU firms including oil companies HPCL and BPCL, power firm Neyveli Lignite Corp, fertiliser major Rashtriya Chemicals and Fertiliser, which saw spectacular run up in prices over the past one year on hopes of divestment, is now uncertain. 

Besides, hopes of increasing the foreign holding limits in banks and privatisation of some public sector banks, which has been a key trigger for banking stocks in the 2003 rally, may be dampened. Similarly, the NDA-government talked about increasing the FDI limit in retail sector and telecom sector. 

The fact that the Left favours foreign direct investment only in priority areas casts a pall of gloom on the FDI in the above mentioned sectors. And then there is the fear of populist measures coming in. Labour reforms and agricultural reforms, including rationalising subsidies, may be set aside.
 
For oil companies there are more worries. Crude oil price has been rising continuously in the international markets and is ruling at a five-year high of $41 per barrel. However, the domestic prices of petrol and diesel have not been revised upwards for over five months. 

The new government may not effect an increase in fuel prices immediately affecting the profitability of these companies in the ensuing quarters. 

Moreover, the NDA-government had deregulation of gas prices and elimination of subsidies on LPG and kerosene in its economic agenda. This again is unlikely to happen when the Left is part of the current ruling coalition. 

Obviously, markets are set to tank as some amount of exceptions built into stock prices will be defied. The Nifty saw triple-digit losses for the first time on Friday and Sensex plunged to 5068, recording the largest intra-day loss since 2000. 

Further losses cannot be ruled out in the immediate term, say analysts. Yet, the India Shining tone set by the NDA government may not lose its sheen so soon. 

"India's intrinsic growth story led by consumer spending, infrastructure build-out and outsourcing will remain unaffected," says Nikhil Vora. 

One view is also that populist measures may come in, but they may not necessarily slowdown the economy. "We must not forget that the Indian economy has grown in the past despite the subsidies. I don't think the national economic policy may change that much but the calibration might change state wise," says Shah. 

One this is clear. Short-term blips are inevitable. But over the medium-term there will always be stocks that will deliver substantially higher returns than debt. 

Given the new set of constraints, stock investors will have to re-orient their strategies in favour of firms which may not depend too much of government policies. 

Mudlapur's advice is this: "Do not be highly optimistic. It could be costly. The BSE Sensex should hover in a range of 5,000 - 6,000 points for some more time as foreign institutional investors could get slightly defensive in their investment positions and may continue to book profits on market rises. Maintain a defensive portfolio, and invest only on considerable declines." 

For the patient investor, this may be a good opportunity to pick up stocks. "From a long-term investment perspective, markets have given an opportunity for people to get in. If people believe that India will grow, come what may, then definitely it is a market worth investing in. We could see 15-20 per cent growth per annum coming in the next three years," says Nimesh Shah. 

Sectors which may actually benefit may be textiles, gems and jewellery, leather, software, engineering, consumer goods and tourism, according to Mudlapur. Sectors heavily dependent on reforms like oil and gas, fertilisers, sugar, banking and finance may have to bear the brunt of populist moves. 

Sectors like steel and cement may outperform with domestic demand driving prices up. Similarly the housing sector and two-wheeler stocks should be reasonably strong. 

Infotech, auto ancilliaries and pharma stocks should rise with the outsourcing story remaining intact. Equity research firm Refco says FMCG, textiles and cement should outperform this year. SSKI has reduced weights in oil and gas and increased allocation to infotech and pharma stocks. 

Having said that, for long-term investors it should not really matter who rules and how reforms shape up. After all, stock prices are determined by business credentials in the long haul, not politics! 

Amidst this chaos, we bring three equity research professionals to give their best picks. 

Jaideep Goswami, head of research, HDFC Securities.

I would advise investors to wait for clarity to emerge on the common minimum programme and the economic reform programme of the new government. 

The markets are likely to show sluggish trends and there may not be any big rally for some time. Sectors like technology, pharma and cement are not expected to come under any direct impact of any drastic changes in policy. 

Sectors like auto and auto ancillary can also be good bets on correction. One can also look at dividend yield stocks as safe bets in this market. 

Infosys
Current price: Rs 5,081.80

I expect technology stocks to do well. Earnings growth is likely to improve going forward. Rupee appreciation is also likely to reverse because of an outflow of foreign investments from the country. This means there will be less pressure on margins. 

The outlook for the US economy, too, is encouraging, which could encourage more technology spending by US firms. Infy is expected to post an EPS growth of 21 per cent to Rs 228. 

Dr Reddy's Laboratories
Current price: Rs 839.25

The company's valuations are comparatively cheap. Though there is no immediate trigger for the scrip to climb higher, the bright outlook for pharma companies and the company's strong fundamentals bode well for the future. The scrip has seen a correction in the recent past, which indicates a buying opportunity at the counter. 

Going forward, Dr Reddy's is likely to post an EPS growth of 36 per cent at Rs 51.20 in FY05. 

Grasim
Current price: Rs 1,081.15

The restructuring taking place at Grasim with regard to L&T's cement division is positive. It is likely to result in major logistics benefits for Grasim. 

The company's three business divisions (cement, sponge iron and VSF) are doing well. This, along with the good outlook for the cement industry, makes Grasim a good bet. It is expected to post an EPS of Rs 94.50 in FY05, up from last year's Rs 62.40. 

Ashok Leyland
Current price: Rs 220.55

Ashok Leyland is a good valuation play. The commercial vehicle sector is also poised for growth. Low interest rates are likely to benefit the company. 

Given low valuations and the expected growth in the auto sector, the stock is attractive at current levels. The firm is also expected to record an EPS of Rs 24.60, up from Rs 16.40 in FY04. 

Aurobindo Pharma
Current price: Rs 392.95

The pharma sector is among those unlikely to be affected by changes in government policies. Aurobindo has added capacities which have received USFDA approval. 
The company's generics exports is also on the growth path. The stock looks attractive on the valuation front, too. The company is expected to achieve an estimated EPS of Rs 40.70 in FY05 (Rs 26.50 in FY04). 


Nimish Shah, chief executive, Parag Prikh Financial Advisory Services

The market's behaviour in the last few days has thrown up a lot of opportunities. Herd mentality amongst investors has made a lot of stocks attractive. 

Fear of PSU divestment not happening has pushed down stocks that were never divestment targets. Gail and Concor are cases where investors can take advantage. Also, certain oil stocks valuations like HPCL look good from the dividend yield perspective. 

So, these are the times when Mr Market gives an opportunity to long-term investors to take advantage of the behavioural anomalies affecting other investors who sell in panic.
 
Till now, we have seen an improvement in the financials of companies because of lower interest rates, reduction in working capital and rationalisation of resources. 

From now onwards, the growth is going to come purely from higher volumes. So we have to look at companies which have restructured their assets and are going to grow on the back of the economic boom.
 
Certain stocks in metals sector also look attractive. These include Hindustan Zinc, Hindalco and Tisco. 

Hindustan Zinc
Current price: Rs 77.45

HZL is expected to benefit from the demand-supply mismatch in the industry. It has managed to reduce its costs in the last few quarters. The company plans to bring down costs to $490 per tonne. 

That will further improve the bottomline. With the demand situation expected to improve on the back of further cost reduction, valuations could well see a re-rating. 

Aventis and Wyeth Lederle
Current price: Rs 757.60 and Rs 419.20

With the patent regime scheduled to change from 2005, MNC pharma companies are going to be in for interesting times. This is a segment where we could see big growth. 
Both Aventis and Wyeth Lederle possess the capability to launch latest products. These products are mostly high-end ones and the realisation is higher than that of other products. 

Besides, these products have niche markets. Valuations of both these companies are very attractive at current levels. 

HDFC Bank
Current price: Rs 360.65

HDFC Bank's percentage of the income coming from treasury is very less. This year the interest rates are going to be very volatile, and will probably inch up towards the end of the year. 

So from that point of view, they have a higher income coming in from other sources rather than the treasury income, which insulates them from interest rate risk. 

Also they have the advantage in terms of expansion and the branch net work and reach.

HDFC Bank has also been able to expand into various other segments, like the broking industry. The bank is also very well poised in terms of valuations. 


Rajesh Jain, head of research, P-Sec.

I believe that the markets should pick up the pieces after a small decline and key sector stocks should shine. Fundamentals would be the key now. 

Reliance
Current price: Rs 476.80

The bellwether should benefit from any ensuing upsides in the markets after the drubbing. 

The fact that it is a key Sensex stock along with its inherent fundamental strength puts it in good stead. I am also positive on the prospects of Reliance's telecom and petroleum business going forward. 

Apart from the cash break-even in the year of launch in its telecom business, the significant improvement in petrochemical margins and aggressive retaining plans in refining are positive factors and a lot of value in the stock would be unleashed going forward.
 
ITC
Current price: Rs 914.50

The threat of higher excise duty notwithstanding, the FMCG major's fundamentals are expected to keep it in good stead. The overall growth in its businesses, the extension of existing products to target markets and strong growth in gross revenues form a case for investment. 

The upturn in the economy, which lends improved occupancies and room realisations in the hotel business, is another positive for the company. 

Infosys
Current price: Rs 5,081.80

The safe-haven-in-bad-times stock is another which goes on to provide value in ensuing times. 

The company's fundamentals and recent reorganisation of its business into certain verticals to provide greater industry specialisation and focus are expected to work in its favour. 

Higher revenue expectations from the IT bellwether and its ability to meet them is another positive. The company's entry into the consulting arena is also expected to bring in high-end work. 

Bharti Tele
Current price: Rs 143.60

The company's solid business model and its recent upbeat results are positives. The sustained growth acceleration in mobile subscriber base as well as the company's ability to sustain its market share in the face of competitive pressures set it apart. 

Bharti's business is likely to remain in a high growth phase for the next couple of years and valuations reflect the strong growth ahead. 

Bhel
Current price: Rs 499.90

The engineering major is a compelling buy, even if the divestment does not take place. The company's burgeoning order-book position and a slew of new orders are expected to lend tremendous visibility to its earnings and revenue outlook going forward. 

The company's thrust on the overseas business and the resultant buoyancy in exports also augur well for it. The higher investments in the infrastructure is also a positive for the company.



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