The year 2008 looks uncannily like 1994-95. Will the lessons of the past work for us in the future given that there have been changes in the business and financial environment?
Some jumped ship early and cut their losses. For those who did not, it looks like a long trudge up to its last highs. And even as that happens, some are looking to enter the market now that prices are low. What would be the smart thing to do? Is there any way that past experiences can point the future for investors in markets?
We decided to look for a period of time that was fairly similar in major macro-economic aspects as those that we face today. We looked for a period of sudden high inflation, we looked for slowing economic growth and high interest rates. We found a perfect fit 14 years back. The years are 1994-95 and this is just after the 1991 liberalisation euphoria got dampened by reality.
The bull run of 1991-92 was just over and the market was still licking its scam-induced wounds. Industry was in shock as it realised that infrastructure and bureaucracy were still India Inc.’s biggest problems. So what happened then? Let’s find out.
The Past And The Present
For the full year 1994-95, annual inflation was 12.60 per cent, up from 8.40 per cent the year before. On a monthly basis, it peaked at 16.90 per cent in February-March 1995. During that fiscal year, gross domestic product (GDP) grew at 7.8 per cent. Meanwhile, the prime lending rate (PLR) of the Reserve Bank of India (RBI), which was 15 per cent in 1994-95, went up by 150 basis points in 1995-96. The year on year (y-o-y) growth in M3 (a broad indicator of money in the system) was 22.40 per cent in 1994-95.
Today, inflation has climbed to 12.14 per cent (for week ended 13 September 2008) from 4 per cent a year ago. The latest growth expectation announced by RBI for 2008-09 is 8 per cent. RBI’s latest PLR is 13.25-14 per cent, up from 12.75-13.25 per cent in July 2008. The y-o-y growth in M3 is currently 21 per cent.
Dharmakirti Joshi, director and principal economist, Crisil, says: “High growth exerted pressure on prices during both time periods. We witnessed over 7 per cent growth in 1994-95 and now, too, the growth is quite robust. Money supply growth had shot up to over 22 per cent in 1994-95. It is above 20 per cent (above the central bank’s target) in the current episode of inflation.”
So, would it be reasonable to expect the future to pan out the same way as a-decade-and-a-half ago?
The Change In The Landscape
While history does repeat itself, it never does it exactly. So, given the changes in business environment, (higher) capital inflows and increased global exposure in India, everything may not be the same.
Abheek Barua, chief economist, HDFC Bank, says: “High inflation seen in 1995 was primarily driven by local demand pressure, spurt in investment and liberalisation. Usually when there is a structural change in the system, spurt in various things leads to a sudden rise in domestic demand. And often supply is not adequate, resulting in high inflation. The recent episode of inflation is qualitatively of a different kind. It has been driven by commodity price movement. Hence, the effect on sectors could be different.”
Subir Gokarn, chief economist, Standard & Poor’s Asia-Pacific, agrees. He says: “High inflation during 1994-95 was the result of overheating. Demand surged because of high investment and export growth. Rural demand was growing steadily. As these came together, it resulted in demand-pull inflation. While
capacity was increasing, it wasn’t keeping pace with demand. Besides, trade barriers were high. Today, inflation is the result
of a supply shock. Higher prices of oil, food and other commodities have been major contributors.” Given the global nature of the shock, individual countries have very little control over the situation, says Gokarn.
During the 1990s, one was used to higher levels of inflation, but now the tolerance for high inflation is low (average inflation in the last seven years has been below 5 per cent); the shock is therefore larger this time, adds Joshi. Besides, the supply shock from oil and commodities has driven the recent bout of inflation, when, in the 1990s, they were quite benign.
Where Does That Leave Us?
Everyone agrees that inflation will be down latest by next year. Shankar Sharma, director & chief global trading strategist, First Global, says the strong inflation we are seeing now will get contained by the same time next year. He adds: “We see commodity prices, including that of agricultural commodities, falling; this will cool inflation significantly, back to comfortable levels.”
“We might see it peak at 13 per cent during October-November,” says Barua. In fact, Joshi thinks it will come down to single digits by March 2009. Interest rates, too, are likely to peak by November, then stabilise and reduce, says Barua.
The need to tighten monetary policy is less acute now. Joshi expects growth to moderate as a result of RBI’s tight money policy. Adds Gokarn: “A slowdown in the economy is already visible. How long it persists will depend on how quickly commodity prices moderate. If oil prices do not go up further, we should see inflation coming down next year, allowing RBI to begin easing interest rates to stimulate growth.”
The expectations create a scenario that is not far different from that of 1995. It took inflation till June 1995 to fall to single digits and till January 1996 to drop to the level of 5 per cent and growth was a modest 7.6 per cent. So, to see the cues that we can take from the last episode, so to speak, Outlook Money looked at five sectors—healthcare, fast-moving consumer goods (FMCG), capital goods, automobiles and banking—and analysed the performance from 1994. These companies are part of the BSE sectoral indices—BSE FMCG index, BSE Healthcare index, BSE Capital Goods index, BSE Auto index and BSE Bankex and 1993-94 is the base year (1994-95 for banks). That gave an indication of what is in store for the next three to four quarters.
Fast-Moving Consumer Goods (FMCG)
Then: Margins for companies in the BSE FMCG index fell during 1995-97, but their turnover grew steadily—during the high-inflation period of 1994-98, the compounded annual growth rate (CAGR) was 22 per cent, but fell to 5 per cent during 2000-04, when inflation was low. There were blips in operating margins and EPS too.
A few companies, such as ITC and Nestle, faced margin pressure only in 1995-96. The sector PE did take a hit though, and recovered to 1994-95 levels only four years later. Even a stock like Hindustan Unilever (HUL), bought in May 1994 for Rs 65-67, saw prices down 10 per cent in May 1995, but returned 32 per cent a year later and over 60 per cent by May 1997.
Now: Turnover in Q1 FY09 has grown slower than a year ago, partly because high crude prices have increased input costs. Premium products could take a hit. Sumit Chopra, head (consumer research and consulting), Datamonitor, says, “Companies have faced some pressure on their growth and margins, but they have also adopted ways to tackle this—product launches, brand positioning and changes in pricing and packaging.”
HUL, for instance, has reduced the weight of its popular Wheel detergent from 1 kg to 850g, while keeping the price unchanged and Godrej has introduced Cinthol, Fair Glow and Godrej no.1 in 50g packs priced at Rs 4-5. Long-term prospects, though, are good, what with rising disposable incomes, growing per capita consumption and increasing penetration in rural areas.
What to do: Invest for steady returns.
In the OLM portfolio: HUL, Britannia Industries, GSK Consumer Healthcare, Colgate Palmolive and Tata Tea.
Healthcare
Then: During 1994-2000, the financial performance of companies that are now in the BSE Healthcare index shows that despite some ups and downs in growth rates, earnings per share (EPS) continued to rise. As for the index, within two years of the peak inflation period, the price-earnings (PE) ratio had recovered to its old levels. Even during inflation, companies such as GSK Pharmaceuticals gave positive, although modest, returns. If an investor had bought GSK Pharma in April 1994 at Rs 210, he would have gained 3 per cent by April 1995 and 16 per cent by In April 1996.
Now: Ranjit Kapadia, head of research (PCG), Prabhudas Lilladher, says: “The pharma sector is likely to report strong growth of over 15 per cent over the next 2-3 years.”
Demand at home and for generics from abroad has been buoyant and more drugs will be available as $60 billion worth will go off patent in 4-5 years. Growth in Q1 FY09 has been a robust 19.30 per cent compared to 14.65 per cent a year ago despite exchange rate losses for companies such as Ranbaxy Laboratories. But if the rupee continues to weaken, exports earnings will rise.
Lupin managing director Kamal Sharma says input costs have gone up because of inflation and a shortage of active pharmaceutical ingredient (API) supplies, especially from China. Also, increasing control over drug prices is worsening the situation. Despite pressures on margins, pharma is expected to see volume-based growth. Anthony Basumatary, managing consultant, healthcare consulting, Datamonitor, India, says stock prices of pharma companies with net positive international exposure (exports greater than imports) will be largely unaffected.
What to do: Invest for modest capital appreciation.
In the OLM portfolio: Lupin, Cadila Healthcare, Alembic, Abbott India, Piramal Healthcare and Bilcare.
Capital Goods
Then: In 1995-96, to contain inflation, the interest rate, as represented by the prime lending rate (PLR), was hiked to 16.50 per cent from 15 per cent the year before. That hit demand and halved the growth rate of companies now in the BSE Capital Goods index. But projects being long-term, growth took five years to flatten and another five to return to double digits.
PE of companies now in the BSE Capital Goods index fell from 21.26 in 1994-95 to 5.46 in 2001-02, reflecting their problems with high inflation. arsen & Toubro (L&T) fell 30 per cent from Rs 290-310 in June 1994 to around Rs 208 in December 1996. ABB fell from Rs 125-130 in April 1994 to Rs 50-55 in 1999, when the industry had stopped growing.
Now: PLR has risen by about 1 percentage point in 2008 and could rise a bit more around October. Neither is inflation likely to ease before the year-end and nor will PLR be cut before that happens. Making matters worse are higher costs of materials such as zinc, steel and copper. The sector slowed down in Q1 FY09 compared to a year ago.
Anand Vyas, research analyst, Anagram Securities, says: “Drawing clues from the initial set of numbers of Q1 FY09, we see margin pressures along with slower order bookings. Going forward, we reckon that cost pressures will be predominant along with corporate capital expenditure slowdown taking its toll on order flows.”
Companies, meanwhile, are trying to protect margins by passing on costs, cutting expenses, placing advance orders for raw materials and using resources better. Things are likely to get a little worse before they turn for the better, possibly sooner than last time.
What to do: Avoid fresh exposures.
In the OLM portfolio: None
Automobiles
Then: The curtailed turnover growth during 1995-97 and a contraction during 1997-99 is evidence of impact of inflation on the auto sector. The margins held up till 1998 as companies traded off turnover and profitability. So, EPS rose steadily. But the slower growth pulled PE ratios down. If an investor had bought Hero Honda in June 1994 at Rs 30-34, he would have lost over 35 per cent in a year and taken another to get back to where he started. Escorts was different. Having bought at Rs 110 in June 1994, an investor would have gained 18 per cent by June 1995, held on to similar gains the following year, but lost 30 per cent by June 1997. Since there was little by way of exports then, most of the impact was from the domestic market. Also, during that phase of high inflation, margins actually grew as demand was high.
Now: This time, demand has slowed down. The companies in the BSE Auto index are feeling the pinch of high interest rates. Loan financed purchases, a substantial portion of the total, are down. That is getting reflected in falling PEs. But factors not present the last time around are also doing their bit. High fuel prices are discouraging new buys. Input costs have risen with commodity prices. Those apart, trends like growth in international contract manufacturing, cross-border product sourcing, and using India as a manufacturing hub, while helping the domestic players, have increased their exposure to dollar exchange rates. So, the global slowdown has hit them. It all shows up in the fall in operating margins for Q1 FY09 to 12.41 per cent from 15.13 per cent a year ago. EPS has flattened out notwithstanding cost cutting and efficiency increasing efforts.
Daljeet Kohli, PCG head, Emkay Global Financial Service, says, “Companies will have to find alternate ways of savings. Hero Honda, for instance, has cut down on ad spends for the last three quarters. By the first half of FY10, things will get better.” Mudit Gupta, project manager, automotive and transportation logistics, Datamonitor India says the automotive industry will have to shift from its supply-centric focus to a more customer-centric focus to ride the inflation. The last time around, the industry took a good half decade to recover. And though Kohli is still bullish on two-wheelers as he expects the growing rural economy, riding on a 30-40 per cent hike in minimum support prices, to hold up sales, it is likely that value gains will take time.
What to do: Avoid
In the OLM portfolio: None
Banking
Then: The 150-basis-point PLR hike to 16.50 per cent in 1995-96 took 8 percentage points off the growth rate of banks and they recovered only three years later. Bank stock PEs nearly halved between 1994-95 and 1997-98.
If you had bought Kotak Mahindra Bank at Rs 42 in June 1994, you would have taken a 14 per cent hit in a year, a 50 per cent loss by 1996, and lost three-fourths of the value by July 1997, when it was trading below Rs 10.
The State Bank of India fared better, but its volatility would have given a lot of headaches. The banking sector, as a whole, took three long years to get back on an even keel.
Now: Because of high interest rates on borrowings individual borrowers are taking less credit and defaulting more. Companies, too, are deferring projects due to high capital costs. The evidence of this slowdown is visible in the turnover growth in the first quarter, which has decreased to 25 per cent from 37.81 per cent a year ago.
Profit margins have thinned during this period and PE has slumped. The interest rate hike in July 2008 will only strengthen this trend.
Says Saurabh Tripathi, partner and director, Boston Consulting Group: “High interest rates will stress out the floating rate retail lending portfolios and the quality of risk management systems of banks will get fully tested. The ones who have diluted credit standards or not fine tuned collections will suffer.”
A further squeeze will come as the bonds that the banks hold as securities lose value and banks book those losses. Volatility in FX could lead to substantial losses, both for clients and banks. These will not be system-wide, but could hit individual banks hard, creating volatility in banking stocks.
What to do: Avoid for the time being.
In the OLM portfolio: None
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