Portfolio selection is a patient act

Outlining the risks and the way to de-risk your portfolio.

MUMBAI: How does one deal with a manic depressive?

A manic depressive has mood swings from deep despair to high euphoria. Manic depressives require medical attention and a lot of understanding and patience.

That’s what the Sensex requires now, a lot of understanding and patience.

The Sensex has behaved like a manic depressive in the last one month, plunging to 9000 levels from 10500 and going up at the same pace as it came down.

Intraday swings have been extremely high, with average daily intraday swing (the percentage change from highs and lows) at over 4.41% for the month of June.

Market watchers would call this kind of Sensex movements “unhealthy”. Unhealthy markets tend to drive away genuine investors and usually leads to further fall in value as stocks in weak hands cannot stay up for long.

Maintain minimum cash levels of 25%
The way the Sensex is behaving, a minimum cash level of around 25% is a must. The cash is a cushion from many factors such as:
a) selling in panic as the market crashes
b) picking value stocks at lower levels
c) decreases anxiety factor, and,
d) enables deployment quickly if the market moves up

Cash is the best hedge available in the market as hedging with derivatives leads to unsound decisions if the market moves against expectations and the Sensex has been doing just that.

Outline risks and derisk portfolios in the market

The fall in the Sensex of around 26% in over a month’s time is because the markets are foreseeing risks ahead, which could potentially upset earnings estimates or temper high growth expectations.

What are the risks that investors face in equities?
Inflation: Inflation is creeping up. As measured by the changes in wholesale price index (WPI), inflation has come in at 5.24% against market expectations of 5.01%, for the week ended June 10, 2006. The WPI index went up from 201.9 for the week ended June 3, 2006 to 203 for the week ended June 10, 2006. The index was at 192.9 in the corresponding period last year. Inflation is going up on the back of higher primary article prices, higher fuel prices and increasing commodity prices. The government and the Reserve Bank of India (RBI) has made it a priority to fight inflationary pressures in the economy. The government will do its part by curbing all price increases in products such as agricultural commodities, metals, cement etc. The RBI will increase interest rates and curtail liquidity to curb demand led inflation.

Interest rates: The RBI raised benchmark rates in June by 25 basis points (a hundred basis points makes a percentage point, or what’s commonly alluded to as one percent). The move was unscheduled and prompted by inflation and volatile financial market conditions.

The move was followed by the government increasing the size of a scheduled government bond auction in order to bring down liquidity. These two measures took the ten-year benchmark Government of India security yield to 8.10%, from 7.70% levels at the beginning of the month, an increase of 40 basis points.

The rise in yields have increased borrowing costs for the corporate sector and the government and this effect will be felt on corporate earnings down the line. This rise in interest rates will also affect capital expenditure plans of companies leading to slowdown in capacity expansions and mergers and acquisitions activity.

Currency:  Current account deficits (merchandise trade balance plus invisibles) are brought into focus bearish times. The current account started going into deficit in the year 2004-05 and is forecast by economists at $26 billion for the year 2006-07. If the current account deficit is not balanced by capital flows, then the currency tends to weaken. Falling stock markets and rising inflation are not positive for capital flows and indications are that the rupee could weaken against the dollar. The rupee has already depreciated by 5% this calendar year, in light of the factors mentioned above.

Politics:  The Communist Party-supported government at the Centre has virtually not carried out any reforms in the last two years. Disinvestment and foreign direct investment have been put on hold due to Left protests. The government has gone against the dismantling of the administered pricing mechanism of oil, and has let public sector oil companies bleed rather than passing on oil prices to end users. The lack of reforms will tell on the economy down the line, especially with the government running a large fiscal deficit at over 4% of GDP.

Oil - High oil prices have affected the consumer, government finances and the trade balance of the country. High oil prices have started taking its toll on inflation and interest rates and continuing high oil prices will slow down the economy.

Sectors to avoid
The risks mentioned above have a direct impact on many sectors of the economy. High oil prices and higher interest rates affect automobiles directly and all the sectors surrounding automobiles indirectly. High oil prices in the Indian context also affect public sector oil companies as they are forced to share the burden of subsidies. Oil prices also affect power producers using oil or its equivalent as the main fuel source.

Inflation has its impact on increasing raw material costs, affecting margins of companies who are not able to pass on the increased prices to consumers. Pure-play FMCGs, two-wheelers, metals such as steel, drug companies are all affected by rising inflation.

Banks and other financials are affected by interest rates and liquidity, leading to losses in their investment portfolio, declining net interest margins and slower loan growth.

Companies which have recently raised funds in dollars are facing a double whammy in higher US interest rates and stronger dollar. They would have to start provisioning for this in the coming quarters and this would have an impact on their bottomline.

Sectors which can outperform
Information technology, especially the large software service companies are highly derisked against economic risks as earnings are largely from exports. These companies have high earnings visibility, zero debt and gain from currency depreciation. Overweight the portfolio on information technology stocks.

Pharma companies looking for windfall gains from US patent expiry’s also present a good risk return profile in current economic environment. These companies have a steady cash flow from domestic sales and any have earnings upsides from selling directly or supplying to companies that have rights to sell in the US any drug that goes off patent.

Engineering, the large ones that have healthy order books also present a defensive investment. While valuations are on the higher side (20 x plus one-year forward), the order book protects downside to a large extent.

Investors could work on such a thought process to traverse tricky market conditions which exists at the moment. Patience and understanding will work.