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How equity investors should play the falling GDP scenario

Despite the govt and RBI taking several efforts, the slowdown is likely to extend to the medium term.

, ET Bureau|
Updated: Dec 09, 2019, 08.45 AM IST
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Slow economic growth may continue for the medium term as a fallout of structural issues.
The economic slowdown in India became worse in the second quarter of 2019 and the GDP growth rate fell to 4.5%—the lowest in the last 26 quarters (see chart). More bad news followed: the expected economic recovery was not going to happen anytime soon. Most economic indicators like industrial production, merchandise exports, bank credit, freight movement, electricity production, among others, are pointing to weak growth in the first months of the third quarter.

Since this could mean lower growth rate in the third quarter, economists are busy cutting their growth projection for 2019-20. “Growth could weaken further to around 4% in the third quarter of 2019-20, which will mark a trough. For 2019-20, we are cutting our growth forecast from 5.7% to around 4.5%,” says Nikhil Gupta, Lead Economist, Motilal Oswal Securities.

GDP growth rate has been plummeting
With GDP growth hitting a 26-quarter low, investors need to be cautious.
Source: Bloomberg

Medium term slowdown
The government and RBI are taking several steps to fight the slowdown. However, despite the efforts, the slowdown is likely to extend to the medium term. “Due to several structural issues faced by the Indian economy, growth rate is expected remain moderate—around 4-5%—in the short to medium term”, says Santosh Kamath, MD & CIO – India Fixed Income, Franklin Templeton. ‘Debt aversion’ among businesses is one of the main reasons for this. Most businessmen are leaning towards avoiding debt altogether. Even Mukesh Ambani wants to make Reliance Industries debt free in 18 months.

Though good for the long term health of the economy, the ongoing clean-up of the financial sector and massive deleveraging drive by companies will continue to put pressure on medium term growth rates. Fall in nominal GDP growth rate is another worry. Nominal GDP growth rate is real GDP plus inflation and this matrix is very important for stock market investors because the aggregate corporate growth usually mirrors nominal GDP growth rates.

Valuation another concern
While the broader market has reacted to growth concerns, benchmark indices like the Sensex and Nifty are still quoting close to all-time highs, pushed up by a few stocks. Valuation parameters of these indices are also at high levels now. “Though not in the overvaluation zone, their valuation now is above average. In other words, the current market valuation is not supported by the current economic fundamentals,” says Kaushlendra Sengar, Founder and CEO, Advisorymandi.com.

Don’t avoid mid & small caps
Though mid and small caps usually underperform during slow growth periods because industry leaders get stronger during such periods, there is no need to avoid these segments altogether this time. This is because some of the mid-cap stocks are sector leaders (they are midcaps because these sectors are small) and therefore, they should be able to do well even during bad times. Reasonable valuation is another reason to look at these segments now.

Mid-cap stocks that are sector leaders are worth considering
Reasonable valuation is a reason to look at mid-cap stocks right now. Small-caps also offer good opportunities.
Source: Bloomberg, ETIG Database & Capitaline

This is why most stocks selected by us— except Infosys—are from mid-cap space. The small-cap space also offers good opportunities. However, direct equity investing is riskier there and it is better that investors use the mutual funds route to invest in the small-cap segment.

Also read: Intensity of slowdown in certain pockets is surprising: R. Gopalakrishnan, Principal Mutual Fund

Export sectors
The best way to beat the domestic slowdown is to bet on export-oriented sectors like IT, pharmaceuticals, etc. “These low beta stocks are the best bet now. In addition to a stable US economy (their main market), companies from the IT and pharma segments will also benefit from the rupee depreciation triggered by domestic slowdown,” says Sengar. Even among good sectors, investors need to be selective. They should avoid highly valued stocks because the market is now chasing growth at any cost.

The entire pharma industry can be treated as a defensive bet now because their valuation has been down for the last 4-5 years due to their US FDA related woes. However, Cipla continues do well in the US market and its US revenues grew by 26% y-o-y during the second quarter. Another advantage of Cipla is its strong domestic base. Around 40% of its revenues come from India and since people are not going to stop taking medicines during economic slowdown, domestic pharma players are also treated as a good defensive bet. After a dip in the first quarter, domestic sales picked up in the second quarter and the same grew by 29% q-o-q and 6% y-o-y. In addition to the 22% exposure to the North American market, Cipla’s export pie is also diversified to Europe, South Africa, Sub Saharan region, emerging markets from other regions, etc.

Pharma industry can be a defensive bet
Domestic woes will not affect pharmaceutical companies like Cipla.

Unlike pharma, IT is mostly a global play. We decided to pick Infosys because the same is still quoting at a discount to the sector market leader TCS. However, its valuation is expected to improve because several research houses have started upgrading the stock. “We upgrade Infosys to ‘buy’ based on better visibility on growth, stable margin trajectory and the recent stock underperformance,” says a recent HDFC Sec report. Infosys is now focusing more on large deals and the same is yielding results—large deals grew by 77% in the first half of 2019-20. Since Infosys is now growing faster than the sector average, its valuation gap with TCS should come down further.

Organised retailers

While normal retailers and small traders are suffering from the slowdown, triggered mostly by the NBFC-driven liquidity crisis, organised retailers are reporting good revenue growth. The economy-wide shift from unorganised to organised due to the implementation of GST is helping them. More importantly, most of the listed players have come of age now. “The systems and processes of organised retail players are established now, helping them to report faster growth and they did the same in the second quarter,” says Kumar.

Though growth is not an issue, exorbitant valuation is the biggest problem with listed retail chains and many are quoting at PEs well above 100. However, Future Retail is still quoting at a PE of 23.22 against the industry average PE of 98.33. Future Retail always used to quote at low valuations because it is not one of the fancied retail players like D-Mart or Trent. However, things are expected to improve at Future Retail due to the strategic tie-up with and a small stake purchase by Amazon. Future Retail’s new strategy of growth with profitability and deleveraging of balance sheet should also result in better valuation ratios. In addition to the cost savings initiatives, Future Retail also plans to shut down unprofitable small stores.

Real estate players
Though the real estate sector is still facing problems and waiting for the implementation of the government’s bailout package, listed players continue to do well. In other words, the strength of strong and organised players are getting amplified by the ongoing turmoil in the real estate market. For example, aggregate housing sales value and absorption of listed players have moved up by 5% and 9% respectively q-o-q. Small time builders winding operations or selling out to bigger players is the main reason for this. “Even the most conservative industry estimates indicate a staggering number of developers in top cities who have been either been wiped off the map or have merged with organised developers,” says Anuj Puri, Chairman, Anarock Property Consultants.

Organised real estate players will fare well
Phoenix is expected to report better growth in coming years.

As organised retailers are expected to do well in coming years, the best real estate player to bet on now is Phoenix Mills, one of India’s largest mall owners and operators. Phoenix is expected to report better growth in coming years because some of its mall projects are expected to get completed in the next 2-3 years. While its Lucknow mall is expected to be operational in 2019-20, the remaining four are expected to be fully operational between 2020-21 and 2022-23.

Corporate facing banks
Retail-facing banks like HDFC Bank, Kotak Mahindra Bank, etc. will continue to do well even during periods of turmoil. However, analysts are more bullish on corporate facing banks now for three reasons. First, the valuations of corporate facing banks are much lower. Second, they are mostly out of the NPA related problem, which was plaguing them for the last 3-4 years. Third, the business opportunity is also increasing for them. “Through aggressive lending, NBFCs weaned away the SME segments from corporate banks in the past and these banks are now regaining market share due to the pains of NBFCs,” says Kumar.

Federal Bank is a good example of a mid-cap bank with improving fundamentals and reasonable valuations. First, its shift to retail book is playing out well and its retail loan growth was placed at 25% in the second quarter of 2019-20, mostly because of increased contribution from low risk housing and gold loans. Asset quality improvement is also visible and its 30% y-o-y increase in other income during the second quarter was because of recovery from written off accounts. “Given Federal Bank’s largely steady watch-list and healthy capital adequacy ratio coupled with low valuations, we are positive on the stock,” says a recent Axis Securities report. Federal Bank’s price to book ratio is placed at 1.22 times, compared to the industry average of 1.60 times now.

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