How investors can survive the coming recession

India is staring at its first recession in 40 years. Despite the stock market appearing upbeat, economists are revising growth estimates downwards regularly. “Our current estimate for 2020-21 is -2.1%, assuming the lockdown will not be extended beyond 31 May. If it is extended, we will revise estimates,” says Sunil Sinha, Principal Economist, India Ratings. He is not alone. Crisil has also downgraded its growth forecast for 2020-21. “Due to the Covid pandemic, the first quarter of 2020-21 will suffer a staggering 25% contraction and despite some recovery in the second half, the Indian economy is expected to end the financial year with a 5% contraction,” says Dharmakirti Joshi, Chief Economist, Crisil.

Unlike previous recessions—India has seen four since Independence—agriculture is expected to report normal growth this time. The overall numbers will be dragged down by the services sector and industries like manufacturing, mining, etc. One of the major factors contributing to the sorry state of affairs has been the prolonged lockdown. “Industry and services would have restarted if the lockdown was withdrawn after the first phase. However, the massive reverse migration of labourers is changing the picture now. Due to this, economic activity will not be back at normal levels anytime soon,” says Sinha. The global nature of the pandemic has added to the woes. “The global disruption has upended whatever opportunities India had on the exports front,” says Joshi.

1. Blow at a bad time
While much of the problems in the economy can be traced to Covid, the picture was not rosy to start with. India’s economic growth hit a decade low in October-December 2019—much before Covid and the lockdown happened.

Compared to the same period last year, industrial production contracted by 16.7% in March. As the lockdown came into effect only in the second half of March, negative performances of this magnitude can’t be attributed to the pandemic. GDP fell to a decade low of 3.1% in the fourth quarter. India’s core sector output contracted 38.1% in April, the worst performance since 2005. This does not bode well for first quarter numbers.

India Inc was struggling even during the January-March period and its aggregate revenues and net profit fell 6.36% and 9.95% respectively y-o-y (see chart). Most sectors reported falling net profits in the fourth quarter (see table). Agrochemicals and cement were among the handful that bucked the trend. While last year’s good monsoon and increased planting helped agrochemical companies, fall in input costs helped cement companies. Several sectors like construction, real estate and telecom, slid from profit to losses.

Already weak economy becoming weaker
Instead of slower growth, economy is expected to contract in next two quarters.

Contraction in industrial production worse than what it was during 2009 crisis
The numbers will become worse as the lockdown halted all activity April onwards.

Compiled by ETIG Database

Q4 numbers look grim, more bad news likely
Despite the tax cut benefit, net profits show fall of 9.95% so far.

* Based on the results declared by 290 companies so far.
Compiled by ETIG Database

Q4 net profits slump in most sectors
Only agrochemicals and cement managed to buck the trend.

Note: Values in bracket are number of companies that have declared results.
Compiled by ETIG Database

2. Earnings shock
Corporate profitability remains an area of concern with the numbers expected to be bad in 2020-21 as well. This is because the first quarter will be a washout due to the lockdown and there is no clarity on how things will shape up in the second quarter. “Earnings growth in 2020-21 will be really bad. Even if the lockdown goes, it will take some time before things come back to normal,” says Raamdeo Agrawal, Joint MD and Co-Founder, Motilal Oswal Financial Services.

So how much would the aggregate net profits fall by? “Nifty earnings are expected to contract by around 20% in the first quarter and 5%-7% in the second quarter,” says Shailendra Kumar, CIO, Narnolia Financial Advisors. “Aggregate earnings in 2020-21 may fall by high single to low double digits. This is on the assumption that Covid-19 cases will peak in June-July. If there are second or third waves as feared, the earnings contraction will get extended to 2021-22 as well,” predicts Pankaj Pandey, Head of Research, ICICI Direct. The high base effect, triggered by corporate tax cut in 2019-20, will also impact earnings. “Though the lockdown impact was only for eight days in March, the fourth quarter results are not great. Lack of corporate tax cut benefit will be another reason why 2020-21 earnings growth will be negative,” says Rajat Sharma, CEO, Sana Securities.

However, it may not be all doom and gloom. “Recent increase in power demand shows that some economic activities are back, may be in green zones, and that is positive news,” says Agrawal. “Most stores are empty now because they are not getting enough products due to the lockdown and logistic issues and restocking by dealers before Diwali will push sales at company levels,” says Kumar.

One can’t decide on market investments based on fundamentals alone. While fundamentals are expected to be weak in 2020-21, the stock market may remain strong in the short term due to increased liquidity. Here is what you should do as an investor.

3. Ignore the left out feeling
Along with global indices, the Sensex has also rallied 25% from the March closing bottom of 25,981, mostly on hopes of further actions by governments and central bankers across the globe. Feeling left out, several investors are ready to jump in now. However, experts say this is not the correct strategy. “When things turn around, the market will give enough opportunities to get in. Investors should avoid the fear of missing out and wait for opportunities,” says Jimeet Modi, CEO, Samco Securities.

While the broader economy is heading towards a recession, stock market valuations are still high, another reason why experts are asking you to be cautious and wait for further corrections. “The Nifty has fallen from its peak, but it still remains overvalued. Though liquidity can keep the market strong in the short-term, reality will catch up eventually. The Nifty may go back to 7,500 levels in the next 6-8 months,” says Sharma. Amit Jain, CEO & Co-Founder, Ashika Wealth Advisors concurs. “Due to expected fall in EPS, the measured PE ratio will go up in the coming quarters. Market sentiment will also take a hit later because the health crisis is turning into a financial crisis now and soon, this will turn into a geopolitical crisis. Wait till October for better opportunity,” he says.

Analysts have cut EPS estimates for 2020-21
This fall is expected to gain momentum once all companies declare results.

Source: Bloomberg; Compiled by ETIG Database

Sensex PE still above 20-year average
Need to be cautious because PE may go up in future due to fall in earnings.

4. Sell on rallies
While weak fundamentals drag the market down, the same is supported by liquidity injections by global governments and central bankers. That means the market may go up further in the short term. So, the best strategy right now is to utilise the prevailing bullishness. “We are in a sell on rally phase and investors can lighten their equity load if the market continues to move up,” says Modi.

5. Moderate fin sector numbers
Since RBI’s recent measures will help banks to supress their non-performing loans (NPLs), the reported profits from the sector are likely to be higher than the real profits. For example, extension of moratorium by another 3 months means fewer ‘recognised’ defaults by banks and NBFCs during the first and second quarter of 2020-21. RBI also allowed banks to convert interest on working capital loans into term loans repayable by March 2021. In addition to helping report higher loan growth—just book entry, not actual new loans—this will also help banks push this default to the next financial year.

6. Look beyond P&L account
Avoiding small companies with weak balance sheets and sticking to big companies with strong balance sheets can be the next strategy. “In crisis situations like this, there will be mortality in the corporate world as several weak companies will die.

Since big and strong companies will become bigger and stronger, investors should bet on them,” says Agrawal. The expected earnings volatility is another reason why experts are asking you to concentrate on balance sheet strength. “With this kind of earnings volatility, earnings-based valuation won’t work. It is better to look at the balance sheet. The companies with strong balance sheets can survive the turmoil,” says Pandey. Modi agrees. “Concentrate on companies that have the balance sheet strength to survive 2-3 years of pain,” he says. In addition to cash on books, investors should also look at cash flows.

7. Shun cash-strapped firms
We all know debt is a bad word now and it is prudent to avoid companies with high debts or those expected to raise debt in future. However, investors should also avoid companies that need to raise capital in the form of equities in the near future. “In the current depressed market, dilution will be high because companies won’t be able to get the right multiple. For example, banks raising equity below book value is bad for existing investors,” says Pandey.

8. Stick with promising sectors
A strategy that will work in the short-term is to go with sectors that are expected to do well in 2020-21. For example, IT and telecom may do well because the entire world is becoming more digitised thanks to the age of working from home. As the pandemic is a health crisis, pharmaceutical is an obvious sector that is expected to do well. “Pharma sector is also getting a lot of funding now,” says Sharma. Since people can’t avoid basic consumption, FMCG is another sector that will not be impacted badly in this turmoil. The impact of lockdown is much smaller in rural areas and therefore, agriculture and related sectors are also expected to do well in 2020-21.

9. Look at market share
You may be tempted to look at sectors that are expected to do badly because of falling share prices. Anyone using this strategy should scan the quarterly numbers for market share gain and not headline earnings. Profitability will fall because the entire market will shrink. “The companies that can gain market share in situations like this will be the ones that will be able to report good numbers in future years,” says Kumar. However, one should not ignore valuations. Let us take the example of the NBFC sector, which has been in turmoil for the last few years. Strong NBFCs have increased their cash holdings to survive this phase (see chart).

Strong NBFCs are increasing cash in their balance sheets
While looking for stability, investors should consider valuation as well.

Source: Motilal Oswal report

There is no doubt that a company like Bajaj Finance will survive the turmoil in the consumer finance space using its balance sheet strength. However, is its high valuation justified? “Bajaj Finance’s high valuation is not justified because people are losing jobs and they may not be able to pay back their loans taken for consumer durables,” says Sharma.