AFP

LEADERS AND LAGGARDS: Often fundamental strength is not enough to stay ahead in a race that is dotted with tough hurdles like high inflation, long credit squeeze, global slowdown, an economic downturn in the US, dollar doldrums, crude price uncertainty and a looming general election on the domestic front. The Indian investor is today faced with a tough choice in deciding which star performer to stay with and which ones to desert.

One man's loss is another's gain. Given the stance taken by the RBI and the government, it is evident that till the next general elections are over, focus will be on curbing inflation, even if it means sacrificing some growth.
So, a slowdown is inevitable, and RBI measures, in the next few quarters, will bring down inflation as also the rate at which India Inc has been growing. Investors should thus be ready to see a slowdown in the bottom-line growth of some of the companies in their portfolios.
The ongoing bear phase is expected to hit some sectors hard, while others may go unscathed. An investor should shuffle his portfolio by moving out of sectors that are likely to under-perform, and taking positions in sectors that are expected to weather the storm and bring gains to him. An understanding of the current economic scenario should better help us gauge why a particular sector should be picked or avoided.

The Problem
The year 2008 has certainly not been among the most auspicious for the Indian business. Spiralling crude oil prices, rising inflation and political uncertainty that ended not too long ago (over the Indo-US nuclear deal) have had a negative impact on economic growth.
Inflation accelerated to 12.63 per cent for the week ended August 9, the highest in more than 16 years, surpassing the 12.44 per cent for the previous week. Rising raw material costs have increased the cost of manufacturing of finished products, eating into the margins of companies. Costs of key inputs like steel and cement have shot through the roof in the past 12 months, throbbing key sectors like capital goods, auto and real estate. Rising input costs have compelled firms to raise prices as a result of which they have witnessed a fall in demand, hurting their profitability. Measures to curb inflation (interest rate hikes) have hit the banking sector hard – hurting the economy as
a whole.

DOWN AND OUT
India's problems have only been exacerbated by a slowdown in global economic activity resulting from the US bad loans crisis. So, which sectors will be hit the most?

Oil & Gas
Oil companies have been piling losses, as they have been unable to pass on the increased cost to consumers. The debt on their balance sheet has been increasing over the past few quarters. Higher interest rates will have an adverse effect on bottom-lines of these companies. Till the time oil prices cool down for a sustained period, oil companies will face this problem. Given the current trend, it appears that higher interest rate regime is going to dent the balance sheet of public-sector oil companies, with the exception being upstream companies like Cairn India that does not have to share the subsidy burden. Expected correction in crude prices may hamper the profitability of this company. However, since ONGC shares the subsidy burden of oil marketing companies, the impact on it will be mixed. Investors should avoid oil PSUs despite the fact that they have reached a valuation that is far lower than their replacement cost.

Power
Companies in the power sector are also going to be among the biggest losers in this bear phase. These companies depend a lot on external borrowings for setting up plants. Being high-debt companies, they will be faced with problems as higher interest rates make borrowings expensive. This is expected to hurt profitability.

Real estate
Being one of the most interest rate-sensitive sectors, companies in this sector are expected to take a hit. High interest rates deter customers from buying properties. Also, real estate companies are high-debt companies that secure external borrowings for completion of big projects. For example, real estate developer Unitech has a debt to equity ratio of 3.55.
Many companies in this space are facing difficulties in completing their projects in the absence of capital, as banks and other financial institutions are reluctant to give loans. Moreover, the rate of loan has also gone up and a delay in completion of projects will result in cost over-run. The slowdown would be visible in balance sheet of these companies by the end of this year.

Auto
This sector is expected to be a mixed bag. (Details of auto-parts makers on page 2). On one hand, rising interest rates would compel consumers to postpone their buying decisions, which would hurt demand. But this sector can gain when commodity prices fall, as that would reduce the manufacturing cost, allowing companies to enjoy better margins. For instance, steel and aluminium prices have seen a correction of around 17 per cent and 15 per cent from their peak. In fact, as demand falls, companies may offer discounts to customers to offset the high financing costs, making a new buy not too expensive. In the first quarter, two-wheeler sales were up by merely 7.2 per cent to 18.65 lakh units in comparison to their last year's figure. However, there has not been much impact on the passenger cars segment during the first quarter and sales have gone up by 12.4 per cent to 3.09 lakh units.
Major companies in this space have managed to grow their top line. But many of them failed to grow their bottom line, due to high interest rates and rising input costs. For instance, Ashok Leyland, Bharat Forge, M&M and Maruti Suzuki have witnessed negative growth of 42.65 per cent, 59.01 per cent, 16.67 per cent and 6.75 per cent, respectively.

Consumer goods
Although FMCG is supposed to be a defensive sector, FMCG index, in this bear phase, has lost 8.93 per cent since early January. FMCG firms and consumer durables sector have witnessed decent growth in their top line. But some of them have seen negative bottom line growth. Net profits of ITC, Godrej Consumer and Tata Tea have gone down by 4.36 per cent, 4.21 per cent and 8.53 per cent, respectively, in the last quarter.
Indians have the habit of buying consumer durables through loan. Therefore, when interest rates rise and the costs of loans go up, it further hurts demand, which in turn affects profitability of companies in the sector. However, with the government accepting the Sixth pay commission recommendations and the scheduled release of funds to government employees, demand may go up.

FIGHTING IT OUT
However, there are still certain sectors that investors can consider putting money into. These are either less vulnerable to a slowdown or possess certain advantages that help them perform better than the rest in a falling market.

Telecom
Telecom firms should be able to escape this slowdown. India is the world's fastest growing telecom market and is witnessing big subscriber growth. Inflation is unlikely to discourage people from using phones.
Sales figures of major players are showing the same story. Sales of all major players such as Bharti Airtel (40.65 per cent), Idea Cellular (47.11 per cent) and Reliance Communication (10.19 per cent) have gone up in the last quarter.
Vice-president (research), Kotak Securities, Dipen Shah, says, "The impact on the telecom sector will be limited. It's mainly because during the slowdown, the demand does not come down. As regards capex plans, high interest rate will impact their profitability but since these companies enjoy high profitability, they can meet most of their cash requirement internally. Hence the impact of high interest rate will be limited."

Healthcare
Healthcare is certainly another sector that would not be washed away in this phase. Healthcare spending is not an expense that can be wishfully reduced in a slowdown or inflationary phase. Also, healthcare stocks are not sensitive to interest-rate changes. This gives them an advantage over stocks of other sectors. Currently, the Sensex is down 32 per cent from its January 8 high of 20,873.33 points. In contrast, the Healthcare Index has lost a nominal 0.6 per cent in the same period.

Insurance
Another sector that is expected to enjoy continued customer interest is insurance. Indians today are more willing to spend on security of life and assets and insurance becomes a priority. Therefore, it is a sector that is less likely to be deeply hurt when markets slump.
Now we have some listed companies in this sector that have outperformed the market in the past. Given the current scenario and very low insurance penetration in the country, we are likely to see continued growth in these companies.
It needs to be noted that even in case of sectors discussed above, investors should be careful in selecting companies as industry leaders are better positioned to withstand downturns, and are able to outperform respective sectors in a booming market. Also, companies with higher free cash flows should be given priority over their counterparts.