Picking winners

Every investor is on the look out for the next sector that could deliver above-normal returns. In some bull runs, those sectors appear naturally, like the one we saw in 2000 when the IT sector gave superlative returns. In other cases, excess market liquidity creates artificial sectoral bull runs, like the one we saw in the consumer space in the last two years and recently in the non-banking finance company (NBFC) space.

Which will be the next sector that would outperform the current bull phase? This is hard to predict, given that the Indian market is over-researched by a riot of brokerage houses and the glare they create. A sector that could probably have come up in this round of bull run was e-commerce. But this got played out and busted in the private finance space itself, never making it to the public space.

While a sectoral bull run might remain elusive, a select group of companies could possibly give above normal returns in the coming year. The good part is that these companies would belong a mix of sectors. This distinct set would comprise firms from sectors which had been in trouble for very long.

This would take us to the global financial crisis of 2008. India Inc is still to get over that shock. For more than eight years, companies have been grappling with lower demand and declining margins. But some companies have emerged operationally stronger and niftier in the process of battling the crises, though financially they are still stressed. Such firms could come out of their troubles soon.

Eight-and-a-half years is too long a time for companies to survive on borrowed oxygen. Either they lie on the death bed or make a strong comeback, aided by changes in macro environment, government policy or external environment.

When such companies return to form, their stock prices would start spiking sharply since speculative build-up and institutional holdings in such stocks are pretty low now. When the surge in price coincides with promising top line numbers, institutional investors would come back to the stock, leading to a sustained uptrend.

Such a hope is actually getting played in the market now. To cite an instance, recently, when a real estate firm announced that it would divide its operations into two separate entities—one as an asset-light residential business while the other will have all the commercial properties, possibly with a partner—its stock rose 42 per cent in one single session, taking its market capitalisation beyond the $1- billion mark. This rise in m-cap was on expectation that post-demerger more clarity would emerge on the company’s earnings. Next morning, when another real estate company said it too will de-merge its commercial and residential businesses, its stock also went up.

Going ahead, companies from other sectors would also be coming out with such new plans, presenting investors with an opportunity to gamble. But fortune favours only those who work hard to understand the numbers, have patience and control their greed. Which are the sectors where such outperformers would emerge?

By the latest data, the top five sectors where corporate debt restructuring is happening are infrastructure, iron & steel, EPC, engineering and construction. Together these sectors account for 67 per cent of the debt being restructured, as on December 31, 2016. And the number of companies involved, both listed and unlisted, is 77. The highest number of companies is the iron & steel space (see chart).

Of all the five, a sector investors should keep off is iron & steel, even if a turnaround occurs. For this sector is perennially in trouble. On March 31, 2009, steel topped the list of troubled sectors, with 34 per cent of debt restructuring being planned in that sector alone. Historically, this is also one sector where globally anti-dumping duties had been imposed by various countries for the maximum time. In fact, it was in the steel industry that an anti-dumping duty was first imposed in the world. Also, the steel industry cycle is such that it is tough to find a sustained investment opportunity in this space.

So an investor can look at the remaining four sectors for sustainable investment opportunities. Amongst them, the engineering industry stands out. Its troubles have largely been from weak demand and its debt problems would ease with an economic revival at home and in the global economy. Also, operating margins are high in this sector.

After this, opportunities could be found in the EPC—engineering, procurement and construction—space. EPC companies in the road construction space are already on their way out of their troubles. Those working on sectors like fertilisers and irrigation might also see an end to their troubles, with policy support and domestic economic revival.

A key point to keep in mind is that one should avoid companies where management are over optimistic about a revival. Many a time, they talk up their stock prices to take undue advantage of the bullish market condition. Investors have to go by research; check out the assets which would come handy in the restructuring effort; compare the balance sheet of 2009 and 2016 and see how the numbers have changed in terms of assets and interest costs.

Mind you, these are not investments that will yield short-term results. So such companies should not take up a large part of your portfolio. Only the portion of capital where an investor can afford underperformance should be used to buy into these stocks.

rajivnagpal@mydigitalfc.com

(Rajiv Nagpal is consulting editor, Financial Chronicle)