Stock Sector

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PREFACE

CONTENTS

Year 2003 was in many ways a land mark. We witnessed taming of the bull in the debt markets and a re-emergence of strong buying interest in the stock markets. The change, although some time in the offing, came as a shock to investors who were closed to the idea of taking on risk to earn a return. This change also hurt those who believed that debt funds could never post negative returns. These developments took place almost simultaneously, as if it were planned to jerk the risk averse investor into taking on some risk!

Finding a method in the madness ---------------------------------------------------- 3

Retail investors, always the last to board a rally, did the same again in 2003. Towards the end of the year, when the stock market rally seemed to be in its final stages, there was a rush towards monthly income plans from mutual funds. The higher the equity exposure, the greater was the interest! Given the happenings in recent weeks, a lot of investors must already be reconsidering their investments in aggressive monthly income plans.

Software Funds: Shining inconsistently -------------------------------------------- 11

This most recent experience of retail investors only reinforces the view that investments are driven more by opportunity than need. It is pertinent that retail investors devise an asset allocation plan that suits their risk profile and needs, and more importantly, stick to the plan.

Identifying a domestic pharma stock: Do’s and Don’ts ------------------------ 22

Basic Industries Funds: Basic ally for the future? -------------------------------- 5 FMCG Funds: More stable than fast-moving --------------------------------------- 7 Pharma funds: Not the right remedy! ------------------------------------------------- 9

Miscellaneous funds: The others! ---------------------------------------------------- 13 Identifying an aluminium stock: Do’s and Don’ts -------------------------------- 15 Identifying a banking stock: Do’s and Don’ts ------------------------------------- 19

Identifying an FMCG stock: Do’s and Don’ts -------------------------------------- 25 Identifying an OIL stock: Do’s and Don’ts ------------------------------------------ 28

This issue of Money Simplified aims to take forward the task we have undertaken - to empower you with information, research and tools so that you can realise your investment objectives. Part one of this booklet lays out a strategy for investing in sector funds and also analyses the leading types of funds available. Sector funds, as we have often stated, do not suit the profile of most investors. But for those who have a better understanding of the happenings in the economy and its sectors, these funds do present an opportunity to earn better than average returns. The second part of the issue deals with the do's and don'ts while selecting stocks in the six most popular sectors - a task that may seem easy but is not. This section has been powered by our sister website www.equitymaster.com. We hope this book will, like all our initiatives, help you make better investment decisions! Thank you,

Identifying a software stock: Do’s and D on’ts ------------------------------------ 31

Content provided by : Quantum Information Services Limited Websites www.personalfn.com www.equitymaster.com Contact Information: 404, Damji Shamji Vidyavihar (W), Mumbai - 58 Tel No: 022 - 5599 1234 Email: [email protected]

Team Personalfn January, 2004 DISCLAIMER This booklet a) is for Private Circulation only and not for sale. b) is only for information purposes and Quantum Information Services Limited (Personalfn) is not providing any professional/investment advice through it and Personalfn disclaims warranty of any kind, whether express or implied, as to any matter/content contained in this booklet, including without limitation the implied warranties of merchantability and fitness for a particular purpose. Personalfn will not be responsible for any loss or liability incurred by the user as a consequence of his taking any investment decisions based on the contents of this booklet. Use of this booklet is at the user’s own risk. The user must make his own investment decisions based on his specific investment objective and financial position and using such independent advisors as he believes necessary. Information contained in this Report is believed to be reliable but Personalfn does not warrant its completeness or accuracy. Copyright: Quantum Information Services Limited.

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FINDING A METHOD IN THE MADNESS… Sectoral funds have been the bugbear of many an investor. Their legacy from 19992000 is still fresh in the minds of investors and there is reservation to invest in them going forward. While some investors nevertheless muster the courage to invest in them, this is often on impulse or a hot tip from the neighbourhood broker or the like. In other words, there is little thought process, if at all. On our part, we have tried to find a method in the madness. Make no mistake; this is not about glorifying sectoral funds. Far from it! This is about defining, rather redefining, how sectoral funds can be used to meet one’s investment objectives. Historically, the problem with sector funds was not the high-risk involved, it was a problem of the high-risk not being conveyed adequately to the retail investor. Consequently they got projected as a sure-fire mantra to clock above average growth at average risk. Since the premise was flawed, the disastrous results were not surprising. But what if we change the premise? Will that help show sectoral funds in a ‘different’ light? We will let the experts answer this question. Mr. Prashant Jain (Head-Equity, HDFC Mutual Fund) asserts, ‘Sectoral funds are suitable for the initiated, sophisticated investor who has a view on a particular sector and knows when to enter and exit.’ This comes from a fund manager who has never handled a sector fund and therefore has no hidden agenda. The question is if sector funds are risky and can yet find a place in investor portfolios, how does one grapple with this contradiction? Having a large portion of your assets in sector funds is without doubt a high-risk strategy that you would do well to avoid. However, smaller 3

exposures (about 5% of the total investable surplus even for the aggressive investor) to sector funds may actually prove rewarding. Lets see how: 1. For an aggressive investor who invests directly in the stock markets, and takes stock and sector-specific risks, sector funds help him dilute both these risks. Say for instance Mr. Aggressive Investor has an investable surplus of Rs 1,000,000 and decides to invest Rs 50,000 in just one pharma stock, lets say Ranbaxy. This would involve active tracking of the stock and the sector to make the investment worth his while. Even then the risk of owning 5% in a single stock isn’t exactly a prudent decision. What he can do is invest an equal or a slightly lower sun in a pharma fund. That way the risk is diversified across about 15 stocks. So while the sector risk (in pharma) remains the same, the stock risk (in Ranbaxy) is diluted considerably. This is what a pharma fund can do for him if he wants to invest in just one pharma stock. If he wants to invest in several pharma stocks, then a pharma fund is not just a recommended solution, it is a must, because he is unlikely to manage his pharma portfolio as competently as a pharma fund manager. 2. If Mr. Aggressive Investor has a view on sectors like banking, software, pharma and petroleum, then sector funds can serve him equally well. Instead of investing in individual stocks across these sectors, investing in the sector funds would help him diversify across over 50 stocks in these 4 sectors. He can determine his allocation to each sector and invest accordingly in a bouquet of sector funds.

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If he had to do this by investing directly in individual stocks across these 4 sectors it would become cumbersome and time-consuming. 3. If Mr. Aggressive Investor is sure of a sector’s potential but is not aware of which companies are best placed to exploit the opportunities within the sector, then a sector fund is the answer to his dilemma. For instance, Mr. Aggressive Investor has heard of the great BPO (business processing outsourcing) opportunity but doesn’t really know the companies that are in the forefront within the segment. He can leave the stock selection in the hands of an experienced and competent software fund manager by investing in a software fund. Having drawn some strategies around sector funds, the investor must note that the fundamental premise still remains the same. The investor still needs to be aware of the sectoral developments and book profits at regular intervals whenever there is an uptick in the NAVs. Otherwise,

he may find himself at the same level after 2-3 years (as has been the experience in the past). As we have seen, sectoral funds do not deliver over the long-term (3-5 years) but perform in short bursts of 3-6 months, that too at infrequent intervals (not to say they never will!). If the investor finds the active monitoring of sectors a burdensome task, then he should stick to diversified equity funds and spread his risks across a wider gamut of sectors. A good sector fund must ideally: 1. Have at least 15-20 stocks in the portfolio 2. Not have more than 60% of net assets in the top 10 stocks 3. Be well-diversified across segments within the sector 4. Have an expense ratio of less than 2.50%, which is how most diversified equity funds are placed. 5. Have an asset base of at least Rs 500 m so as to benefit from scale economies.

PREMIUM RESEARCH, DELIVERED TO YOUR MAILBOX! Presenting FundSelect, a Mutual Fund Advisory Service from Personalfn. To know more, please click here.

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BASIC INDUSTRIES FUNDS: BASIC ALLY FOR THE FUTURE? Introduction Sector funds are consistently criticised on account of low diversification which makes them high risk–high return propositions. This is one aspect where basic industries funds have an edge over other sector funds. As the name suggests these funds largely invest in stocks from all the six basic industries i.e. steel, cement, power, petrochemicals, oil and gas and engineering. The fund manager has the liberty to choose stocks from any/ all of the abovementioned industries. Investment rationale and sector outlook 1. Growth in the engineering industry is directly related to growth in industrial and production activities. Year 2003 was a particularly good one for the engineering industry as the index of industrial production (IIP) grew by 6.1%. Development of infrastructure, power sector reforms and growth in the automation business are likely to aid the industry in the future as well. 2. The petrochemical industry (which is cyclical in nature) saw capacity additions at the lowest in the last ten years. With no major capacity additions expected in the next two years, prices have started moving up. Clearly the industry is on an upturn.

3. The oil and gas industry looks upbeat following the new exploration and licensing policy (NELP) initiated by the Government. Companies have started focusing on exports to tackle the oversupply scenario and healthy growth can be expected going forward. Peer comparison The past year, which witnessed a rally in the equity markets, has been a rewarding one for basic industries funds. The top performing fund, Alliance Basic Industries Fund (157.1%) has topped the list followed by UTI GSF-Petro Fund (138.4%). Even JM Basic Fund (87.9%), which comes in at the bottom of the rankings, managed to rake in impressive returns. However, returns over a short period can be misleading. Track record over 3-5 years provides an accurate picture about the funds’ performance. The laggard in the past 12 months JM Basic Fund emerges as a strong contender over the longer term. The fund outscores its peers with returns of 50.0% CAGR over 3-Yr and 52.4% CAGR over 5-Yr. Basic industries funds have managed to match and at times even outperform some of the leading diversified equity funds as far as absolute returns are concerned.

HEADING FOR GLORY? SCHEME NAME

NAV (Rs)

ALLIANCE BASIC IND. 30.23 JM BASIC 14.64 PRU ICICI POWER 31.07 TATA SELECT EQUITY 17.72 UTI GSF- PETRO 25.54 Diversified Equity Funds FRANKLIN BLUECHIP 55.43 SUNDARAM GROWTH 28.32

Return (%) 1 yr 3 yr

SI

SD (%)

36.8 37.3 12.9 18.5 40.9

7.4 7.6 5.9 6.8 9.4

37.7 138.9 34.2 29.9 33.0 127.0 29.8 23.2

7.1 6.2

3m 28.7 20.3 25.1 36.7 34.8

157.1 87.9 131.5 130.2 138.4

50.1 50.0 34.1 27.6 45.6

SHARPE RATIO (%)

ASSETS (Rs m)

EXP. RATIO (%)

0.7 0.5 0.7 0.5 0.5

851 221 8,058 590 1,017

2.5 NA 2.5 2.5 2.7

0.6 0.6

1,489 814

2.1 2.3

(NAV data as on Jan 15, 2004. Growth over 1-Yr is CAGR. Expense ratio as in FY- 03. SI - Since Inception; SD - Standard Deviation)

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Volatility Standard deviation of funds measures by how much the values have deviated from the mean of the values and highlights the element of risk associated with the fund. Since the funds being profiled in this case are sector funds, the standard deviation figures assume a higher degree of importance. Interestingly, the basic industries funds have standard deviation figures which are remarkably similar to those of diversified equity funds. For example diversified equity funds like Franklin India Bluechip Fund (7.12%) and Sundaram Growth Fund (6.22 %) have comparable standard deviation figures. Risk-adjusted return However, basic industries funds disappoint in terms of risk adjusted returns. The Sharpe ratio measures the returns offered by the fund vis-à-vis those offered by a risk-free instrument. Sector funds are high risk propositions and it’s only fair that investors should be rewarded with commensurate returns. Even diversified equity funds Franklin India Bluechip (0.57%) and Sundaram Growth (0.55%) have managed to outperform basic industries funds. Investors would clearly be better placed by investing in diversified equity funds. AUMs & Expense ratios Wide disparities exist in the area of funds’ net assets. The assets under management for basic industries funds range from Rs 220 m to over Rs 1,000 m. A larger asset size may act as a constraining factor for the fund manager. It is very vital for a fund manager to seamlessly maneuver between various socks as per changing market conditions. Larger the assets managed, lower is the fund manager’s ability to reposition his portfolio. In the basic industries funds category the expense ratios are largely in tune with the assets managed.

Portfolio Strategy The portfolio strategies of basic sector funds throw up a very interesting picture. Schemes like JM Basic Fund and UTI-GSF Petro Fund in the first category, rigidly invest in basic industries’ stocks. The petrochemical and oil & gas sectors stand out as the most dominant ones. The number of stocks held rarely exceeds 15– 17 in number, indicating high concentration levels. For example, UTIGSF Petro fund holds just 14 stocks with more than 70% in the top 5 funds. The second category i.e. Tata Select Equity and Alliance Basic Industries have adopted a different strategy by investing in a much broader spectrum of stocks. Apart from conventional basic industries, these funds are also invested in pharmaceuticals, textiles, software, banking etc. These funds have taken diversification with the sector funds category one step further. Conclusion The national Gross Domestic Product (GDP) has risen steadily and basic industries are known to be closely linked to the GDP. The Reserve Bank of India recently chose to revise upwards the GDP estimate to 7% for financial year 2004. A bullish outlook for the Indian economy clearly augurs well for investors in basic industries funds. Basic industries funds offer fund managers marginally more breathing space than a conventional sector fund. However, a sector fund continues to be a high risk proposition. Also the risk-adjusted returns of basic industries funds do not inspire too much confidence. A key point to remember is that basic industries tend to be largely cyclical in nature. Hence knowing when to enter and exit assumes prime importance. Think of investing in the fund only if you have a view on basic industries and can read them well, else diversified equity funds are your best bet!

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FMCG FUNDS: MORE STABLE THAN FAST-MOVING… Introduction The fast-moving consumer goods (FMCG) sector has historically played second fiddle to its more aggressive peers software and pharma, and over the last 12 months even to basic industries. The FMCG sector is defensive by nature and investors who have invested in it expecting it to fly like other sector funds are obviously disappointed. But does this mean that FMCG funds should not command a place in investor portfolios? Hopefully, you will have the answer to this and other questions by the time you finish reading this. Investment rationale and sector outlook 1. Typically, the FMCG sector consists broadly of personal care, cosmetics, home products, branded foods and tobacco. If one were to break these down further, it would include dental care products, soaps, detergents, surface cleaning products, skin care, hair care products, ‘atta’, ice-creams and chocolates. 2. The industry is volume driven and is characterised by low margins. Products are branded and backed by marketing, heavy advertising, slick packaging and strong distribution networks. 3. In stark contrast to 2002, monsoons have been relatively widespread in

2003. As per CMIE (Center for Monitoring Indian Economy) estimates, agricultural output is likely to record a 10.7% growth in FY04. At an average GDP growth of 5.5% until FY2007, the present consumer demand is set to boom by almost 60% over this period. This will give a fillip to the sector. Peer Comparison There is little doubt that FMCG funds have delivered over the course of the rally. It’s only the magnitude of the growth that investors are ‘concerned’ about. Over 3 months, they have grown significantly, but the 12-month performances are rather mixed. We have Magnum FMCG (82.5%) on one hand that has delivered, while Franklin FMCG (51.9%) on the other hand has disappointed. However over the longer time frame (3-Yr) Franklin FMCG (12.1%) emerges as the leader. Volatility There is little to differentiate FMCG funds on the volatility front. Franklin FMCG (4.5%) the top performer over the longer period scores well in this parameter too. Magnum FMCG (5.6%), the leader in the short term category surfaces as the most volatile in the peer group. When you consider that a conservative diversified equity fund like Sundaram Growth Fund (6.22%) and an aggressive one like

Franklin India Bluechip (7.12%) have relatively higher volatility, FMCG funds have redeemed themselves on this count. Again this is a reflection of the defensive nature of the FMCG sector. Risk-adjusted return On the risk-adjusted parameter, FMCG funds haven’t rewarded investors for the higher sector risk. For instance, Magnum FMCG (0.35%) leads the peer group but nevertheless trails Sundaram Growth Fund (0.55%) and Franklin India Bluechip Fund (0.57%). This implies that diversified equity fund investors have been rewarded more per unit of risk vis-à-vis FMCG fund investors. AUMs and Expense ratios All FMCG funds in the peer group have an asset base of less than Rs 500 m. This indicates that the funds operate on a smallish asset base and do not have the economies of scale necessary for effective fund management. In terms of expenses, the disparities are stark – Magnum FMCG (1.54 %) has reined in expenses most effectively while Franklin FMCG (2.50%) fares poorly on this count. Portfolio Strategy A peculiarity with the FMCG sector is that

despite being a sector it embraces a variety of segments. For instance, we have personal care, cosmetics, home products, branded foods, tobacco, and all these segments have varying demand and supply mechanics. This tends to lend a degree of diversification to the sector and widens the fund manager’s choice considerably. While fund managers have been largely faithful in their stock selection, we have often seen companies like Asian Paints and Zee TV sneak into FMCG fund portfolios. Funds have maintained a good mix of large cap and mid cap FMCG stocks. The fund portfolios are very concentrated with about 12-15 stocks. They are particularly concentrated in their top 10 picks, which generally account for over 70% of assets. Conclusion While the FMCG sector does hold a lot of potential, investors need to understand the fundamentals. They will have to be patient because none of the potential is going to unlock overnight. So the investment horizon will have to be adjusted accordingly. Aggressive investors who have chosen to invest in a sector fund will nonetheless have to come to terms with the fact that FMCG at the end of the day is still a defensive sector.

NOT YET OFF THE BLOCKS… SCHEME NAME

NAV (Rs)

3m

FRANKLIN FMCG 16.57 MAGNUM FMCG 10.82 PRU ICICI FMCG 13.12 Diversified Equity Funds FRANKLIN BLUECHIP 55.43 SUNDARAM GROWTH 28.32

18.6 30.4 21.6

Return (%) 1 yr 3 yr

SI

SD (%)

SHARPE RATIO (%)

ASSETS (Rs m)

EXP. RATIO (%)

51.9 12.1 11.8 82.5 9.2 2.3 62.6 9.4 5.4

4.5 5.6 5.3

0.3 0.4 0.2

239 177 431

2.5 1.5 2.1

37.7 138.9 34.2 29.9 33.0 127.0 29.8 23.2

7.1 6.2

0.6 0.6

1,489 814

2.1 2.3

(NAV data as on Jan 15, 2004. Growth over 1-Yr is CAGR. Expense ratio as in FY- 03 - $ Indicates Nov 03. SI - Since Inception; SD - Standard Deviation)

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PHARMA FUNDS: NOT THE RIGHT REMEDY! Introduction 2003 was a good year for the Indian pharmaceutical industry. While growth in domestic markets was stunted, revenues from international markets continued to grow strongly. Needless to say pharma funds had a good run at the markets as well. Investment rationale & sector outlook 1. The cabinet has approved a third amendment to The Patent Act, signaling government’s commitment towards accepting the TRIPS agreement. As a result, performance of MNC pharma companies is likely to get a fillip. 2. The US government has taken policy decisions like inclusion of generic drugs in its Mediclaim policy and has also eased the process of introducing generics in the markets. Domestic companies with a presence in the US markets are likely to benefit from the same. 3. Given India’s expertise in manufacturing and the fact that the highest number of US-FDA approved manufacturing plants is located in India, outsourcing opportunities will drive growth for domestic companies. However competition from other countries like China is likely to intensify as well.

Peer comparison During the 1-Yr period, Magnum Pharma Fund (107.9%) comfortably outscores its peers Franklin Pharma Fund (85.1%) and UTI Pharma and Healthcare Fund (73.6%). However, over a longer period i.e. 3 years, the variations taper down sharply and Magnum Pharma Fund (24.7%) holds a tiny edge over its peers. The returns since inception are modest considering that investors undertake higher risk by investing in sector funds. Even equity funds like Sundaram Growth Fund (127.0%) and Franklin India Bluechip (138.9%) have managed to beat pharma funds hollow during a 1-Yr period. Over a longer term period (3-Yr to 5-Yr) equity funds fare far better vis-à-vis pharma funds. Volatility Standard deviation measures the volatility of returns and the risk levels associated with the fund. Sector funds are intrinsically risk prone considering the low diversification levels. However, pharma funds have managed to curtail volatility levels to those seen in diversified equity funds. Diversified equity funds like Sundaram Growth Fund (6.22%) and Franklin India Bluechip (7.12%) are on par with the pharma funds being profiled.

Risk-adjusted return Risk adjusted returns measure how well a given fund has performed vis-à-vis a risk free instrument. In other words, it determines how much return it has given the investor per unit of risk. Pharma funds are positioned as high risk-high return offerings. The returns offered by pharma funds are moderate at best, when you consider that diversified equity funds Sundaram Growth Fund (0.55%) and Franklin India Bluechip Fund (0.57%) have outperformed them. Obviously this is one case where the risk-return tradeoff hasn’t paid off.

Portfolio strategy The investment horizon for a pharma fund is fairly limited as can be seen from their holdings. On an average pharma funds are invested in 18-20 stocks. The concentrated holdings are a cause for worry. Nearly 50% of the entire corpus is invested in the top 5 stocks. Again, an abnormally high holding in individual stocks is a common trend. For example in the case of Franklin Pharma Fund, a single stock accounts for nearly 19% of net assets i.e. 1/5th of the corpus amount. Even one stock losing steam can adversely affect the entire scheme.

AUMs and Expense ratios A correlation between the pharma funds’ assets managed and expense ratios can be observed. UTI Pharma which holds the highest corpus i.e. Rs 1,218 m also accounts for the highest expense ratio (3.51%) amongst its peers. This is surprising as one would ideally expect expense ratios to be lower for larger funds (you do not need more fund managers as the corpus grows).

Conclusion Despite the optimism in the pharma industry, retail investors need to be objective. The concentrated portfolios, mediocre returns in particular stand out as factors to watch out for. Only investors who have a very clear understanding and can read into the intricacies of the sector should consider investing in pharma funds.

HAVE THEY DONE ENOUGH? SCHEME NAME

NAV (Rs)

3m

MAGNUM PHARMA 17.27 FRANKLIN PHARMA 17.12 UTI PHARMA & HEALTH. 16.20 Diversified Equity Funds FRANKLIN BLUECHIP 55.43 SUNDARAM GROWTH 28.32

Return (%) 1 yr 3 yr

SI

SD (%)

SHARPE RATIO (%)

ASSETS (Rs m)

EXP. RATIO (%)

26.1 107.9 24.7 15.3 19.1 85.1 20.8 13.6 15.8 73.6 20.9 11.0

7.0 6.5 5.9

0.4 0.4 0.4

253 1,030 1,218

1.5 2.5 3.5

37.7 138.9 34.2 29.9 33.0 127.0 29.8 23.2

7.1 6.2

0.6 0.6

1,489 814

2.1 2.3

(NAV data as on Jan 15, 2004. Growth over 1-Yr is CAGR. Expense ratio as in FY- 03. SI - Since Inception; SD - Standard Deviation)

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SOFTWARE FUNDS: SHINING INCONSISTENTLY Introduction If there is one sector in the country that has fired the imagination of many an investor it is software. In 1999, this excitement gave birth to software funds, which till date continue to excite and disappoint alike. Questions on top of investor’s mind are – Should one invest in software funds? What percentage of assets should one ideally apportion to such funds? These are some of the questions we have answered over here. Investment rationale and sector outlook 1. The Indian software sector has borne the brunt of the global (read, the US) economic slowdown during the past 2 years. However, increasingly, there have been outsourcing opportunities for domestic companies. 2. Indian software majors are shrugging off the much-hyped concern regarding pressure on margins. The is more focus on increased utilisation levels, scale benefits from investments in human resources and selling and marketing infrastructure abroad. 3. The real test for software companies lies in their ability to move up the value

chain and derive benefits from their initiatives on the scalability fronts. As is evident from the table, software funds perform in bursts across shorter time frames. Over 3 months, they have grown significantly, but the 12-month performance isn’t as impressive, when you consider that all that appreciation has come only over the last 3-6 months. Over longer time frames (3-Yr) most software funds disappoint and are in negative territory. Even those who have a positive growth fail to impress. Birla Opportunities (earlier Birla IT) and Tata Life Sciences are two funds that catch the eye with impressive performances over the short and long term. However, Birla Opportunities had more than 50% of assets in cash for a considerable period of time to stem the rot during the tech slide. Volatility Where volatility is concerned, perhaps no single investment within the gamut of mutual fund products compares to a software fund. The sector by nature is volatile, and what can be more volatile than one software stock? A dozen software

ALL THAT GLITTERS… SCHEME NAME

NAV (Rs)

3m

ALLIANCE NEW MILL. 7.21 BIRLA INDIA OPP. 23.00 DSP-ML TECH.COM 8.27 FRANKLIN INFOTECH 20.51 FRANKLIN INTERNET 9.30 MAGNUM IT FUND 8.63 PRU ICICI TECH. 5.66 TATA LIFE SC & TECH 18.83 UTI GSF- SOFTWARE 11.69 Diversified Equity Funds FRANKLIN BLUECHIP 55.43 SUNDARAM GROWTH 28.32

Return (%) 1 yr 3 yr

SI

SD (%)

SHARPE RATIO (%)

ASSETS (Rs m)

EXP. RATIO (%)

28.5 70.5 -0.4 -17.6 25.2 73.6 21.2 10.7 31.3 70.9 8.5 -0.9 23.8 40.8 -3.9 30.8 28.8 89.4 12.5 -0.8 24.9 46.3 -9.3 7.0 27.5 69.0 4.7 -13.5 28.6 116.6 24.9 17.5 23.4 43.8 -5.1 1.7

7.6 6.8 7.5 8.5 7.0 8.1 8.9 6.9 8.4

0.3 0.4 0.3 0.2 0.4 0.1 0.3 0.4 0.2

1,731 686 265 1,767 2,711 539 1,818 365 2,405

2.4 2.5 1.9 2.39$ 2.33$ 1.7 2.4 2.5 -

37.7 138.9 34.2 29.9 33.0 127.0 29.8 23.2

7.1 6.2

0.6 0.6

1,489 814

2.1 2.3

(NAV data as on Jan 15, 2004. Growth over 1-Yr is CAGR. Expense ratio as in FY- 03 - $ Indicates Nov 03. SI - Since Inception; SD - Standard Deviation)

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stocks! Like their NAV performances, Birla Opportunities (standard deviation 6.79%) and Tata Life Sciences (6.86%) fare decidedly better on volatility. Four funds in the peer group have a standard deviation of over 8%. Compare this to Sundaram Growth Fund (6.22%) and Franklin India Bluechip (7.12%) and one gets an idea of how volatile software funds can be vis-à-vis diversified equity funds. Risk-adjusted return One question risk-taking investors will be most certainly asking is whether the return these generate justifies their high risk levels. Over 3 years, software funds really haven’t justified the higher risk. However, there have been times when they have intermittently given investors a return commensurate with the risk undertaken. Again this has more to do with the vagaries of the sector than incompetent fund management. Birla Opportunities (Sharpe Ratio – 0.42%) and Tata Life Sciences (0.45%) lead the group, but nevertheless trail Sundaram Growth Fund (0.55%) and Franklin India Bluechip Fund (0.57%). This indicates that diversified equity funds have rewarded investors more per unit of risk than software funds. AUMs and Expense ratios In terms of assets under management (AUMs), software funds are better placed than their counterparts in FMCG, pharma and basic industries. In terms of expenses, we have a disparate field with DSP ML Tech (1.87%) and Magnum IT (1.68%) at the lower end and Birla Opportunities (2.45%) and Tata Life Sciences (2.49%) at the higher end. Portfolio Strategy Do software funds have a strategy in place? Not really, at least not a long-term strategy. Software funds invest across various segments - software, hardware, infotech training, telecom, media and even bio-technology. They invest in large caps,

mid/small caps and even unlisted companies. The latter in particular were a rage in 1999-2000 when software/internet startups were a dime a dozen. While it may seem that software funds lack character this has a lot to do with the tech crash post-2000 when the harsh reality of managing a one-sector fund caught up with the fund. Fund managers were forced to look beyond the technology sector and it helped that they had a very ‘broad-based’ investment mandate that extended to practically any sector/company that was even remotely using technology. So we had software funds buying Hindustan Lever because the company had launched an initiative to link all their suppliers with the help of technology. Some funds went right out and applied for a change of investment objective with SEBI to turn more diversified. Mr. Chetan Sehgal (Director-Research, Franklin Templeton Investments) points out, ‘Very often we see that many of the sector fund managers themselves are not committed to the sector and have tried to broaden the scope of investments within a few years of the launch of those funds.’ Of course, this brings into question the need for a software fund that is going to be diversified across several other sectors, but that is another matter. Conclusion Software funds haven’t delivered value over the long-term, at least not to the extent that was expected of them. Diversified equity funds have done significantly better. While software funds have outperformed peer groups across shorter time frames of 3-6 months, in our view this is way below the ideal time horizon for an equity mutual fund (at least 3-5 years). Sophisticated (and high risk) investors can allocate a portion of their surplus (about 5% of total assets) to software funds, and they will need to book profits when the going is good without getting too greedy.

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MISCELLANEOUS FUNDS: THE OTHERS! After having discussed the popular categories of sector funds i.e. software funds, pharma funds etc, its time to appraise the miscellaneous category. Ingenious asset management companies (AMCs) can be credited for the existence of these schemes. While sector funds themselves are a distinctive category, funds in the miscellaneous category are an even rarer breed. 1) MNC Funds Peer comparison As the name suggests, MNC funds aim to generate capital appreciation by investing in multinational companies. The performance over the past 1-Yr has been impressive and there is little to differentiate the two funds. However Birla MNC Fund consistently outscores the Kotak MNC Fund over a longer term period i.e. 3-5 years. Despite the impressive performances, MNC funds are not a patch on diversified equity funds where absolute returns are concerned. Volatility and risk-adjusted returns MNC funds rate favorably as compared to equity funds when volatility of returns is used as a benchmark. Kotak MNC Fund (6.02%) and Birla MNC Fund (5.67%) outperform their equity counterparts Franklin India Bluechip Fund (7.12%) and Sundaram Growth Fund (6.21%). However MNC funds falter in risk-adjusted returns; Franklin India Bluechip Fund SCHEME NAME

NAV (Rs)

3m

KOTAK MNC 15.22 BIRLA MNC 55.17 RELIANCE BANKING 16.99 Diversified Equity Funds FRANKLIN BLUECHIP 55.43 SUNDARAM GROWTH 28.32

31.2 32.3 23.8

(0.57%) and Sundaram Growth Fund (0.55%). AUMs and expense ratios Oddly, despite the inconsistencies in assets managed, both the funds display similarities in their expense ratios. Birla MNC Fund (net assets of Rs 1,521 m) and Kotak MNC Fund (net assets of Rs 405 m) have similar expense ratios of 2.48% and 2.47% respectively. Higher expense ratios eat into investors’ returns and should be countermanded by equally high returns. Portfolio strategy Portfolios for MNC funds are more diversified than those of their sectoral counterparts. The funds invest in approximately 20-22 stocks. However the top 5 stocks account for nearly 40% of the entire corpus. Debt instruments also find a place in the portfolios albeit in smaller proportions. 2) Banking Funds Reliance capital mutual fund boasts of the only banking mutual fund in the country. Reliance Banking Fund purports to generate continuous returns by actively investing in equity/equity related or fixed income securities of banks. The fund’s recent origin (less than 1-Yr) and non existence of peers make it difficult to critically evaluate the fund’s performance. In the 3-month duration diversified equity

Return (%) 1 yr 3 yr

SI

SD (%)

SHARPE RATIO (%)

ASSETS (Rs m)

EXP. RATIO (%)

93.8 17.7 14.0 90.4 23.2 20.4 NM NM 68.9

6.0 5.7 9.0

0.4 0.4 0.9

405 1,521 309

2.5 2.5 0.0

37.7 138.9 34.2 29.9 33.0 127.0 29.8 23.2

7.1 6.2

0.6 0.6

1,489 814

2.1 2.3

funds, Franklin India Bluechip Fund (37.7%) and Sundaram Growth Fund (33.0%) have out performed Reliance Banking Fund (23.8%). Reliance Banking Fund also doesn’t compare favorably in terms of volatility. The Standard Deviation figures for Reliance Banking Fund (8.97%) are far higher than those of Franklin India Bluechip (7.12%) and Sundaram Growth Fund (6.21%). Reliance Banking Fund (0.85%) heavily outscores equity funds in the riskadjusted returns. The fund’s short history could be responsible for the same. The fund’s portfolio throws up an interesting picture. Reliance Banking Fund is probably the only sector scheme which has a healthy diversification across asset classes i.e. equity and debt. Apart from a sizeable equity holding (65%-70%), the corpus is also invested in term deposits, bonds and debentures. Obviously all the above assets relate to the banking industry. Reliance Banking Fund is constructed like a balanced fund within the sector scheme category. However the equity component is low on diversification (top 5 stocks accounting for nearly 47% of the corpus amount) making the fund prone to volatility.

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Conclusion Sector specific funds mirror the risk-return trade off in complete totality. Only individuals with a high appetite for risk should invest in these funds. Remember the proverb which went “Don’t put all your eggs in the same basket”. That is precisely what you do when you invest in sector specific funds.

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(NAV data as on Jan 15, 2004. Growth over 1-Yr is CAGR. Expense ratio as in FY- 03. SI - Since Inception; SD - Standard Deviation)

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acquired from the primary producers, which is in the form of aluminium ingots and billets. The user industries for this segment would be the packaging industry (foils), auto ancillary (wheels), etc.

IDENTIFYING AN ALUMINIUM STOCK: DO’S AND DON’TS Investing in commodity stocks is always a risky proposition because the cyclicality of the sector is one of the most important criteria, which decides the fate of your investments. It must be noted that the only way to successful investing lies in the understanding of a company and identifying the story before the market does and also, identifying which company has a better potential of outperforming its sector. Keeping this in mind, we have tried to highlight here some factors one should keep in mind before investing in an aluminium sector company. Profile The biggest trait of the aluminium industry, being a commodity, is the cyclicality of the industry, wherein there are periodic ups and downs for the industry. Also, it is a highly capital intensive sector (Rs 200 bn required for a 1 million tonne greenfield capacity expansion). Cost efficiency plays a critical role in the survival of a company in the sector for which, control over inputs is of utmost importance. Fortunately, the advantage of having the 5th largest bauxite reserves in the world coupled with cheap

and abundant labour helps the Indian companies to retain the distinction of being the lowest cost producers in the world. On basis of scale of operations and level of integration, aluminium producers can be categorized into the following two types: l

l

Integrated producers / Primary producers: These have manufacturing facilities right from the mining of bauxite (raw material) to producing aluminium ingots (finished product). Some companies may even go a step further and have downstream manufacturing facilities such as manufacturing of semi-fabricated products. For companies, which have restricted themselves from venturing into the downstream segment, the user industries are basically the secondary producers, while some others have a presence in the international markets through exports of alumina. Secondary producers: For this segment of producers, which are involved in the production of semifabricated products, the raw material is

PROFITABILITY REVENUES MULTIPLIED

VOLUMES

EXPENSES

DIFFERENCE

LINKED TO ECONOMIC

DOMESTIC / EXPORTS INFRASTRUCTURE SPENDING (ROADS, RAILS, BRIDGES, ETC.) HOUSING SECTOR OTHER USER INDUSTRIES (POWER, TRANSPORTATION, ETC.)

REALISATIONS LONDON METAL EXCHANGE

POWER

CYCLICAL IN NATURE

EMPLOYEES

PLAYER POSITIONING

FREIGHT

VALUE ADDED PRODUCTS

INTEREST

COMPETITION

COMPETITION

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RAW MATERIALS

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Aluminium products can be classified under three categories. Rolled products find applications in automobiles, consumer durable, construction and engineering sectors. Extrusions include bars, pipes and tubes that find usage in the electrical and the transportation sectors. Finally, foils are used in the packaging sector. These are high-value products and thus enjoy higher margins. Now let us proceed with the various parameters indicated in the flowchart above: Revenues Revenues are a function of volumes and realisations. Lets look at the volumes side first. l

Volumes: Aluminium, being a core industry, is dependent to a large extent on the economic growth of a country. Its impact on the aluminium industry can be gauged from the fact that due to the slowdown in world economies in 2001, the western world demand for the metal declined by almost 6% with demand from the US falling by a sharp 12%. Similarly, in the Indian context, economic slowdown does influence the demand for aluminium, as its user industries like infrastructure, transportation, consumer durables and housing get affected. It must be noted that the consumption pattern of aluminium in India is tilted largely in favour of power and electricity (over 1/3 rd of total consumption), as against the world consumption pattern, wherein transportation, especially airlines, has a major role to play.

l

Competition: This also plays a significant role in determining the prospects of the aluminium industry. Domestic aluminium producers face intense competition from global majors, chiefly due to the latter’s larger scale of operations (giving them benefits of economies of scale). It must be noted that by virtue of the fact that Indian aluminium producers are one of the lowest cost producers of the metal in the world, they have a presence in the international markets.

On the domestic front, protection from competition is in the form of tariffs, which makes the landed cost of aluminium into the country comparatively expensive visà-vis the domestic produce. The industry is also looking at increasing volume sales by presenting itself to the steel-user industries as a good substitute option on the basis of its qualities of strength and lesser weight. This could be a potential opportunity for aluminum, as user industries like auto, railways, etc. where fuel efficiency is an important factor, could switch their preferences to aluminium. Realisations Some factors, which determine the realisations for the company, are: l

Cyclicality: The aluminium industry is cyclical in nature. This means that the realisations in the industry follow a pattern, cyclical ups and downs. The reason for this is simple. When aluminium prices start to move up, in order to cash in on the price rise, not only does the mothballed capacity but also fresh capacity comes into being, which ultimately distorts the demandsupply picture and prices start to crumble. During the downturn, only the efficient producers are able to override the tide, while many others shut shop. This slowly leads to a favourable

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demand-supply mismatch and as economy continues to grow, prices start to strengthen again. l

l

Value added products: Realisations are also dependant to a large extent on the products profile of the company. Companies with a larger presence in value added segments (downstream segment) like extrusions, foils, aluminium wheels, etc. are able to realise higher value for their products, which assists margin improvement. Competition: Competition plays a major role in affecting realisations, as international aluminium companies with huge capacities (thus an appetite to bear lower realisations) have the pricing power. However, since Indian companies are the lowest cost producers in the world, the pressure of imports is negated to that extent as Indian companies can price their products competitively. Indian companies are currently protected in the domestic markets from international competition, owing to tariffs imposed on aluminium imports. However, with the government committed to bringing down the tariff levels, companies will have to improve further and/or maintain cost efficiencies to protect their margins while combating the flow of imports into the country.

Expenses As pointed above, in the face of increasing competition, survival would depend on cost efficiency, more so in times of a downturn. It is, thus, imperative for these companies to keep a strict check on their expenses and maintain and/or improve their standards of efficiency. Some of these expenses are pertaining to raw materials, power, employees and interest cost.

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Since raw material and power constitute over 50% of the total operating expenses, companies with captive facilities have an added advantage as purchasing these requirements from the market is expensive relative to their sourcing from internal (captive) facilities. Employee expense is the next big contributor with a share of 12%-15% of the total operating expenses. Hence, employee efficiency plays an important role in curbing expenses and protecting the profitability. Finally, as aluminium companies are capital-intensive in nature and have significant exposure to debt, managing interest cost is of utmost importance. Key parameters to be kept in mind while investing in an aluminium company: l

l

l

Cyclicality of the sector: This is a very important point, which should be remembered, before investing in an aluminium stock. This is because; this very factor can make or mar the fortunes of the sector and its companies. Investments into an aluminium stock near the peak of its cycle could result in a huge chunk of the investment being wiped it. Nevertheless, identifying the bottom of the cycle is not an easy task. Integration advantage: Whether the company is integrated aluminium producer or not, is a key factor for consideration. Moreso, backward integration has various advantages as control over mines (raw material) and also captive power facilities help to keep a check on cost efficiency of the company. Operating performance: The industry cyclicality is a key determining factor of the performance of a company. However, players with larger presence into contract sales and value added products are insulated, to a relatively

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greater extent, from the aluminium cycle. In this regards, operating profit margins (OPM) is one parameter to consider. OPM is also dependant on various internal parameters such as raw material consumption and power cost per unit and production per employee. However, it must be noted that in the case of production per employee, the numbers could be skewed to the extent of the companies’ presence into mining of raw materials. l

Valuations: Two important ratios to look at before investing in an aluminium company could be the Price to Earnings (P/E) ratio and the Price to Book Value (P/BV). Since aluminium is a core industry and its performance is linked to economic growth, the P/E multiple of the stock should more or less hover around the country’s GDP growth. However, at the same time, companies

with greater exposure to international markets (exports) and/or larger presence in the downstream segment could command a higher valuation. The P/BV ratio can also be used as a parameter for comparison. To sum it up, large integrated companies with significant economies of scale and high cost efficiencies with presence in international markets and valued added products are the best positioned to capitalize on any increase in demand for the metal on the back of ever improving economic prospects. This article is authored by equitymaster.com, a leading financial website focused on Indian equities. It also provides Research Reports on India's leading companies and medium to long term buy/sell stock recommendations.

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IDENTIFYING A BANKING STOCK: DO’S AND DON’TS In continuation to enlighten investor’s on how to analyse a sector and identify stocks, here is our analysis on the banking sector. To start with, unlike any other manufacturing or service company, a bank’s accounts are presented in a different manner (as per banking regulations). The analysis of a bank account differs significantly from any other company. The key operating and financial ratios, which one would normally evaluate before investing in a company, may not hold true for a bank (like say operating margins). However, before we go into analysing ratios, we take a look at the way a bank functions. The primary business of a bank is to accept deposits and give out loans. So in case of a bank, capital (read money) is a raw material as well as the final product. Banks accept deposits and pay the depositor an interest on those deposits. The bank then uses these deposits to give out loans for which it charges interest from the borrower.

Of the cash reserve, a bank is mandated to maintain a certain percentage of deposits with the Reserve Bank of India (RBI) as CRR (cash reserve ratio), on which it earns lower interest. Whenever there is a reduction in CRR announced in the monetary policy, the amount available with a bank, to advance as loans, increases. The second part of regulatory requirement is to invest in G-Secs that is a part of its statutory liquidity ratio (SLR). The bank’s revenues are basically derived from the interest it earns from the loans it gives out as well as from the investments it makes. If credit demand is lower, the bank increases the quantum of investments in G-Sec. Apart from this, a bank also derives revenues in the form of fees that it charges for the various services it provides (like processing fees for loans and forex transactions). In developed economies, banks derive nearly 50% of revenues from this stream. This stream of revenues contributes a relatively lower 15% in the Indian context.

NET INTEREST INCOME INTEREST EARNED

ADVANCES

INVESTMENTS

CREDIT OFFTAKE ECONOMY

INTEREST RATES

INTEREST RATES

AVAILABILITY

AVAILABILITY

AWARENESS

19

BANK RATE OTHER INVESTMENT AVENUES

CORPORATE

INCOME LEVELS

Interest revenues: Interest revenues = Interest earned on loans + Interest earned on investments + Interest on deposits with RBI. Interest on loans: Since banking operations basically deal with ‘interest’, interest rates prevailing in the economy have a big role to play. So, in a high interest rate scenario, while banks earn more on loans, it must be noted that they also have to pay higher on deposits. Also, if interest rates are high, both corporates and retail classes hesitate to borrow. But when interest rates are low, banks yield on advances falls thus adversely impacting topline growth. However, banks are able to compensate for the slowdown in topline, as interest expenses fall at a steeper rate, thus improving spreads.

INTEREST EXPENDED

REGULATIONS RETAIL

Having looked at the profile of the sector in brief, let us consider some key factors that influence a bank’s operations. One of the key parameters used to analyse a bank is the Net Interest Income (NII). NII is essentially the difference between the bank’s interest revenues and its interest expenses. This parameter indicates how effectively the bank conducts its lending and borrowing operations (in short, how to generate more from advances and spend less on deposits).

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BORROWINGS

Since a bank lends to both retail as well as corporate clients, interest revenues on advances also depend upon factors that influence demand for money. Firstly, the business is heavily dependent on the economy. Obviously, government policies (say reforms) cannot be ignored when it comes to economic growth. In times of economic slowdown, corporates tighten their purse strings and curtail spending (especially for new capacities). This means that they will borrow lesser. Companies also tend to become more

efficient and so they borrow lesser even for their day-to-day operations (working capital needs). In periods of good economic growth, credit offtake picks up as corporates invest in anticipation of higher demand going forward. Growth drivers for the retail segment are more or less similar to the corporate borrowers. However, the elasticity to a fall in interest rate is higher in the retail market as compared to corporates. Income levels and cost of financing also play a vital role. Availability of credit and increased awareness are other key growth stimulants, as demand will not be met if the distribution channel is inadequate. Interest on investments and deposits with the RBI The bank’s interest income from investments depends upon some key factors like government policies (CRR and SLR limits) and credit demand. If a bank had invested in G-Secs in a high interest rate scenario, the book value of the investment would have appreciated significantly when interest rates fall from those high levels or vice versa. Interest expenses A bank’s main expense is in the form of interest outgo on deposits and borrowings. This in turn is dependent on the factors that drive cost of deposits. If a bank has high savings and current deposits, cost of deposits will be lower. The propensity of the public to save also plays a crucial role in this process. Key parameters to keep in mind while analysing a banking stock: We would like to touch upon one key aspect here. Why price to book value is important while analysing a banking stock rather than P/E? As we had mentioned earlier, cash is the raw material for a bank. The ability to grow in the long-term

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therefore, depends upon the capital with a bank (i.e. capital adequacy ratio). Capital comes primarily from net worth. This is the reason why price to book value is important. But deduct the net nonperforming asset from net worth to get a true feel of the available capital for growth. The banking sector plays a very vital role in the working of the economy and it is very important that banks fulfill their roles with utmost integrity. Since banks deal with cash, there have been cases of

mismanagement and greed in the global markets. And hence, in the final analysis, investors need to check up on the quality of management before investing in the sector. This article is authored by equitymaster.com, a leading financial website focused on Indian equities. It also provides Research Reports on India's leading companies and medium to long term buy/sell stock recommendations.

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IDENTIFYING A DOMESTIC PHARMA STOCK: DO’S AND DON’TS There is a famous saying that ‘while investing in equities, investors are actually buying the business of the company and not the scrip per se’. If this is the case, there are lots of complexities involved when it comes to picking a pharma company for investment. Here is an attempt by us to enable a retail investor to identify a domestic pharma company for investment. As can be seen from the chart above, Indian pharma companies derive revenues from the domestic and international market. Domestic market: The domestic market can be broadly divided into two categories i.e. bulk drugs and formulations. Two key factors that have to be borne in mind are that the Indian pharma market is highly fragmented due to the lack of a patent regime. Therefore, pricing power is very less and any player can duplicate a product in a very short span of time.

represent the basic raw materials used in the manufacture of a formulation. If the company is engaged in the bulk drugs business, what the investor must look into is the extent of the Drug Price Control Order (DPCO) cover on the company’s products. DPCO is a government regulation that fixes the ceiling prices for the bulk drugs. Thus, a company manufacturing drugs covered by the DPCO loses its pricing power, resulting in lower margins. Therefore, lower the exposure to products covered by DPCO, the better. Another important thing to be looked at is whether the bulk drug company carries out any contract manufacturing activity. In this case, the company acquires a contract from another company for manufacturing its products, which will subsequently be sold by that other company. But why contract manufacturing? Low labour costs and US-FDA approved plants are advantages on which the Indian pharma companies can capitalise and increase revenues.

Coming to bulk drugs, they primarily

REVENUES DERIVED FROM DOMESTIC MARKET

INTERNATIONAL MARKET

BULK DRUGS

FORMULATIONS

GENERICS

OWN MANUFACTURING CONTRACT MANUFACTURING

LIFE STYLE SEGMENT HIGH GROWTH RATES

TRADITIONAL SEGMENT LOW GROWTH RATES

PARA 3

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NDDS

PATENTED DRUGS

NON-PATENTED DRUGS

FILE ANDA

FILE ANDA

PARA 4 PARA 1

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NCE

PIPELINE

PARA 2

22

On the other hand, if a company is dependent on formulations, the investor must ascertain the extent to which its products fall under the National Pharmaceutical Pricing Authority (NPPA) cover. NPPA fixes the ceiling price for formulations. Thus, as in the case of bulk drugs, lower the exposure to products covered by NPPA, the better for a formulations company. Here again the company could enter into a manufacturing contract with an MNC. Even in formulations, there are two broad categories i.e. lifestyle segment and traditional segment. Lifestyle segment comprises of drugs that are used to cure diseases that are linked to stress, urbanisation and changing diet pattern and lifestyle of high-income level population. Major drugs in this segment are anti-diabetes drugs, cardiovascular system drugs, gentio-urinary and sex hormones drugs, CNS drugs, antidepressants and psychiatry. These segments are not price sensitive and are less fragmented. The traditional segment, on the other hand, comprises of anti-infectives, pain management and anti-biotics. This segment is highly fragmented. Thus, if a company has higher exposure in the lifestyle segment, the growth prospects and margins of the company will be higher. International market: As far as international markets are concerned, as is apparent from the graph on the previous page, the sector is broadly divided into three categories viz. generics, Novel Drug Delivery System (NDDS) and developing a New Chemical Entity (NCE). Generics are a bio-equivalent of a patented drug. Simply, if ‘erythromycin’ is coming out of patent, a company can 23

launch the same erythromycin, but with a different composition (end effect however, is the same). Every year, a number of drugs come out of the patent regime. So, a company in India who does not have the R&D capabilities or funds to invest in R&D launches the generic version of the drug that is coming off patent. The advantage here is that the Indian company need not invest large sums in R&D. However, legalities are very complex (like Para I to IV) and time consuming. When the company’s research is at a very nascent stage, it concentrates on the sale of off-patent drugs. Starting from Para I to III, there is no restriction on the number of players that can enter the market (competition is global in nature). Margins therefore, are not very high. It is basically a volume driven strategy. Gradually, as the company grows, it shifts its focus onto developing a new drug delivery system for an existing drug and also challenges existing patented drugs by introducing their bio-equivalents. A company files an ANDA for NDDS when it has developed a new method or dosage of delivering a patented drug to the patient. When a generics company challenges an existing patent, it is required to prove that the patent is not infringed or that the patent is invalid. He is thus required to prove that his drug is bio-equivalent to patented drug. If successful, the company gets a 180-day exclusivity period during which it has the sole right to sell the drug in the market. Consequently, the company enjoys very high margins during this period of exclusivity. However, the litigation expenses are very high in such a case.

look into the long-term prospects of the company and not base his decision on the outcome of a single legal suit, or a single blockbuster generic success. Major aspects that need to be observed: Government policies have a major influence on the domestic pharma sector. As can be seen in the table, due to the

revenues is a very useful tool for evaluating the company’s R&D thrust. As product patents come into effect, only companies with high R&D investment will survive. Thus, higher the ratio, higher will be the R&D focus of the company and the better placed will it be to face the uncertainties of the future. Of course, R&D has its inherent risks as well. Last but not the least, keeping aside

A LONG WAY TO GO Country

Public health exp. as a % of GDP

Per capita health exp. (US$)

No of hospital beds per 1,000 people

India Brazil China Malaysia USA

0.8% 2.9% 2.0% 1.4% 5.8%

94 453 143 189 3,950

0.8 3.1 2.9 2.0 3.7

Source: World Bank website absence of a good health insurance policy, India has one of the lowest public health expenditure as a percentage of GDP. Moreover, even on the health infrastructure front, India has a long way to go as compared to other developing nations. Management is the most crucial aspect for any company’s success. While this is true for every industry, it attains even more significance in the pharma sector. Being an extremely specialised sector, it is very important that the management has the requisite expertise and skills to handle the complexities involved it this business. Thus having ‘the right person at the right place’ is key to the success of a company. Watch out for this in the annual reports. R&D expenditure as a percentage of

growth prospects, the sector has significantly high-risk profile due to the dynamism. Even erstwhile big names in the global pharma industry like Upjohn, Burroughs, Knoll, SmithKline Pharma, Pharmacia and Hoechst, found the going tough alone. Ultimately, they had to join hands with bigger players in a bid to survive. Indian companies are still relatively small. If this is the case, a retail investor has to exercise caution. So ‘pick and choose’. This article is authored by equitymaster.com, a leading financial website focused on Indian equities. It also provides Research Reports on India's leading companies and medium to long term buy/sell stock recommendations.

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An investor has to put more emphasis on the total number of Para 4 ANDA filings rather than the aggregate number of ANDAs filed. Further, the investor should

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IDENTIFYING AN FMCG STOCK: DO’S AND DON’TS Rather than look at the various segments, prospects or market shares of the FMCG sector, let us take a look at ways to identify a good FMCG stock. With the markets currently on an upswing, it is even more important to differentiate the chaff from the wheat. Here goes… Key drivers As we all know, India’s per capita consumption of most FMCG products is well below the global average. That is largely because of the economic conditions, i.e. the purchasing ability, and also because of lack of awareness of these products. A look at the chart below gives a snapshot of the key growth drivers for the FMCG industry. Logistic strength While the purchasing ability is a function of economic growth, awareness is a function of the product reach and its usability. It is in this context, that a company’s logistics strength gains importance. But logistics does not only mean a company’s reach in terms of retail outlets, it also means the level of sophistication of this distribution reach.

How intelligent is this supply chain, how well it is geared for the company’s growth? For example, Company A products reach 1 m retail outlets, but the reach is largely people intensive using the traditional dealer stockist method. Also, the retail outlets are largely small provision and shop owners. On the other hand, Company B has a retail reach of only 0.5 m retail outlets, but almost 70% of its stockists are electronically networked. In the above case, even though Company B reaches out only to half the number of retail outlets as compared to A, it is likely to be more efficient and profitable for the company’s growth going forward. For an FMCG company, once a distribution chain is set up, it is the quality of that set up that gives it an edge. Using the same chain, an FMCG company can introduce more products and brands at a faster pace and at a lesser cost, and optimise the channel benefits. In the long run, such a distribution network will be more profitable as it helps the company to keep adding to its product folio at more or less the same fixed cost.

Growth drivers at a glance ORGANISED FRAGMENTATION

BEYOND THE PURVIEW OF EXCISE DUTY REGIONAL

NATIONAL

UNORGANISED

BLACK MARKET AND IMPORTS, IN A WAY

TRADITIONAL - (MORE RESISTANT TO CHANGE)) USAGE PATTERN INTERNATIONAL TREND - (PACKAGED AND FAST FOODS, URBAN LED) ECONOMIC POLICIES

INCOME LEVELS

AGRICULTURE

ECONOMIC GROWTH EMPLOYMENT RATE

INDUSTRY SERVICES

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Product folio MNC companies form almost half of the branded FMCG industry in India. In case of MNC companies, therefore, it is relevant to look at the parent support and commitment to its subsidiary before taking an investment decision. Again, support and commitment alone is not enough. Have a look at the parent’s product profile and what are its plans for its subsidiary in India. If the parent itself is present only in a few categories globally, all its support is of little help owing to the product hindrance. For all companies, be it domestic or otherwise, a look at the company’s product introduction track record is an eye-opener. How many products has the company introduced in its years of existence, how relevant are they to India’s consumer habits. What are the future plans of the company? Competitive strengths FMCG companies’ success is often attributed to their marketing and branding skills. Ability to continuously create successful brands and advertising which gets the message across often spells success for a company. Once a brand is successful, it easier for a company to piggyback on its initial success introduce more products and associate them with the known brand. As they say, ‘nothing succeeds like success’. As said earlier, the more the number of product offerings, the more each resource is utilised, be it the distribution channel, the marketing or branding strengths. It is in this context, that single or a few product companies are risky. Number one, they have to continuously be wary of competitors coming in and weaning away market share. Therefore, they have to continuously spend higher on advertising and marketing. This is a double whammy

for a company under pressure. On one hand, revenues are under pressure and on the other, costs go up and margins are squeezed. Also, due to this, the company is often shy of investing in new products and expanding its distribution network. Bottomline, future growth prospects get stunted. We talked of MNC companies earlier. One very important thing that an investor should look at is the number of subsidiaries the parent has in the same country. For example, P&G and Glaxo SmithKline, both have a few other subsidiaries, beside the listed entities. If the parent has another subsidiary, especially if it is unlisted, then it is likely that the foreign parent would be inclined to introduce new brands and products through the 100% subsidiary. As such, shareholders of the listed subsidiary will not be able to reap the rewards of the product portfolio expansion. Investors should be wary of investing in such companies where parent focus and plans are under a cloud. Key financials and valuation ratios to look at l

Last 5 years revenue growth (CAGR) and what is the reason for the said growth. If encouraging growth has come about due to continuous new product introductions and growth in market share, it is an encouraging sign.

l

Operating margin trend. What sort of margins is the company earning, vis-àvis its peers. Whether the trend is improving or is there a continuous decline. Find out reasons for both. If it is improving due to efficiencies in supply chain and product focus, it is encouraging. If it is declining continuously due to hike in advertising spends etc., it is a sign of the company

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facing intense competition. However, if the margin decline is a blip and has come as a result of a new product introduction, it is a good long-term sign. l

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Look at the company’s cash flows and the working capital efficiencies. It will give you an idea of the company’s bargaining power as well as its ability to utilize its resources and supply chain. Look at the return ratios, especially ROCE (return on capital employed) trend. It will give you an idea how effective the company is in optimising its resource strengths. Also, look at the dividend paying track record. A healthy dividend payout, i.e., the ratio of dividends to earnings, is also a good indicator of the company’s willingness to share wealth with small shareholders. Valuations: It is also important to look at the P/E (price to earnings multiple) and market capitalisation to sales, which the company is trading at vis-àvis its peers. Growth oriented companies’ will most likely be trading

at a premium to peers based on these parameters. If so, then one has to gauge whether that premium is justified. If the premium is unrealistically high then it may not be a good idea to invest at that juncture. After all, valuations have to justify the company’s prospects. Above all this, look at the past record of the management, its vision and its integrity. For it is the management finally, which is decision maker and therefore the guardian of your interests in the company. So if the management has a track record of being on the sly or slow to react to market conditions, then the biggest distribution channel and the most diversified product folio may not give you your rightful share of the company’s growth and profits. This article is authored by equitymaster.com, a leading financial website focused on Indian equities. It also provides Research Reports on India's leading companies and medium to long term buy/sell stock recommendations.

IDENTIFYING AN OIL STOCK: DO’S AND DON’TS It is often said that the dynamics of the world economy are often altered due to the crude oil price movement. As a result, the dynamics of companies operating in this sector are very different. Here in this article, we deal with key factors that impact the performance of petroleum products companies. Profile Petroleum products can be broadly classified as kerosene, diesel, petrol, naphtha, aviation fuel (ATF) and liquefied petroleum gas (LPG). As the name itself implies, crude is ‘refined’ into various usage based products or distillates. Without going into much complexity, the three broad classifications are heavy distillates (furnace oil and bitumen), middle distillates (diesel, kerosene, aviation fuel) and light distillates (LPG and petrol). This is how most of the companies in India classify products in their balance sheets. Margins are higher in middle and light distillates.

www.equitymaster.com Globally as well as in Indian markets, government has a vital role to play in

internal policies and external diplomatic relationships. This is because crude oil involves diplomatic relationships on the sourcing front and outgo of foreign exchange. On the other hand, the government also plays a key role in fixing excise duties on petroleum products. Moreover, it also deals with basic requirements of industries and public in general. Revenues Revenues are a function of volumes and realisations. Volumes Volumes in case of oil sector are linked to economic growth. Why? Economic growth, as you know, is linked to the performance of the agriculture, industrial and services sector. When growth gains momentum, demand for petroleum products tends to increase and vice versa, as it is a source of energy. This is not just restricted to the industrial side but also from the retail market (more units of cars and CVs sold, higher is the demand for fuel).

PROFITABILITY REVENUES MULTIPLIED

VOLUMES

REALISATIONS

LINKED TO ECONOMIC

INDUSTRIAL

EXPENSES

DIFFERENCE

CRUDE PRICES

EXCHANGE RATE

CRUDE PRICES

RETAIL

UTILITIES

AUTO

FERTILISERS

LPG

GOVT. POLICIES POLITICS

AVAITION ALTERNATIVE SOURCES OF FUEL

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The industrial side Demand for petroleum products is relatively inelastic to change in prices. In case of industrials, the key user segments are fertilizer (naphtha or natural gas), utilities (naphtha or natural gas) and aviation (ATF). Any increase in power capacity, growth in tourism sector and better agricultural sector performance has a positive impact on petroleum companies. Hence, one should keep abreast of developments in these user segments. However, alternate sources of fuel like natural gas may adversely affect volumes growth. The retail side On the retail sector, demand drivers are primarily linked to income levels at the hands of people. Higher income growth will lead to a rise in automobile demand as well as usage of LPG. On the auto sector front, diesel accounts for an estimated 40%-45% of total consumption. Kerosene and petrol account for 8% and 13% of consumption respectively. Realisation One cannot however, ignore the realisation angle. Before deregulation in 2002, the government fixed prices of petroleum products. Prices were crosssubsidised. While petrol prices were higher compared to the actual cost, kerosene, diesel and LPG were sold at lower rates. But with the dismantling of APM (administered price mechanism), prices of these products are now linked to international crude prices. What this means is that whenever crude prices go up, petrol and diesel prices will mirror the trend. Though LPG and kerosene continue to be subsidised, the government has decided to remove the subsidy in a phased manner. As mentioned earlier, government has an active role to play in this sector. Hiking 29

diesel and petrol prices is a politically sensitive issue, which could affect the vote bank of any ruling party. In this context, prices of LPG, diesel and kerosene are not based on reality. Government intervention and policies play a major role in determining the prices and hence one should be aware of these developments.

this front. Higher contribution from light and medium distillates is beneficial. Higher the refining capacity, higher the chances of altering product mix to derive more revenues. Though branding is possible, petroleum products are largely a commodity. l

Expenses Since the prices of crude oil (major raw material) are linked to international prices, one must be aware of the prevailing prices internationally. Crude oil price is known to be very volatile (has moved from a low of US$ 10 per barrel to a high of US$ 35 per barrel) and is a function of demand and supply and also various geo-political situations. This apart, currency fluctuations alter the cost significantly. Let’s take a hypothetical example to understand these currency fluctuations. Consider that the currency rate last year was Rs 49 per US$. The crude imports were about 81.2 m tonnes. Crude prices were at US$ 27 per barrel. Now one year later, we assume that crude prices are at the same levels but the rupee has appreciated by about 6%. Then, the company that is sourcing crude will have to shell out less for the same quantity resulting in a saving of Rs 47.2 bn. Since refineries are now allowed to source crude independently, exchange rate fluctuations impact profitability.

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Integration benefits: Another key aspect is to note whether a company is integrated forward (distribution), backward (crude oil exploration) or a standalone player (only refining). Standalone players have less bargaining power, as products have to be sold to consumers through an external distribution network. Integrated players have an upper hand. Distribution network: Petroleum products are usually sold through retail outlets that offer lot of leveraging opportunity for a company. See whether the company owns most of the outlets or it is franchise based. It costs Rs 20 m to set up a retail outlet and if a company owns a major part of the distribution, it can be valued accordingly. By leasing out part of its

distribution, a marketing company can maximize revenues (like ATMs). Valuations: Since it is a commodity sector, valuations should be in line with the economic growth in the long-term. But some companies get lower valuations due to the PSU status. But if a player is integrated, valuations tend to be on the higher side. Price to earnings and price to book value are useful tools.

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And last but not the least, the management’s past track record. Though the government owns some companies, watch out whether the management has been proactive in branding the product and new capacity expansions. But government intervention is still a reality and therefore to that extent, caution has to be exercised. This article is authored by equitymaster.com, a leading financial website focused on Indian equities. It also provides Research Reports on India's leading companies and medium to long term buy/sell stock recommendations.

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Refining capacity: To set up a 1 MT plant, an investment of Rs 10 bn is required. Of course, the cost goes down if one goes in for a higher MT plant. So, it is a very capital-intensive industry and therefore, barriers to entry are high. Besides, with environmental regulations expected to become stricter, watch out for the company’s status on

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IDENTIFYING A SOFTWARE STOCK: DO’S AND DON’TS As global economies are getting more integrated, technology companies are finding it an onerous task to align to the changing realities. In such a scenario, analysing stocks from the technology sector requires utmost caution and understanding. We will, in this article, try to elucidate the factors one should keep in mind before investing in a software sector company. Profile Large english speaking population and low employee costs compared to developing countries have been the foundations upon which the Indian software sector has evolved over the years. Software sector sells man-hours i.e. its earnings are from billing rates (dollars/rupees earned per hour of work) multiplied by number of hours worked by an employee in a year. However, there is one critical factor here. A software company can increase revenues by adding employees and/or by increasing utilisation (no. of employees actually working on projects as a percentage of total employee base) and/or by charging more per hour (i.e. billing rate).

THE LEFT-HAND SIDE (Hours Worked) Scalability Not every software company has systems in place to manage large addition in employees per annum. A company can increase its staff strength to say 3,000 in the first three years. However, to increase the number to 6,000, the business model should be robust. Scalability therefore, is of high significance. To succeed on the scalability front, a software company needs to figure out the kind of capacity (physical infrastructure like development centres, marketing and distribution channels), people, and technology it needs to invest in. However, the most important aspect of scalability is to make sure that employees are absorbed and trained (including the understanding of the company’s culture and values). Utilisation Another aspect of scalability is the level of utilisation. A software company needs to make sure that its capacity is utilised as effectively and fully as possible. This will result in revenue maximisation and higher productivity per employee.

GLOBAL IT SPENDS AND ABOVE TOWARDS OUTSOURCING DETERMINES

REVENUES MULTIPLIED

HOURS WORKED

NUMBER OF EMPLOYEES

UTILISATION LEVELS

HOURS PER EMPLOYEE AYEAR

BILLING RATES

ONSITE OR OFFSHORE

COMPETITION

IS A FACTOR OF SCALABILITY OF OPERATIONS EMPLOYEE RETENTION THROUGH REWARDS

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COMPANY’S POSITION IN THE VALUE CHAIN

But both the factors listed above depend on the management vision, talent and ability to foresee future industry trends. Employee retention Owing to increasing competition for talent, the need to reward employees for the value they create is another critical factor that determines sustainable growth. The need to attract proper talent and retain it gains utmost importance. Software companies’ resort to measure like performance based incentives and ESOPs to reward their employees. THE RIGHT-HAND SIDE (Billing Rates) Having looked at factors that influence hours worked per annum, consider billing rates now. The value-chain Put simply, value chain has low-value add services like body shopping at the bottom of the chain to products at the higher-end. Moving up the value chain is delivering a service or product for which the customer is willing to pay a higher price because he perceives a higher value. However, moving up the value chain involves a whole set of issues. While marketing and branding play a key role, delivery of services is even more important. One way to measure the delivery strength of a software company is revenues from repeat business (basically, satisfied customers). Moving up the chain is an ongoing process. It takes time for a company to attain critical mass before it has the ability to bid for large value-add contracts. Onsite and offshore As per the outsourcing model, employees and their efforts are divided into two elements – onsite (at clients’ location) and offshore (at company’s premises). Although most of the Indian software majors are growing, success depends

much on the way these onsite and offshore efforts are integrated in the most efficient manner to provide seamless services to clients. While onsite involves higher billing rates, offshore offers higher margins because costs are relatively lower. Competition Competition, both from domestic players and global players, also has a bigger say in billing rates. Since Indian companies are miniscule when viewed on the global scale, the bargaining power is on the lower side. Competition has surfaced from global majors setting up development centres in India in an effort to replicate the Indian offshoring model. Another thing to note here is, the higher a company is in the value chain, the lower the competition. Key things to look at before investing in a software stock l

Management: A management with vision is one of the major competitive advantages. Since the software sector is dynamic in nature, management quality has a high weightage. The ability to foresee threats/opportunities without diverting from the vision is important. Retail investor could gauge this from how the company has performed in a downturn/upturn compared to its peers in their respective competencies. Scanning the companies’ annual reports or the official web site also gives an indication of the management’s future vision.

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Employee productivity: Productivity (revenue per employee divided by cost per employee) indicates how much value a company’s employees are adding relative to the costs that are incurred on them. These are relative terms and have to be compared with the peer group.

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Revenue concentration: Since this industry has a high risk-profile, it becomes important to understand from where (geographical mix), from whom (client concentration) and how (industry verticals) is the company generating its revenues. Though few clients accounting for larger share of revenue is not necessarily a negative, diversification insulates a software company from volatility. Remember, earnings visibility in the sector is relatively poor.

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Financial ratios: Some quantitative measures for evaluating a software company stock are P/E (relative to the sector), Return on Equity, Return on Assets and Return on Capital (for profitability) and Operating margins (for efficiency). Some companies command a higher premium due to subjective factors like management quality and their position on the value chain.

A final note: Global IT spending and a move towards outsourcing Apart from the inherent features as mentioned above, there are a few external factors like the level of global IT spending and the percentage share India is likely to get from the same (simply, move towards outsourcing). At some point, the advantage of low employee costs could dry out and the sector could get commoditised. Besides, India has competition from the likes of China and South East Asia as other outsourcing destinations. So, building a competitive advantage is very important and for that, management quality plays a vital role. Investors do need to apply great caution before investing into software stocks. This article is authored by equitymaster.com, a leading financial website focused on Indian equities. It also provides Research Reports on India's leading companies and medium to long term buy/sell stock recommendations.

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