Mid and smallcaps lose flavour
Closing

There are too may concerns that seem to be clouding the minds of Indian investors these days. Volatility in corporate earnings, high inflation, possibility of interest rate hike, risk of sovereign default and asset bubble in other economies being the prime ones. Thus despite some positive news on the economy and corporate earnings investors seem to have chosen to take some profits off the table. As a result, the benchmark indices failed to make inroads into the positive territory despite struggling through the session. The markets finally closed today extending the losses seen last week. While the BSE Sensex closed lower by around 86 points (down 0.5%), the NSE Nifty lost around 34 points (down 0.6%). Midcap stocks were also at the receiving end, losing 1.3% while smallcaps lost 0.9%. Losses were largely seen in auto, realty and engineering stocks.

As regards global markets, while most Asian markets closed lower today, the European markets have also opened in the red. The rupee was trading at Rs 46.18 to the dollar at the time of writing.

In an effort to help the government stick to its fiscal deficit targets for the current financial year, the RBI will be shelling out an additional Rs 50 bn in addition to the Rs 250 bn of dividend already paid to the government. The higher dividends coupled with the expected disinvestment proceeds to the tune of Rs 250 bn for FY10 are expected to bridge 2009-10 fiscal deficit gap and bring it closer to the target of 5.5% of the GDP. Keeping the fiscal deficit within the estimate will also mean the government not overshooting its anticipated market borrowing that is already at a record high. In the current fiscal, the high market borrowing has depressed the prices of government securities, hitting the treasury income of Indian banks. While the deficit levels may be curbed by these measures, wasted non-plan expenditures can continue to play spoilsport.

Engineering major Voltas announced its results a while ago. While the net sales grew by 4% YoY in 3QFY10, the growth was 12% YoY in 9mFY10. The growth in topline was aided by a relatively better performance from the unitary cooling products business, which grew by 27% YoY during the quarter. Operating margins expand by 3.6% YoY primarily due to substantially lower cost of raw materials (as percentage of sales). This gave a boost to the company's bottomline, which has grown by 60% YoY (excluding extraordinary items). The profit growth was further helped by a fall in interest expenses.

One of India's fastest-growing generic drug companies Lupin is planning to set up three new manufacturing facilities at an investment of Rs 2 bn in Indore. The new facilities are part of the company's aggressive expansion plan to tap the US and Japanese markets. The company plans to get into new niche product areas in dermatology, injectables, eye care and oral contraceptives. It is also looking to acquire established brands in the US market, in segments like paediatric and primary care. Over the last few years, the focus of Lupin's business has shifted from low margin APIs to high margin formulations. This can be gauged by the fact that the contribution of formulations to total revenues has increased from 47% in FY04 to 82% in FY09.

No respite from selling yet
01:30 pm

The Indian markets remained extremely choppy witnessing alternate bouts of buying and selling during the previous two hours of trade with Sensex still trading below the dotted line. Stocks from the realty, IT, banking and telecom sectors are leading the pack of losers, while FMCG and capital goods stocks are garnering investors' interest currently.

The BSE-Sensex is trading lower, down by around 82 points while NSE-Nifty is down 28 points. The BSE-Midcap and BSE-Smallcap are also trading lower, down by around 0.8% and 0.4% respectively. The rupee is trading at 46.19 to the dollar.

According to a leading business daily, pharma major, Piramal Healthcare,is rethinking its investment plans worth Rs 1 bn aimed at setting up a new unit for manufacturing Codeine, a basic ingredient for cough syrups like Corex, Phensedyl. The company is currently doing a cost-benefit analysis for the project which entails a lot of government controls and issues in long-term raw material supply. It may be noted that the company previously planned to set-up a codeine manufacturing facility which was expected to be operational by the first quarter of next fiscal. However, this drug which is derived out of opium, a nacrotic is a difficult drug to manufacture given the government policies and vigiliance. India annually imports around 30 tonnes of codeine on account of poor supply in the domestic market. Only 2 government companies process opium which creates a huge derth of supply.This is despite the fact that in 2008 Indian government relaxed its monopoly and allowed private players to manufacture codeine. Dr Reddy'd DRL) and Piramal Healthcare are the only 2 private companies allowed to produce the chemical. However, as of now Dr Reddy's has also decided not to go ahead with its proposed plant to make this drug. We believe that in a sector where government policies are so crucial, not being able to capitalise on such a strategic position will pinch the company. The brands like Corex and Phensedyl annually generate sales worth over Rs 1500 m each for their companies i.e.Pfizer and Piramal respectively.

India's forth largest IT major, HCL Tech which is a June ending company, declared its 2QFY10 results today. The company's topline remained flat during 2QFY10 (financial year begins July) on account of muted performance in the major segments like financial services and manufacturing particularly in the US market. Though performance remained subdued for BPO and engineering and R&D services, the company mananged to maintain its leading position in the IT infrastructure management business. It's operating margins contracted by 1.6% QoQ during the quarter mainly on account of weak topline and increase in expense. Net profits declined by 7.3% QoQ during 2QFY10. Profits for the quarter impacted by decline in margins,extraordinary losses on cash flow hedges and a lower other income. The company added 1,691 employees to IT services business during the quarter taking the headcount to 55,688 by end of 2QFY10. The company also declared an interim dividend of Re 1 per share. We believe that the company's performance though impacted by the forex volatility was very weak as compared to bigger IT rivals like TCS, Infosys and Wipro.

Markets languish in the red
11:30 am

The Indian markets continued to languish in the negative territory during the previous two hours of trade due to lack of buying activity needed to take the indices higher. Currently, selling activity is being witnessed across all the sectors except capital goods and FMCG. The stocks from the realty, IT, and telecom sectors are bearing the maximum brunt of profit booking.

The BSE-Sensex and NSE-Nifty are trading weak, down by around 120 points and 40 points respectively. This weakness is being witnessed in the mid and small stocks as well. The BSE-Midcap and the BSE-Smallcap indices are trading lower, down by around 0.8% and 0.2% respectively. The Rupee is trading at 46.21 to the Dollar.

As per a leading business daily, pharma major Lupin is planning to set up three new manufacturing facilities, and will invest Rs 2 bn for the same. As indicated by the company's management, these facilities are slated to come up in Indore before the end of FY11. It may be noted that this move will take the company's total number of manufacturing units to 11. These new facilities are in line with the company's aggressive expansion plan to tap the US and Japanese markets with new niche products in dermatology, injectables, eye care and oral contraceptives. Further, Lupin is developing 25 products each in the dermatology and ophthalmic therapeutic. These plans necessitate the setting up of these new manufacturing units. The stock of Lupin is currently lower along with its peers Sun Pharma and Biocon that are also trading lower.

IT major Tech Mahindra announced its 3QFY10 results recently. The company's topline grew by 4% QoQ in 3QFY10 on account of improved volumes in its ‘Telecom Service Provider (TSP)' segment. Operating margins declined by 1.7% QoQ during the quarter. This was on account of higher operating expenses, lower utilisation and the rupee's appreciation against the US dollar. Its bottomline grew by 2.3% QoQ during the quarter on the back of higher topline coupled with lower interest and tax outgoes. For 9mFY10, the bottomline declined by 40% YoY on account of huge interest burden subsequent to the acquisition of Satyam. In order to sharpen its focus towards the customers, the company is in a restructuring mode so as to react more efficiently to the changing market dynamics. Tech Mahindra's management indicated that it saw some definite signs of revival in its customer base particularly in the emerging markets like the Middle East and India. The company believes that IT outsourcing as a tool to improve operational efficiency will continue to drive growth in the developed markets.

Weak global cues continue to hurt
09:30 am

Carrying on from the weakness that we saw last week, Indian markets have started this week on a similar note. The benchmark indices opened way below the breakeven mark and have not managed to recoup the losses since then. Other key Asian markets are trading in the negative with Japan (down 1.2%) leading the pack of losers. The US markets closed 2% lower last Friday.

Currently in India, heavyweights from the BSE-Sensex are trading in the red with banking and software stocks facing the brunt of selling activity. However, auto and metal stocks are trading in the positive. The BSE-Sensex is trading lower by around 130 points, while the NSE-Nifty is down by about 45 points. Selling interest is also being witnessed among mid and small cap stocks as the BSE-Midcap and BSE-Smallcap indices are trading lower by 0.6% and 0.3% respectively. The rupee is trading at 46.13 to the US dollar.

Banking stocks have opened the day on a weak note. Losers here include Allahabad bank and Vijaya Bank. As per a leading business daily, India's largest lender SBI is eyeing acquisitions in Indonesia, Thailand and Philippines. It may be noted that SBI acquired PT Bank IndoMonex in 2006. Now called SBI Indonesia, it has seven branches. Each new acquisition is likely to require about US$ 200 m. Most of it will be sourced from SBI's internal accruals. In our view, SBI's move to establish a presence in these countries is tied to the fact that Indian companies are setting up operations there. Many Indian companies are especially interested in acquiring companies in Indonesia, due to it rich coal and oil reserves. SBI's overseas operations now span 33 countries contributing 12% of overall topline. The bank plans to take the number up to 25% in the future.

Pharma stocks have opened the day on a positive note. Gainers here include Cadila Healthcare and Orchid Chemicals. As per a leading business daily, Piramal Healthcare is reviewing its plans to set up a new unit to make codeine, the basic chemical used in cough syrups and pain killers. The new unit requires an investment of Rs 1 bn and was expected to commence operations in June this year. Currently, two public sector companies produce codeine in India and 30 tonnes is imported each year. It may be noted that there are strict government controls and difficulties in the availability of raw material given that it is derived from opium, a narcotic substance. Recently Dr. Reddy's also shelved its plans to produce codeine.

Can India Inc. sustain such growth?
Pre-Open

The last week saw some of India's largest companies announce their December quarter results. As such, we now have some sense on how this last quarter has been for India Inc. As the chart below shows, it is turning out to be the best quarter in terms of profits since the financial crisis started eight quarters back. A large part of this improvement in profits has been brought about by cost cutting measures of companies across sectors. Lower interest costs have also helped matters. And the lag effect of lower commodity prices has been seen amongst companies from sectors like engineering, energy, and power.

* Performance of results announced till last week; Source: Equitymaster Research

So where do we go from here on?

One thing is clear. The profit growth numbers, as we have seen this quarter, are not sustainable in their current form. First, these have come on a low base of a weak last year. Second, a large part of this growth is due to cost cutting by companies, not growing topline sales.

You can see how, in the short run factors like cost-cutting can lead to increased profits. But this can't go on for long. The more businesses cut costs (like by firing employees or freezing pays) the more their sales go down, because consumers (who are also their employees) have less money to spend. We are already seen pay hikes coming back to IT companies.

What Indian companies would have to do to sustain a high growth in profits in the future would be to grow their sales. And we see a tremendous scope there, especially in the long run. With the rural market still untapped for so many fast growing sectors like retail, healthcare, and financial services, we see a tremendous scope for Indian companies to sustain a robust growth in sales over the next 10 to 15 years. This is however notwithstanding the temporary hiccups that will come their way in terms of the usual business cycles.

For you as an investor in the Indian growth story, it will make sense to invest in companies that are growing without much need for incremental capital infusion. While one might get tempted to buy into the hyped growth stories across fast growing sectors, intelligent investing would require having a margin of safety before making any investment decision.