Sometimes there are opportunities for investors to take a directional view on a sector and make the most of the trend. However, your sector exposure should be monitored continuously and meticulously.
Stock markets are often about sector stories. The 1992 rally was driven by cement stocks, the 1999 rally by software stocks and the 2007 rally by real estate stocks. These were the mega rallies. Then there have been smaller rallies like capital goods in 2006, power stocks in 2007, pharma stocks in 2014 and FMCG stocks in 2017. These are opportunities for investors to take a directional view on a sector and make the most of the trend. However, diversification should still remain your underlying portfolio theme. That means; your sector exposure should be monitored continuously and meticulously. Here is how to go about it…
1. What is the overall exposure to the sector in the portfolio?
When you chase a sector story, don’t lose perspective. Ensure that your overall exposure is limited to a predetermined percentage. For example, if your exposure to FMCG is normally 20% in your overall portfolio and if you decide to temporary increase the exposure to 35%, then maintain that discipline. To calculate your exposure, look at your direct exposure and also your indirect exposure via mutual funds.
2. Keep a tab on the key drivers of the sector story
Every sectoral story is driven by a key theme or key driver. Ensure that the driver is still valid and there are no disruptions to your basic theme. For example, falling rates can be a driver for auto and banks. Ensure that the RBI is not turning hawkish. Telecom diversification can be a theme for Reliance, but ensure that there is no weakness in the core business. Consumer spending theme can be a driver for the FMCG theme but ensure that there is no liquidity tightness in the economy. These checks will put sector exposure in perspective.
3. Is there direct or indirect competition emerging for the sector?
This is a critical aspect. Is there new competition emerging for the company? Look what happened to Nokia when Apple and Samsung flooded the market with smart phones. The company went from leadership to bankruptcy in no time. In India, retail was a great story till it faced competition from online e-commerce. Similarly, competition for land line telecom and PSU banking came from the more fleet-footed private players. Keep a tab.
4. Watch out for signs of growth faltering
Growth always has a saturation point; especially once the cycles peak. We saw that for IT, telecom, infrastructure and FMCG stocks at different points of time. Stock market is all about the ability to grow in top line and bottom line. When the capital investment cycle peaked out in 2012, L&T and BHEL turned to negative growth and that was visible in stock performance. Most products have life cycles; so ensure that you ride the down cycles.
5. Is stiff competition in the industry squeezing margins?
Airline companies are a classic example. In a year when the global aviation companies are expected to report a combined profit of $35 billion, Indian airline companies are bleeding. This is despite passenger traffic growing at 18-20% per year. The answer lies in the pressure on margins. Fuel prices are rising and companies are not able to pass on higher costs due to stiff competition. Hence, all airline companies are currently operating on negative RASK-CASK spreads. That is a sectoral risk you need to watch out for.
6. Beware of sectors that are binging on debt
Which are the companies that are struggling at the NCLT? They belong to sectors like steel, textiles, infrastructure etc. The reason is too much debt taken on in good times. Get wary of sectors that are piling debt on the balance sheets. When you take on high cost debt the first casualty is your interest coverage and that is how companies go bankrupt. Sectors with low levels of debt like IT, pharma and FMCG have been among the best sector stories.
7. Does the sector have un-hedged foreign currency exposure?
The culprit is again infrastructure and telecom. It could be your exposure to imports or it could be exposure to foreign currency borrowings (FCNR). Either ways, unsustainable levels of debt cannot run for too long. In case of foreign currency liabilities, a strong dollar can make things much worse. Keep a close tab on this front.
8. Are there corporate governance concerns in the sector?
NBFCs are the most recent example. As the real impact of maturity mismatch and weak disclosure practices came home to roost, the entire industry has come under strain. Let us spend a minute on why the maturity mismatch matters? Normally, NBFCs borrow from institutions and then led the money to retail. The problem arises when you take a 1-year short term loan and invest the money in a 5-year asset. At the end of 1 year the NBFC may find itself strapped for cash as the funds are stuck in illiquid assets. That is what happened to NBFCs like IL&FS, Dewan Housing, and Indiabulls Housing etc. The problem gets compounded because the NBFCs are not required to disclose such maturity mismatches. Be wary when the sector you are invested faces a slew of auditor qualifications or auditor resignations. Be careful of the use of contingent liabilities to dress up the balance sheet.
9. Is the sector seeing too much churn?
There are two ways to look at churn. One is that it is a signal of opportunities in the sector. The other factor is that there is an exodus. Normally, the people in the know are the first to smell the exit opportunities. Infosys performance ran into trouble when the churn ratio became much higher than TCS. You need to immediately act on the stocks in a sector in such cases. En masse resignations at the top level in a number of companies in the sector should be the first signal that all is not well.
10. Is the sector outperforming general benchmark indices?
The proof of the pudding lies in the adding and your sector must outperform to justify special treatment. Temporary hiccups are fine but if you see underperformance for 2-3 quarters, it is time to review.
Sector ideas are not a bad deal. In fact, they can be good opportunities to tap. Ensure that you don’t go overboard and also ensure to manage your risk prudently.