Welcome - the new year

This article is rather delayed - I had written it for Wealth Insight Jan edition.

The equity market sentiment has suddenly turned bullish over the past few months. Unrelenting foreign inflows have pushed the nifty to deliver a >25% gain in the current calendar year. Readers of this column will recall that I had laid out a framework in the mid year which had pointed to a set-up for a rally despite the all pervading gloom. It is time now to bring out the crystal ball again.

One of the problems with gazing at a crystal ball is that it soon begins to reflect the thinking of the watcher. Since forecasting depends on the assumptions made, it is important to lay out the assumptions and the consequent possible outcome. Let us therefore start with the bull story – which, as I said, is the pervading sentiment.

The “Bull”

The bullish argument is predicated on two important hypotheses – (a) a lower interest rate (b) lower commodity prices, including that of energy.

The RBI in its last two policy statements has hinted towards being more open to lowering policy rates to boost growth. This, despite the fact that inflation has remained steadfastly high and above RBI’s stated “comfort zone” of less than 7%. Expectations are that with growth slowing to sub 5% in the last quarter (projected) of the current fiscal, policy emphasis will shift from controlling inflation to propping up growth. If interest rates were to fall, asset markets including equity markets will rise.

The second argument is also linked to the first. China has been witnessing slower growth. With China becoming slightly less dependent on exports and more on domestic consumption, it is expected that commodity intensity of its economy will reduce. Additionally, in many cases, production of commodities has increased with increased investments in production capacities across the globe over the past few years. 

Consequently, with the world economy not recovering, a weaker Chinese economy, and fewer production constraints, commodity prices will remain under pressure. This too will play into lower inflation. Lower commodity prices are generally good for the Indian economy which is still a consumer of basic materials, and a large importer of petroleum.

1 yr forward P/E

If both the above were to materialise, we are looking at a consensus earnings growth of 15%-16% , taking the sensex eps to higher than Rs1410 (march 2014). At that level, sensex valuation (@19350) is lower than 14x, much lower than trend level of 16x-18x. Additionally, with lower interest rates, valuations can rise, yielding a sensex target of 22560 or higher – a growth of 16%. The other factor in our model is liquidity – and the postulate here is that with Japan joining the band wagon of countries willing to print money, and Europe having given up its earlier prudery in being “modest” about loose monetary policy, liquidity will not be a constraint. The “bull” seems to be alive and kicking – or is it??

The “Bear”

The bear too seems to have sharpened claws. Let us start with inflation. Despite the best efforts of the officials (the Indian economic data is extremely prone to manipulation), inflation that a consumer sees is still above 9%. Government economists therefore tend to focus on the WPI (whole sale price index). Unfortunately, this too remains stubbornly high – and above 7%. In addition, various government officials have mentioned in passing that in the next year, there will be increases in price of diesel, railway fares (including freight), power, fertilizers and perhaps an increase in service tax and excise rates. All or any of this will be inflationary. There may be a temporary fall in inflation in Jan, but anyone willing to push the figures will see that this is not going to last even for one quarter.

RBI may succumb to the enormous pressure it is being subjected to by the government and industry and cut policy rates. In such a scenario – depending on which inflation number you look at, the real interest rate will be either negative or just marginally positive. The impact on the credibility of monetary policy will be large and negative. This in itself will be inflationary.

A cut in interest rates is not a given, and even if it were to come through, has to be restricted to a marginal cut to get hawks off the back of RBI.

As mentioned above, with rising costs, it is very difficult to believe that corporate margins can improve. Passing on further price increase to customers is going to be really difficult. Consequently, a 16% growth in earnings against a single digit growth expected till March 2013 seems to be extremely optimistic, and will likely result in a lowering of consensus estimates over the next few quarters.

The fiscal deficit has been alarming and given that we enter an election year next fiscal, is likely to remain so, government protestations to the contrary notwithstanding. The current account deficit is also high – hovering around $20 bn for the past couple of months. With oil prices showing signs of increasing again, India has only 14 months of cover for our net imports. The rupee will likely remain under pressure and this pressure will be further exacerbated if interest rates were to be cut.

Portfolio flows may not be as robust towards emerging markets as we have seen this year.        

Country Performance
MSCI Index (20th Dec 2012)	3MTD	YTD	1 Yr	3 Yr	5 Yr	10 Yr
TURKEY	16.1%	57.5%	54.8%	8.1%	-2.7%	18.4%
PHILIPPINES	11.2%	43.6%	45.2%	22.7%	7.1%	19.8%
EGYPT	-8.5%	48.2%	45.1%	-7.2%	-12.1%	24.9%
POLAND	13.2%	33.8%	33.3%	2.1%	-8.9%	10.4%
MEXICO	6.8%	28.8%	30.3%	12.4%	4.1%	17.0%
THAILAND	5.6%	30.6%	29.3%	24.3%	11.5%	19.0%
COLOMBIA	9.3%	28.1%	26.5%	18.4%	16.3%	34.2%
INDIA	0.5%	24.2%	25.4%	-1.3%	-7.2%	16.4%
KOREA	4.7%	20.0%	23.9%	10.7%	0.3%	12.1%
CHINA	12.3%	18.4%	21.0%	0.2%	-5.3%	15.7%
CHINA 50	11.3%	18.3%	20.6%	2.0%	-5.2%
TAIWAN	0.3%	12.0%	19.3%	2.9%	-0.3%	5.2%
SOUTH AFRICA	4.1%	13.3%	17.1%	8.7%	3.4%	14.3%
MALAYSIA	1.8%	9.5%	14.7%	12.4%	4.6%	11.7%
RUSSIA ADR/GDR	2.3%	9.9%	8.8%	0.9%
RUSSIA	2.4%	10.0%	8.7%	1.2%	-11.9%	11.8%
CHINA A 50	7.9%	7.7%	8.0%	-6.8%	-11.6%
INDONESIA	-0.4%	1.3%	3.0%	11.7%	6.1%	24.6%
CZECH REPUBLIC	-5.0%	-4.3%	-3.4%	-7.6%	-12.2%	15.3%
BRAZIL	3.1%	-2.7%	-4.2%	-7.3%	-5.8%	21.0%
BRAZIL ADR	3.5%	-5.9%	-5.6%	-8.9%	-6.9%
MOROCCO	5.5%	-13.0%	-17.1%	-7.2%	-8.5%	10.1%
EM (EMERGING MARKETS)	5.0%	14.9%	16.9%	3.5%	-2.5%	13.3%

 Source : www.msci.com

Sitting in India, we tend to forget that our markets too move in tandem with global markets. A look at the table above reveals that performance of Indian indices not extraordinary. It is in line with other emerging markets. More importantly, the last three months of so called “reforms” have yielded far less (see 3 mtd returns) than is being attributed to it.

Money is chasing emerging markets on the basis that there is “growth”. However, with slower growth, and a possible rebound in larger markets say the US where the low price of energy seems to suggest a resurgence in manufacturing activity (theme for another column) could make asset allocation shift back to developed markets

In summary, persistent inflation, expectations of higher prices of administered goods, an out of control fiscal deficit and a persistent current account deficit put various pressures on the Indian economy. It is reasonable to expect that consensus earnings will fall. A 5% cut in consensus could imply that the market is fully priced for next December. With no expected returns from the current level, markets will have to first fall and then rise to deliver nil returns over the year.

Chose your scenario and watch the assumptions

 Investing is not about being brave or even being optimistic. It is about taking a view on the possible scenarios, and positioning oneself on the basis of what is the most likely outcome. Since the outcome is based on a probability, it is important to be clear on the assumptions being made, and to see if they still hold as time passes. It is very likely that two people given the same set of data will plump for completely different outcomes. There is NO “expert” view here – only one which you are comfortable with. I currently favour the second view – chose your own – and a very happy new year ahead.

  

Globalising Pharma?

My article on the aftermath of India recognising product patents in pharma industry - published in Wealth Insight last month

Consumers should prepare for a price hike as foreign ownership increases & competition decreases

By Anand Tandon | Jan 5, 2013

The recent elections in the US could almost have been about a single issue - the cost of healthcare. In his first term, President Barack Obama made some radical changes in the US health care system - amongst the largest and costliest in the world. He brought in a policy (popularly called “Obamacare”) which made it possible for a large number of previously uninsured Americans to get some basic health care at a relatively affordable price. It can be argued that this was one of the key reasons for his re-election.

Healthcare in India – return of the multinational
The policy framework for health care in India has undergone substantive change in recent years. Before India abolished product patents in pharmaceutical products in 1972, the Indian pharma industry was small, and dominated by multinationals. Medicines were largely imported and expensive. Post 1972, domestic industry grew rapidly – to become the third largest in the world in terms of volume. India today has some of the most sophisticated manufacturing facilities (more US FDA approved facilities anywhere in the world outside the US). Foreign dominance dramatically reduced. In 2005, the Manmohan Singh government signed the TRIPS agreement – which re-introduced product patents. Since then the market share of foreign companies - which was in the early teens, has more than doubled. This has happened through a series of takeovers – Ranbaxy, Piramal, Dabur Pharma; and several marketing alliances – Orchid, Dr. Reddy’s. In addition, foreign ownership was allowed to the extent of 100 per cent. Foreign companies have increased holdings in their Indian subsidiaries – Pfizer now has a 100 per cent subsidiary in India, Novartis increased shareholding from ~51 per cent in 2005 to ~76 per cent by 2010, Aventis from 50 per cent to 60 per cent in 2010.



Foreign investment benefits?
When demanding greater market access, lobbyists are prone to offer a few arguments:
* Foreign investment allows access to new technology
* Foreign investment creates jobs
* Foreign investment increases consumer choice and affordability





These arguments were heard in recent times with respect to foreign investment in retail segment. Given that 100 per cent foreign ownership was allowed in the pharma sector almost a decade ago, it may be worthwhile to see what has transpired since. It may also be a pointer of the shape of things to come if the policy of FDI in retail were to stay.

Hoax 1: where is the investment?
Pharma is not a very capital intensive industry. Despite this, investment in manufacturing by the foreign companies decreased from 70 per cent of the investment made (1995) to less than 5 per cent of the investments made in the industry over a period of 15 years. Without investments in manufacturing, it is clear that multinational sales were largely driven by imports (see graph: Formulation trade) shows that while exports have stagnated of late (as foreign ownership increases) imports continue to grow at an annual growth rate of over 20 per cent. Without investment in physical infrastructure, it is debatable if any technology transfer would have taken place, or significant number of jobs been created.

Hoax 2: consumer choice and affordability
With Indian companies being prevented from manufacturing drugs which have been patented post 2005, foreign monopolies will increase in India. Consumer choice will be limited, not enhanced.
The impact of the 2005 policy is currently muted since many drugs where patents were granted post 2005, were already manufactured in India, and therefore continue to be produced. As time elapses, product pipelines will dry up – leaving monopoly producers to charge what they deem fit. Already, anti-cancer drugs cost up to Rs 20 lakh per person per year, while chronic diseases like rheumatoid arthritis have a single does costing between Rs 15,000 to Rs 40,000.

The impact of re-introduction of product patents, and increased foreign ownership is in fact extremely detrimental to consumers and their health – both of body and wealth!

Market Leaders are price leaders
Another defining feature of the pharma industry is that consumers do not determine the choice of medicine – it is decided by either the doctor or the chemist. In such a case, companies that have large marketing budgets, and can offer foreign trips for “educational seminars” for doctors, say, are more likely to find their products prescribed despite the existence of cheaper alternatives. Price of the most expensive brand of the same product can be higher by a factor of 50 times compared to the least expensive (see table: Price swings).




A new pricing policy
In November 2012, the union cabinet approved a new policy for pricing medicines in India. Set a time limit by the Supreme Court, the new policy has changed the basis of calculating price of drugs under price control. While earlier, drug prices were fixed on the basis of cost plus mark-up, the new policy posits average market price of a particular drug as the basis of fixing selling price. Ostensibly, this will lower prices of “essential” drugs (as defined under the ‘National list of essential medicines in India’ (NLEM)) – but will it?
As argued earlier, over the next decade or so, the number of drugs where monopoly pricing will prevail will only increase. With greater foreign ownership, dependence on imports too will go up – further reducing the ability of the government to correctly gauge the actual cost of drug production. As competition reduces, so will the effect of “averaging” the market price – in effect allow collusion among few players to hike up prices to unjustifiable levels.

Near term, expect to see the new pricing policy to reduce industry revenues by 2-3 per cent. However, even in the next couple of years, that is more than likely to be made up by galloping prices. Be prepared for higher health insurance premiums.

Did I hear someone say that the process patent regime was better after all? All “globalisation” is not a good thing necessarily.