Top stocks from good sectors to bet on in a polarised market
With polarisation likely to continue for some more time, find out how to make sure you don’t end up with bad stocks from good sectors.
In the past year, the Sensex gained by 12%, while the small-cap index lost by 18%, a cumulative difference of 30%. Though this is not a new phenomenon—it has been going on for the past several years—the speed of polarisation has increased significantly in the recent past. For example, while the Sensex remained flat on 31 July, the mid- and small-cap indices lost by 0.87% and 0.92%, respectively. The second polarisation is on a sectoral basis. While some sectors, such as the FMCG, IT and health care, continue to generate fabulous returns, others like real estate, capital goods, power and cyclical metals, are bleeding (see chart). Surprisingly, the ongoing rally is among counters that are supposed to be defensive.
How did this happen? To begin with, the smart set of investors moved out of high-beta sectors, such as infra, capital goods and cyclical commodities, to defensive sectors like FMCG, pharma, IT and high-quality private-sector banks some time ago. Since these counters generated positive returns in an otherwise falling broader market, the existing investors are not ready to sell even at higher valuations. Besides, more and more new investors are chasing these sectors. These momentum chasers have started taking their valuations to much higher levels.
This is why these sectors are slowly changing from ‘defensive’ to ‘momentum’. In fact, the polarisation is taking the valuation of some sectors to unsustainable levels. However, this sectoral shift is hardly cause for concern. After all, sector rotation is a common phenomenon in the equity market and winning stocks and sectors keep shifting from one year to the next (see table). Instead, experts are worried about the acute polarisation, which is almost reaching the level of capitulation.
When investors sell equities, giving up any previous gains in the stock price, so that they can move out of the market into less risky investments, it is called capitulation. “Capitulation is happening at both the ends of the market,” says Sanjay Sinha, founder of Citrus Advisors. “While there is panic selling at one end, there is panic buying at the other end,” he adds. While one end of the Sensex is quoting at 30-40 times, the other end is quoting at six to eight times, clearly the current trailing Sensex PE is not displaying a true picture.
The general consensus is that the sectoral/segmental polarisations may continue for some time. This is because the market believes that the RBI and the government may not be able to bring the economy back on track anytime soon. A case in the point is the failed effort by the RBI to support the rupee.
It has only ended up hurting both the equity and debt markets. “It may take another 18 months for the broader economy to recover, and the market may regain its strength only after this happens,” says Phani Shekhar, fund manager, PMS, Angel Broking. With the economy still facing trouble and the interest rate outlook turning muddy, investors have no option but to hide behind these strong sectors and avoid the highly leveraged companies.
The ongoing polarisation may also continue for a little longer due to the sectoral rotation mentioned earlier. For example, most sectors that led the 1988-1992 rally, be it banks or construction, did not participate in the 1998-2000 rally.
During that period, FMCG and pharma had fallen behind after the initial thrust, leaving only the information technology, media and telecom sectors to lead the Sensex.
No matter how the chips fall, it’s worth taking a closer look at these ‘momentum’ sectors, not least because of the emerging trend of division within them. “Compared to a few good stocks, there are several bad ones in each sector,” says Shekhar. This makes sector-wise analysis complicated. So, investors need to be careful that they don’t end up with bad stocks from the right sectors.
Since the depreciating rupee is increasing the cost of imported raw materials, the FMCG sector is now facing margin pressure. With this fact being reflected in the quarterly numbers, minor cracks have started developing in the FMCG counters. The one-year return of this sector is currently at 35%, compared with the one-year return of 52% a week ago.
Despite the correction, FMCG remains the costliest sector and, hence, it may not be able to participate in a big way in the coming years. “Since the FMCG valuations are still high, the investors who are not tracking the market very closely can avoid this sector,” says Shekhar.
Though this sector is a beneficiary of the rupee depreciation and the economic recovery in the US, it continues to be plagued by domestic issues. The most notable among these is the drug prices control order (DPCO), which forces them to sell drugs at lower prices in the domestic market. In addition, investors need to worry about company-specific negative surprises, such as Ranbaxy, Wockhardt, and the like. Therefore, the outperformance by this segment may not be so strong in the coming months.
Another segment that has remained firm during these troubled times is the private-sector banks. However, investors have started separating the quality banks, such as the HDFC Bank, which can report a strong revenue growth without the asset quality issues, from others.
At the same time, investors should not ignore the fact that these banks are working in the current economic environment. This means that the revenue growth slowdown and/or asset quality concerns may well crop up even in the ‘quality’ banks if the economic growth goes down further.
Currently, this continues to be the favourite sector because it is not affected by domestic problems. The hope of economic recovery in the US, a major source of revenue for IT companies, is another reason for the bullishness. The recent depreciation in the rupee will also help IT firms to improve their profitability. “IT may continue to rally and become more expensive before the crash there,” says Sinha.
However, don’t ignore the segmental shift in this sector. “I am not as bullish about the mid-cap IT companies as the large-cap ones,” says Shekhar. Even within the large-cap universe, experts recommend companies like TCS and HCL Tech, which are reporting high growth compared with companies like Infosys and Wipro, both of which are laggards at this point of time.
This sector is a late entrant to the current rally. However, it may participate in it as strongly as during the 2000 rally. This is because several factors are working in its favour. The 2G scam and other issues plaguing the sector are acting as an entry barrier. With the latest entrants finding it difficult to survive, the competitive pressure in the sector has come down significantly.
This explains why strong incumbents like Bharti Airtel and Idea, among others, have managed to report good numbers. Since Bharti is still struggling with its South African operations, investors can bet on Idea, a clear example of the domestic telecom recovery story. Idea Cellular hit a new all-time high last week despite the market being under severe selling pressure.
As far as mutual funds are concerned, the current market has thrown up big winners and equally big losers. However, it is clear that the mutual fund investors who bet on the winning ‘momentum’ sectors are happy. On an average, the funds dedicated to the technology sector have generated a return of 32% in the past year, while those focused on the FMCG and pharma sectors have generated returns of 27% and 21%, respectively.
On the other hand, the funds dedicated to the infrastructure sector have lost 13%. Since the winning stocks are a handful of large-cap names, most mutual funds focused on the smallcap segment are also bleeding.
Expectedly, the diversified fund managers are struggling to cope with polarisation and their performances are starting to feel the impact. This is especially true for those who failed to latch on to the winning sectors/stocks in time. This explains why most diversified equity fund categories have underperformed the Sensex/Nifty during the past year.
For example, the one-year return generated by fund categories like large-cap (8.22%), large- and mid-cap (5.81%), multi-cap (4.26%) and tax planning (6.13%) are well below the returns generated by the Sensex (12.24%) and Nifty (9.81%) during this time.
To help the readers, we have highlighted the schemes that emerged as top outperformers and underperformers. We have included all open-ended diversified funds that are benchmarked to large-cap indices like the Nifty, Sensex and BSE-100. Among the 152 schemes listed, only 51 beat their respective benchmarks in the past year.
The situation is the same if we analyse the schemes benchmarked to BSE-200. Only, the outperformance is restricted to 20 of the 58 schemes. In both cases, only one-third of the managers beat their benchmarks.