In defence of the defensives: Why IT, pharma stocks are not pariahs

April 21, 2014

(Any opinions expressed here are those of the author and not of Thomson Reuters)

Expectation that the ongoing general election will throw up a stable government has spurred a return to risk in domestic equities. The consequent rally has meant those favoured defensives of the sluggish times – information technology and pharma stocks – received a shearing.

The CNX IT index shed 7.8 percent and CNX Pharma 10.1 percent in March – even as the benchmark Nifty surged 6.8 percent.

Assuming a strong government is indeed voted in, will it mean the two export-oriented sectors will become market pariahs? Unlikely.

The reason for this is not hard to find. Have a look at what was behind the recent weakness.

First, being defensives, both IT and pharma tend to lose their attractiveness when a risk trade is on. The decline in March, therefore, was to be expected.

Second, some $3.3 billion net inflows from foreign institutional investors (FIIs) helped the rupee close March at a strong 59.90 per dollar. This hurt exporters who earn in dollars but report the earnings in rupees – a weaker dollar leaves fewer rupees in their hands after meeting costs.

Third, there were some adverse sectoral developments. On March 13, Infosys shares fell almost 10 percent after a revenue warning. On the same day, the U.S. Food and Drug Administration issued an import alert on one of the units of Sun Pharmaceutical, adding to the woes of a stock that had already lost 10 percent in the month.

Yet there’s much the two sectors have working in their favour. For starters, CRISIL Research believes the rupee will be under pressure even if there is a stable central government. The new government may initiate reforms that would stimulate demand. This will push up the import bill and lead to a higher current account deficit (CAD).

Last fiscal, a good part of the CAD was financed by non-resident deposits – a cushion that is unlikely to be available going forward. Financing a higher CAD could still be a daunting task and could check the rupee’s appreciation. And global liquidity will keep reducing as the U.S. Federal Reserve continues to taper its quantitative easing programme.

While India’s attractiveness within the emerging markets could improve, a pick-up in the U.S. economy and a revival in Europe will mean the two regions remain the largest and the most-preferred destinations for global funds. So FII inflows may not significantly strengthen the rupee.

Next, we believe the inherent strengths of the IT and pharma industries in India lie in their execution capabilities and scale, which are difficult to replicate quickly. While exchange rates may have an impact on margins in the short run, the advantages would stand the players in good stead going forward. In the past, IT companies have achieved good growth by bagging and executing large orders. We expect this trend to continue even if there is pressure on the currency in the short term.

We see Indian IT industry revenue touching $99 billion by 2018-19, growing at an enviable 15 percent annually in the next five years. In recently announced results, Infosys and TCS recorded year-on-year dollar revenue growth of 7.9 percent and 15.1 percent respectively in the fourth quarter of FY14. Both companies have also given a positive outlook for growth in FY15.

Pharma companies, on the other hand, are already partaking of a windfall opportunity with drugs worth $130-$150 billion going off patent between 2012 and 2017. What will provide additional ballast is the greater emphasis of the governments in regulated markets to promote generics.

To sum up, the defensives haven’t turned dogs overnight. Their investment case remains. More so if the battle of the ballot is inconclusive.

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