Invest in defensive stocks? Yes

The stock market decline in the second half of March almost ran parallel to the disillusionment experienced by cricket fans who were expecting an easy victory over arch rival Pakistan. Players who could do no wrong till recently were suddenly found to have had feet of clay.

As soon as Virender Sehwag got out, nervousness gripped one reputed batsman after another, resulting in a calamitous crash.

As for stocks, the big run-up of the past year is tapering off alarmingly. A bit of selling by foreign institutions last week and warnings by certain corporates regarding the adverse impact of VAT on sales sent jitters down the market's spine. Stocks fell sharply mid-week before recovering in the last two sessions.

The obvious question is: if we are headed for a bearish or jittery market, how can stock investors safeguard their investments? One way to do so is to shift focus to defensive stocks.

To be sure, marketmen are not predicting a bear market for now, but given the uncertainty about growth and fund inflows, a defensive strategy may still be appropriate at this time.

Defensive stocks are essentially those which are less volatile, do not get affected too much by short-term mood shifts, and thus fall less than the market in the event of a downturn.

For starters, one can take cues for defensives from cricket. The question to ask oneself is: who would you choose as your anchor batsman if you had to bat for your life?

If the answer is strong players with good technique, mental stamina and experience, say a Steve Waugh or a Sunil Gavaskar, for example; then you might as well apply that analogy to stocks, too. When the going gets tough, look at stocks, which have a good record, have the staying power and will most probably see you through the tough times.

Defensive stocks

	Aventis	Glaxo S K Pharma	Gujarat Ambuja	HDFC	HDFC Bank	ITC	Nestle	ONGC	Reliance	TCS
Beta*	0.51	0.47	0.89	0.72	1.10	0.69	-	1.03	1.07	0.14
Volatility*	1.62	1.35	1.26	1.69	1.60	0.88	-	1.03	1.22	1.23
FY06 estimate (Rs)	82	42	35	50	26	90	34	117	55	57
Current price (Rs)	1270	724	413	717	555	1359	640	881	564	1447
P/E (FY06)	15.49	17.24	11.80	14.34	21.35	15.10	18.82	7.53	10.25	25.39
	Low beta stock; cheapest good quality MNC pharma available	Strong product pipeline, healthy cash flows; offers good dividend yield (4% based on 2004 pay-out)	Construction sector is growing strongly. Favourable demand-supply equation should mean price could inch up.	Housing demand should grow steadily, thanks to tax sops; the company should be able to get its share in the business	Strong retail growth coupled with quality management makes it look like a growth stock; should hold value in all market condition	Steady to rising cigarette sales and higher realisation should mean steady growth in earnings; traditionally a low beta stock	Good sales and margin expansion are expected in 2005; trades at the lower end of its historic trading band	Rising crude price will aid earnings growth even after subsidy sharing. As crude settles down at a high trading range, a re-rating is overdue	Has under-performed the markets despite good operating performance; valuation looks cheap and business credentials should protect further downside	Has visibility in earnings and room for growth in profit margins; large size lends stability to business

In other words, go for large-cap stocks, which are usually quality stocks that tend to post stable growth. In comparison, mid-caps offer promise of better earnings growth during good times while the quality and stability of small-caps is mostly suspect.

While preparing for a downturn or corrective phase, it may be a good idea to exit small- and mid-cap counters. Says Prudential ICICI Mutual Fund chief investment officer Nilesh Shah, "A defensive strategy will have to be centred around large-caps."

It is well known that when the economic cycle is turning for the better, large-cap stocks - which represent more large-sized, financially stable companies -- will usually underperform their smaller and financially weaker siblings.

This is simply because the earnings of smaller companies can go up much more sharply as compared to larger ones when product prices are on the rise and vice versa. A defensive strategy also means moving to lower momentum-driven stocks within each category.

For instance, within each sector, one could switch from volatile to stable. Example: PNB to HDFC Bank, Reliance Energy to Tata Power, Ultra-Tech Cement to Grasim and Satyam to Infosys. Given this premise, we have listed four ways to approach defensives.

Low beta stocks

On a good pitch, even a limited player in good form can outperform truly great players, but it requires solid technical abilities to negotiate a bad pitch. The equivalent for a flat-track bully in stock markets is probably what we call high beta stocks.

Beta is a statistical measure, which represents how much a stock will move up for a given movement in the market index. A beta of one indicates that the stock will mimic the market.

A value greater than one means that the stock will go up more than the market during an upmove and also fall more than the index in a downturn.

Some safe havens from the Nifty basket based on beta for the past one year are HDFC, HDFC Bank, Gujarat Ambuja, Grasim, ITC, Hindustan Lever and Dabur.

Interestingly, several technology, media and pharma stocks qualify, as low beta stocks while banks are high beta stocks. The problem is beta itself is extremely fickle, since the metric is derived from stock price data for a particular time period and the behaviour of stock prices during different time periods may differ widely.

For instance, check out State Bank -- over the last one year, the beta value was 1.60 -- which is fairly high -- while for the past five-year period it was 0.97, meaning low beta.

"Since beta values change with alarming speed, it may be difficult to formulate a strategy anchored around beta values always," says Shah.

The fact is that the recent bull market has been driven largely by economy stocks, which have boomed on account of strong domestic and global demand apart from reform initiatives. Several infrastructure companies have grown several-fold, moving ahead of fundamentals.

"Though order books of infrastructure companies give them visibility, stocks prices are already reflecting the positives," says K N Siva Subramanium, fund manager, Franklin Templeton.

Similarly, improved earnings visibility in capital goods companies has also resulted in a re-rating in these stocks.

But these companies have disappointed in terms of margins. With the steady rise in steel prices, margins could continue to be a cause for concern. Since the momentum in these stocks has been fairly strong till now, they look inherently more vulnerable.

Consumer surprise

FMCG could very well spring a surprise this year. There are reasons to believe this will happen.

According to AC Nielsen's retail sales data for January, 2005, sector sales grew fairly strongly by 8.2 per cent (y-o-y). Only 10 of the 62 categories tracked by the firm recorded a decline in sales during the month. The largest player, Hindustan Lever's sales rose 4.1 per cent in January, in line with the 3.4 growth in the last quarter of calendar 2004.

"Margins appear to have bottomed out and with volumes growth sustaining, earnings should grow," says Yasmin Shah, FMCG analyst at Anand Rathi. ITC may prove to be an excellent defensive play. Dabur, Marico and Godrej Consumer are other attractive bets. But analysts are still divided on HLL.

Though pharma fits well into the defensive logic, expert views differ. Some say the dynamics of the domestic pharma industry as it stands today makes the sector risky. Pharma companies are going to be driven by a lot of policy changes and other external factors.

Says Tridib Pathak, chief investment officer, Cholamandalam Mutual Fund, "Pharma may remain volatile because of the transition that the industry is going through right now. The new patent regime in the country plus the fact that several domestic companies are just about discovering themselves and creating their own space in the international markets leaves them with a streak of unpredictability."

But others maintain that the pessimism is already factored into prices. "Given the recent correction witnessed in the stocks of many pharmaceutical companies, the downside appears to be limited. MNC pharma companies look favourably poised, given the new patent laws in place," says Subramanium.

The class of underperformers

As the saying goes, "form is temporary, class is permanent." Notes Pathak, "There is no substitute for fundamental valuations when it comes to investing for the long term. Stocks, which look undervalued considering their growth potential are the best choices now."

Good quality stocks, which have underperformed in the recent past may be wonderful buys. First, they will be less susceptible to a fall in the overall market. Secondly, cheap valuations may shift the focus to these stocks.

One classic example is ONGC. While energy analysts are convinced than crude will now trade in the new range of around $35 per barrel (at the minimum), the market seems to value the company based on crude realisations of $20-25 per barrel.

At $35 a barrel, some analysts value ONGC's stock at Rs 1,600. There can be no asset, which can offer a better hedge against the rise in oil prices.

The stock, however, still trades close to the public offer price last year. That is because the market often does not accord high valuation to firms where the government has a stranglehold. Currently, the stock trades at 7.5 times FY06 earnings.

Another such stock is Reliance Industries. The company has posted excellent numbers over the past year and yet the stock has underperformed due to the feud between the Ambani brothers.

Analysts say even if the market loses value, Reliance may be less hurt as fundamentals provide a solid cushion. Currently, the stock trades at 10x FY06 earnings.

Contrarian buys

One can even follow a contrarian approach. As Pathak explains, "If you are sure that the market is only seeing a correction and not really slipping into a bear market which will persist for long, then it might actually be a good idea to pick up high beta stocks."

On that count, banks may win. If there is one reason why banks are not looking bad despite the sharp run-up in prices in this bull run, it is their valuation relative to the market. Banks are still trading at 7-8 times forward price-earnings multiples compared to 12x for the Sensex.

"Given the good economic growth and improvement in retail offtake, private sector banks, especially those which are increasing their retail footprint, look favourably placed," says Subramanium.

Another contrarian call could be techs. Both Subramanium and Pathak say earnings visibility in techs is quite high compared to several other sectors, making them attractive as defensive plays.

Techs are now seeing their best times after the bust in 2000 with business volumes growing and margin pressures easing. However, there is a caveat: expectations from techs are still running high.

The top three companies -- Infosys, Wipro and TCS - trade at P/E multiples of 24-25x based on FY06 earnings estimates. This, combined with the risk of dollar weakness, means that techs can also be risky bets.

The pitch isn't bad

Marketmen do not seem perturbed about the market's fall last week. The main reason, of course, is that fundamentals seem to be intact. Take a glance at stock valuations. For the 30 stocks constituting the Sensex, the consolidated earnings per share for FY04-05 stand at Rs 490.

Assuming that earnings grow at the rate of 15 per cent in FY05-06, the earnings would be Rs 570, indicating a forward earnings multiple of 11.8x at the current level of 6,350 for the Sensex, which does not look expensive.

Even if one assumes no growth for the year and that the earnings would remain constant at Rs 490, the market is trading at 12.8x forward earnings.

Says Nilesh Shah, chief investment officer, Prudential ICICI Mutual Fund, "valuations do not look too bad even if we assume that earnings will not grow at all next year."

While valuations seem comforting, concerns about growth are not unfounded either. Analysts have been warning that the high base of last year will impede growth this year.

Higher prices of raw material, especially steel, is eating into the profits of several manufacturing companies, particularly autos and capital goods.

Maruti has already announced its intention to raise prices. And M&M has said the company's profit margins are under pressure. Growing competition in two-wheelers and higher oil prices are also keeping auto stocks nervous.

Added to that is the confusion over the implementation of value added tax, which is making corporates nervous. Industry believes that VAT is good news over the long term; in the short term it may inject inflationary pressures and slow down sales growth. This would affect the entire manufacturing sector, especially those catering to consumers directly. Foreign fund flows, which drove the markets last year, have also turned uneven over the past few weeks.

Though the dollar's weakness over the long term is not in question, the more-than-expected hike in US interest rates and the pull back in the dollar over the past weeks have also led to some selling pressure in emerging markets.