The novice is often introduced to the stock market by the classic quote "everything that goes up must come down". The rates at which stocks go down remain undefined and fiercely opinionated. This is so because equity investing is more of an art rather then science. But once they are up they go down no doubt and when they do there is chaos when they don't there is confusion.
One of the most interesting things I learnt in this game was that you had to lose only 80% from the top to wipe out 400% of the gains. When channels go about trumpeting that we have lost just 12% from the top after having gone up 100% over the last 15 months the analysis hides more then it reveals. Extending the earlier argument the same data can be interpreted as " Gentlemen please hang on for dear life. While we think that by losing another 38 percentage points you are just about to lose the profits of the past 15 months none of our analysts have the courage of thinking beyond 200 points. When the index was at 8300 we talked of a correction that could take us to 8100, when it was 8100 we talked about 7900 and now we are sure that we are just about 200 points away from the bottom."
In the backdrop of the rhetoric stated above let us see where the index could take us over the medium term. After 2001 the cyclical companies in India reflected tremendous underutilized capacities. While the leaders were just about managing to break even, the second line companies were busy restructuring debt and struggling. As demand increased (fuelled by cheap money) these companies increased production. This surge in aggregate demand worked well with companies as they started to milk their assets much more than before. The result of this operating leverage was a huge growth in profits since depreciation and interest costs remained unaffected. Interest costs actually declined for many of these companies as the R.B.I kept on reducing rates. Now after 4 years of growth these companies seem to have hit the 100% capacity hurdle. The beauty with steel, aluminum, cement and other cyclicals is that as the price of their end product rises a number of projects that were closed down earlier suddenly become viable. This releases a gush of new supply. Rising commodity prices encourage entrepreneurs to start green field projects. Banks and Financial Institutions that were earlier not disbursing loans become eager to advance as project viability increases manifold.
As benefits of operating leverage appear exhausted companies are reverting back to the drawing board stage to increase capacities. The Indian Corporate sector is set to put in more then US $ 150 billion in capex over the next few years. While a good proportion of this capacity expansion to be financed by internal accruals borrowings would be resorted to both from the domestic market and abroad. This additional supply of paper (equity and debt) is bound to push up interest rates. On an average the cost of capital is bound to go up by 150 basis points over the next 18 to 24 months. Higher coupons hits the leveraged company more then the others. Moreover the Fed's inclination to move away from the cheap money policy would not benefit the suppliers of paper.
Now in the backdrop of expanded capital the profits from these new ventures would take some time to kick in. Also since the dollar has started an intermediate up move against all the major currencies the impact on commodity prices is bound to be negative. The US dollar has a high negative correlation to commodities. The net effect of these events would be weaker commodity prices, lower profit growth for corporates, increased expense on account of depreciation and interest, lower ROCE and ROE. Lower Return ratios are perfect catalysts for PE contraction. So while we may have a situation where companies keep reporting better profits the market cap may actually decline. A classic case in point is the Shanghai Stock exchange where in spite of China's stupendous GDP growth of more then 8% the index has continued to disappoint. One of the many reasons being Chinese companies are inefficient users of capital. Instead of focusing on profit growth these companies remain concerned to increasing top line and market share.
The BSE Index is like a big large joint family where the elders decide and veto the direction. The heavy weights like Infosys ITC, HLL & Bharti Televentures would continue to chug along Theoretically Reliance should be negatively impacted as it has perennially run a large capex program but the management's ability to deliver on a consistent basis would reduce the impact. SBI should give way since hardening interest rates has never benefited banks bond prices being inversely related to interest rates. Since the stock trades at a PE of less then 10 times forward there would not be much to lose. HDFC is a classic. It has continuously displayed a growth of more then 20% for the past so many years and one can bet it to continue doing the same way. The companies affected would be the cyclicals especially the ones from the metals and commodity space. But Tata Steel, Hindalco, Tata Motors & ACC have smaller weightings in the index. We may therefore have a situation where the index may not fall but retail investors holding a portfolio of cyclical and commodity stocks may actually be shaven off.
A few sectors that would remain unaffected by this capex cycle could be Technology, Two wheelers, FMCG, Retail and Media. Therefore investors trying to create a long-term portfolio should keep the interest rate cycle in mind before jumping into the so-called bargains in the metals and the commodity space.
Basant Maheshwari is the Managing Proprietor at Financial Strategist. A Cost Accountant with a Post Graduate Diploma in Equity Research & Analysis from ICFAI Hyderabad) Basant is also an AMFI certified mutual funds advisor He occasionally investing in new businesses and also advises people on making portfolio investments through mutual funds. Comments and suggestions are invited at &