Pockets of Pessimism

banner-octIndian Pharma: Fat pitch in sight, get ready for a hard swing!

It may seem odd to talk about a fat pitch when Nifty is at a striking distance from a five digit mark (sorry, struck and gone well past that mark is another matter). It is no secret that Sensex has been soaring to stratospheric valuations on surging liquidity from both domestic and foreign investors. If anything, stocks are simmering at frothy levels for a while now. Yes, this is true for much of the sectors where it is a story of trumpets blaring amid ever-rising list of multi-baggers. But that hasn’t stopped the markets to punish prices in certain select pockets to seductive levels on growing uncertainties in the short-to-medium term. If one looks around for sectors where drums are beating amid plunging stock prices, it is unlikely that one would return empty-handed.

No prizes, of course, for guessing the sectors that have been the laggards in this bull run. It is widely known that the top stocks that have spectacularly soured the sentiments are from the infamous group of three sectors, namely IT, Telecom and Pharma. While all of them are going thro’ sectoral short-term setbacks, on measure of mis-pricing relative to long-term business fundamentals, Pharma seems to be more promising.

In a rare instance of unfortunate coincidence, confluence of factors have miraculously come together to conspire a deadly blow to the fortunes of pharma industry. The sector that helped India to build global prominence is suddenly facing huge set of headwinds on account of following developments:

  • Increased regulatory scrutiny (Increasing cases of warning letters and import warnings from US FDA).
  • Consolidation of distributors in US resulting in pricing pressures for generics
  • FDA’s increased focus on fast-tracking drug clearances leading to more competition in generics and hence putting pressure on prices.
  • NPPA (National Pharmaceutical Pricing Authority) bringing more drugs under price control in domestic market.
  • The risk of dictum from Indian govt. on generics prescription in the local market.
  • To top it all, GST hiccups couldn’t have come at a worse time i.e. destocking and delay in restocking in domestic formulations.

Very rarely, such a series of setbacks suddenly surround a particular sector and cause stock prices to get mis-appraised in a disproportional degree. Pharma is going thro such a painful period in this so called perfect storm. Are these setbacks structural or cyclical? If anything, FDA’s vigorous vigil will play a vital role in streamlining the quality process which is positive in the long-term to achieve bigger business scale in generics. Similarly, accelerated drug clearances by FDA, while putting pricing pressures, will also help small and medium players to gain faster access to US generics. In our recent meeting, CEO of one of the promising mid-tier pharma companies, echoed this long-term view. Moreover, much of the domestic challenges listed above should not dent the long-term prospects for the sector, except the dictum of generic prescription, which many industry insiders don’t see it coming given the practical challenges in implementation. With govt. going slow on this, the noise around it has subsided significantly.

As someone wise said, great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be mis-priced manically. Pharma seems to be offering that classical value opportunities to those who have lots of patient capital. More so with small and mid-cap pharma (stock specific, of course) where relative undervaluation can give additional kicker.

Happy Value Investing!

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Elevated Equity Placements!

Market Overview..

Story on domestic flows is still going strong with monthly MF investments in equity market sustaining at a record level of 10K cr. But that hasn’t stopped the markets to turn weaker this month too. For the second consecutive month, markets are staring at a negative return in June, marginal though. What explains this divergence? With strong domestic flows, one would have expected the markets to sustain strength. Is it something to do with short-term challenges expected in GST implementation? While markets expect short-term pain in GST, it does not fully explain the sudden weakness in the broader markets. Where did the domestic liquidity go, if not into buying stocks in the secondary market? The answer seems to lie in what is happening outside the secondary markets. The heightened action in the primary probably holds the key on why the markets have turned subdued in secondary. Liquidity seems to have found an outlet in the primary placements.

As per estimates by Prime Database, Indian companies have raised nearly Rs 13,800cr so far through IPOs & FPOs (Follow on Public Offer) and nearly Rs 34,000cr through QIPs (Qualified Institutional Placements) so far in the current calendar year. Two infrastructure investment trusts have raised about Rs 7300cr in the current calendar year. The industry estimates suggest, close to $20Bn will be raised from equity placements alone this calendar year, exceeding last year’s numbers by more than double. With this level of elevated placements in primary market, secondary seems to have lost the vigour it had shown in the earlier months.

So much so for liquidity and bulls can’t rely on that alone for further strength. This coupled with subdued expectation on Q1 earnings from GST related challenges, has turned the sentiment weak and could result in more volatile times ahead. For value investors, this loss of momentum is a welcome opportunity as it provides a brilliant window to add to their portfolios with value emerging in select pockets and in select sectors. Watch out for volatile weeks!

Finding Refuge in Arbitrage

Indian market: Is there a way to ride this reckless phase without taking too much risk?

In normal times, bargains come in broader markets, not in blue chips. Broader small and midcaps quote at a meaningful discount to larger blue chips given their low scale and poor liquidity. But when mercury rises and when market moves up manically into a frothy zone, this equation turns upside down to drive valuation multiples into a bizarre zone. Currently we are going thro’ one such phase where small caps are sizzling at a significant premium to large caps. In an intriguing equation, smaller the size, spicier has the valuation become in this new bull-run. Below chart brilliantly captures this valuation conundrum by plotting the multiple across the market-caps. Micro caps have become the new masters when comes to multiples. On one year forward basis, BSE small cap index is at a scary multiple (of over 40+) while their bigger cousins are peevishly behind at 20+ level. As to be expected, the tiny ones (SME platform) are trading at the top of the table.

BizNotes_July17_Rev1

hese vagaries in valuations are not without any reasons. Changing composition of flows has contributed to this new found charm for the lower and middle rung of the markets. Earlier, flows were dominated by FIIs and hence the skew towards large caps as FIIs usually fancy larger market cap companies. With domestic flows taking the centre stage now, small and midcaps have started shining in a spectacular fashion. Given the long-term drivers for a structural shift in household savings from physical assets to financial assets, dazzle in domestic flows is unlikely to diminish, esp. when the other avenues for savings (fixed income) are much less attractive.

In such a situation, when excess domestic liquidity is expected to keep the valuation elevated for small and midcaps, how does one navigate this reckless run without taking too much risks (till eventual correction sets in).

Here goes the most interesting way one can handle investments in an overvalued market such as the current one:

Go tactical with asset allocation thro’ Arbitrage:

As any value investor would understand, building long term positions in a rapidly rising market, while would make the portfolio shine in the short-run, will dent its long-term performance without exception. As is often said, long-term outperformance comes from short-term underperformance. But there are ways by which one can make the short-term performance little more palatable. The trick is to tout for tactical short-term opportunities, but without taking the market risks. Event based arbitrage is one such tactical model that can help to add glitter to the portfolio without carrying the MTM (mark-to-market) risks. They are primarily short-to-medium term opportunities driven by event based corporate actions like buyback, open-offer and other special situations including mergers, demergers and delisting. The most interesting aspect of this tactical allocation model based on arbitrage is that, while it enhances the portfolio returns in the short-term by serving as a superior substitute for cash parking, it releases the cash at the most opportune time (during corrections) for enabling long-term portfolio building.

Besides arbitrage, there are two other critical ways one can deal with expensive markets. Bull market provides a brilliant opportunity to exit from positions that may not hold huge promise at reasonable prices, so to say to cleanup the past mistakes. Similarly, it also provides a huge window to prune profitable positions by booking profits. Both these actions help raising cash levels which can come handy during the market correction that eventually follows any one-way bull run.

Happy Value Investing!