Gaining from falling rates

Falling inflation means the RBI will carry out more rate cuts to spur economic
activity. That is why this may be the right time to buy shares of sectors that
gain directly from falling interest rates.
Rahul Oberoi/Money Today

Edition:March 2015

(Photo: Reuters)

For stock investors, this was just what the doctor ordered. On January
15, Reserve Bank of India (RBI) Governor Raghuram Rajan reduced
the repo rate by 25 basis points, or bps, to 7.75%. The cut, a full two
weeks before a scheduled money policy review, fired up stocks. The BSE
Sensex rose 729 points, or 2.67%, that day. BSE Realty and Bankex, too,
were on fire, and rose 8% and 3.29%, respectively. These two sectors
gain directly from lower interest rates. This is the first rate cut since
Rajan was appointed RBI governor in August 2013. Repo rate, or the
repurchase rate, is the rate at which the RBI lends to banks.
(Update: The central bank surprised investors again on March 4
by cutting repo rate by 25 bps to 7.5 per cent)
Ads by ZINC

Falling inflation means the RBI will carry out more rate cuts to spur
economic activity, which has been slowing at a worrying pace for the
last couple of quarters. Yes Bank expects a cut of 175 bps this financial
year while Morgan Stanley expects a 125 bps cut.

That is why this may be the right time to buy shares of sectors that gain
directly from falling interest rates - banks, auto and real estate. This is
good news for other sectors also. The reason is that when interest rates
fall, stock markets rise. For instance, the RBI cut the repo rate by 300
bps (from 9% to 6%) between April 2001 and March 2004, and the
Sensex rose 63% during the period.
Repo rate
movements
Similarly,
between
July 2008
and April
2009,
when stock markets were battling the global financial crisis, the RBI cut
the repo rate by 425 bps. The Sensex, as a result, recovered from the alltime low of 8,160 that it had touched in March 2009. When the RBI
increased the repo rate from 8% to 9% between 12 June 2008 and 30
July 2008, the Sensex fell 6%. Interest rates reflect the state of the
economy.
If the RBI wants to reduce inflation, it makes loans expensive by
increasing interest rates. And, it cuts rates when it wants to encourage
borrowing and induce growth.
"The RBI's responsibility is to balance growth and inflation, which it
does by tweaking interest rates," says Samar Vijay, director, InvestCare.
Falling interest rates boost corporate profitability by ensuring companies
gets funds at lower rates. The reverse happened in 2013-14, when due to
high inflation and interest rates and, hence, high raw material/wage
costs, corporate operating profit margins fell to 16.1% from 20.2% in
2007-08.
"Fall in interest rates improves corporate profitability by reducing
interest payments and increasing revenue of sectors (such as automobile
and real estate) where demand is sensitive to interest rates. Moreover,
bond yields and market valuation have an inverse relationship," says
Siddhartha Khemka, head of research, equity, Centrum Wealth

Management. Falling rates increase demand for older bonds whose

coupon rates are higher (as they were set in the earlier higher rate
market). So, banks and mutual funds report a rise in value of bond
holdings when interest rates fall.
Retail inflation (5% in December 2014) is not only below theRBI's
January 2015 target of 8% but is also lower than the January 2016
target of 6%. Jayant Manglik, president, retail distribution, Religare
Securities, says, "The central bank expects retail inflation to remain
below 6% till January 2016, which suggests the start of a rate cut cycle."
Rana Kapoor, managing director and chief executive officer, Yes Bank,
says, "The central bank will have an opportunity to cut the repo rate by
another 175 bps during 2015-16, that is, 2% overall."
Rate cut
forecast
"If interest
rates fall,
industries
will be able
to access
credit at an
affordable
rate, which
in turn can
fuel India's
economy,"
says
Ambarish
Datta, MD
& CEO,
BSE
Institute
Ltd Experts say it may take a while for consumers to start spending and
companies to start investing as they would first like to be assured that
low inflation is here to stay. Sunil K Sinha, director, principal economist,

India Ratings and Research, says, "Although slowdown in investments

cannot be attributed to just hardening of interest rates, it is one of the
factors impacting investment activity."
"The rate cut will provide the right signal to companies to invest and
consumers to spend, a perfect recipe for accelerating growth," he says.
LIKELY GAINERS
Piyush Jain, equity research analyst, Morningstar India, says,
"Whenever the interest rate cycle goes down, it usually implies that the
economy is in the last phase of slowdown or early phase of recovery."
1. BANKING & FINANCIAL SERVICES
A rate cut will give a big boost to banks, which have just now started to
bring their spiralling non-performing assets, or NPAs, under control.
They will benefit from lower cost of funds, rise in demand for loans,
gains in the bond portfolio and reduction in NPAs due to pick-up in
economic growth. The banking index has risen 70% since 1 January 2014
(till February 16).
Khemka of Centrum says, "A further rate cut will spur loan growth. Also,
lower interest rates will cushion net interest margins and reduce NPAs."
According to RBI data, net NPAs of banks were Rs 1,42,657 crore at the
end of March 2014, as against Rs 98,710 crore a year ago. As on March
2014, net NPAs to net advances of Punjab National Bank, State Bank of
India and Bank of India were 2.85%, 2.57% and 2%, respectively. The
figures for private sector banks ICICI Bank, Axis Bank and HDFC Bank
were just 0.97%, 0.44% and 0.27%, respectively.
Clyton Richard Fernandes, analyst, Emkay Global Financial Services,
says, "PSU banks' NPAs are high due to economic slowdown in the past
three-four years." Ajay Bodke, head, investment strategy and advisory,
Prabhudas Lilladher, says, "As the investment cycle picks up, corporatefocused banks like ICICI Bank will gain from higher credit off-take and
upgrade in non-performing or restructured assets. Public sector banks
will gain mostly due to sharp rise in profits on investment books (many
hold more government securities than mandated). Improvement in the
economy will also lead to a sharp drop in NPAs, freeing up capital which
can be used for growth. Many public sector banks trading at or below
book values can see upgrades."

INVESTMENT OPTIONS
Yes Bank:
Yes Bank
The stock
has risen
117.57%
since 1
January
2014. It
was at Rs
814.90 on
February
16. In spite
of this, its
valuation
was a
reasonable
17.98 times
trailing 12 months earnings as against the industry price-to-equity, or
P/E, ratio of 21.75.
Interest income has risen more than 2.5 times in the past five years
(from Rs 15,603 in 2009-10 to Rs 30,736 crore in 2013-14). Net profit
rose 2.5 times to Rs 6,309 crore during the period. Jayant Manglik of
Religare Securities is upbeat on the stock. "Given strong earnings
growth, low impaired assets and reasonable valuations, Yes Bank should
continue to give good returns."
HDFC Bank:
HDFC Bank

The stock

underperformed other bank stocks in 2014. It rose 43%. In contrast, Yes

Bank, Axis Bank, IndusInd Bank and State Bank of India rose 106%,
94%, 89% and 77%, respectively. "HDFC Bank underperformed due to
FIIs' inability to buy shares as their holding hit the cap," says Bodke of
Prabhudas Lilladher.
The bank has been maintaining net interest margins at over 4% since
2005-06. As on March 2014, net interest margins and net NPAs to net
advances were 4.40% and 0.27%, respectively. Bodke says, "It is the best
managed bank in the country with net interest margins and return on
assets that are among the highest in the industry. It has shown
consistent 20-25% growth with negligible NPAs. Narrowing of premium
over other banks (price to adjusted book value) will drive investor
interest. It is a retail-focused bank and so will gain from increase in
consumption when interest rates fall." On February 16, it was trading at
Rs 1,067.10, a P/E ratio of 27.44, as against the industry average of 21.75.
Axis Bank:
Axis Bank

The bank
continued
to open
new
branches
even in the
downturn.
This has
not only
helped it
maintain
its low-cost
deposit
(current
accountsavings
account)
base at a healthy 43% but also improved the mix of profitable retail loans
(from 20% to 38% of total loan book).
Consolidated operating profit has been growing at 32% a year on an
average for the past eight years. The stock has doubled since the start of
the financial year and was at Rs 571 on February 16. The Sensex rose
30% during the period.
Vaibhav Agrawal, vice president, head of research, Angel Broking, says,
"The bank raised substantial equity last year, taking its Tier-I capital to
12.4% (as against 7-9% for most public sector banks). This positions it
for growth and market share gains as economic growth revives and
inflation and interest rates head lower. There is scope for gains
considering that the bank trades at a discount of over 30% to HDFC
Bank. We believe the stock can touch Rs 675 in the next 24 months."
2. AUTO & AUTO ANCILLARIES
The sector will be one of the biggest beneficiaries of rate cuts as most
vehicle purchases are financed by banks.

Daljeet S Kohli, head of research, IndiaNivesh Securities, says,

"Reduction in cash outgo of commercial vehicle (CV) owners can make
business profitable despite subdued freight rates." The BSE Auto index
rose 63% in the one year to February 16. This can be attributed to
expectation of further rate cuts, falling fuel prices, recovery in India's
economy leading to feeling of job security among potential buyers and
falling inflation. During the period, Eicher Motors rose 228.68% to Rs
16,109. It was followed by Bharat Forge (225% to Rs 1,175), Bosch (186%
to Rs 25,582), Maruti Suzuki India (115% to Rs 3,574) and Motherson
Sumi Systems (108% to Rs 462.60).
Vinay Khattar, associate director and head of research, Edelweiss
Financial Services, says, "As more than 80% cars and CVs are bought on
loan, rate cuts will have a positive impact on sales. This, coupled with
good investment climate, will encourage gross capital formation
(investments), leading to job generation and further sales," he says.
For financial year ended March 2014, gross sales and operating profit of
auto and auto ancillary companies rose 25% and 13%, respectively. "We
expect faster revenue growth in the second half of 2014-15 due to low
base. Improved sentiment and fewer discounts should improve margins
and profits in 2015-16."
INVESTMENT OPTIONS
Maruti Suzuki India:
Maruti Suzuki India

India's
largest
passenger
vehicle
maker has
15 models
with over
200
variants.
For 201314, its

consolidated net profit was Rs 2,831 crore, 15.6% more than Rs 2,448
crore in the previous financial year. The stock rose 85% in 2014-15 (till
February 16). Bodke of Prabhudas Lilladher says, "Maruti will be the
biggest beneficiary of upturn in volume growth in the car sector when
interest rates fall. It is likely to be an outperformer with its huge market
share and distribution network."
Subros:
Subros

The
company is
market
leader in
auto air

conditioners with 40% market share. It is a joint venture between Shri

Group (40%), Suzuki Motor Corporation, Japan (13%) and Denso
Corporation (13%). It provides air conditioning for passenger vehicles,
utility vehicles, buses and light commercial vehicles. It recently
expanded into transport refrigeration and air-conditioned railway
coaches.
The stock rose 148% to Rs 66.15 this financial year till February 16.
Subros registered a revenue of Rs 1,321 crore in year ended March 2014,
down 7.9% from Rs 1,435 crore in the year-ago period. Net profit fell
1.5% to Rs 20.26 crore.
Agrawal of Angel Broking is positive on Subros. "Earnings are estimated
to grow at a healthy rate of 29% a year over 2013-14 to 2016-17 on the
back of improved passenger vehicle demand and margin improvement
due to increased in-house manufacturing, capacity utilisation and
operating leverage."
3. REAL ESTATE

A cut in interest rates will reduce borrowing costs of both developers and
buyers. The sector has been going through a difficult phase for the last
few years due to liquidity crunch and rising interest rates. Monu Ratra,
chief executive officer, India Infoline Housing Finance, says, "High
interest rates are one of the major reasons for falling residential sales."
Despite the rise in equity markets, the sector failed to attract investors.
The S&P BSE Realty index fell 9.5% between June 2 last year and
February 16 this year. The reasons were high prices and interest rates.
Unitech, Anant Raj, DLF, Indiabulls Real Estate and Omaxe fell 36%,
30%, 26%, 13% and 7%, respectively, during the period. In contrast,
National Building Construction Corporation, Phoenix Mills and Prestige
Estate rose 142%, 43% and 24%, respectively.
Ratra says, "The mid-January rate cut is likely to inject new life into the
sector. The economy is yet to pick up. Further rate cuts will help the
sector. As home loan rates get more attractive, developers are likely to
come up with more offerings in affordable and mid-housing segments,
which will increase sales."
Net profit of real estate companies fell 4% on an average in 2013-14.
Debt, though, rose 6%. "We expect things to improve from 2014-15. If
some positive steps are announced in the Budget, the sector may revive.
Housing finance companies' revenues are likely to grow 30% in 2014-15
and faster than that in 2015-16. However, for real estate companies,
significant revenue growth will come with a lag. If the interest rate
downtrend continues, we may see revenues growing at 15-20% a year
from the second half of 2015-16," says Ratra.
INVESTMENT OPTIONS
Oberoi Realty:
Oberoi Realty

The
company is
present in
residential,
office,
retail,
hospitality
and social

infrastructure segments. Its debt-to-equity ratio was near zero (0.02) on

March 2014. Gross sales fell 23.78% to Rs 798.45 crore in financial year
ended March 2014. Net profit plunged 38.38% from Rs 504.79 crore to
Rs 311.06 crore.
The stock has risen 22% this financial year. It was at Rs 265 on February
16 as against Rs 217.35 on April 1 last year. Manglik of Religare
Securities says, "New launches and commercial leases will improve
prospects. The company plans to build many projects, mainly in
Mumbai's suburbs."
Ashiana Housing:
Ashiana Housing

The
company
operates in

Jamshedpur, Bhiwadi, Jaipur, Jodhpur and Lucknow areas. It has

successfully completed housing projects Ashiana Villas and Ashiana
Rangoli in Bhiwadi, Residency Greens and Ashiana Suncity in
Jamshedpur and Plaza and Shantiniketan in Patna. It is also developing
commercial real estate with projects such as Ashiana Village Mall and
Ashiana Gymkhana Club in Bhiwadi.
Sales grew 33.3% a year to 2.2 million square feet between 2009-10 and
2013-14. Pre-tax operating cash flow grew 33% to Rs 125.9 crore between
2010-11 and 2013-14.
Ashiana, which follows project completion accounting, is one of the few
real estate companies with nearly zero debt. The stock has risen 161% in
2014-15; it was at Rs 244.7 on February 16 as against Rs 93.45 on April 1.
The BSE Realty index rose 19.3% during the period.
Manglik of Religare Securities says, "Ashiana Housing has been
successful in delivering quality projects on time (24-30 months as
against the industry average of 36-42 months). It also plans to enter one
city each year (starting with Chennai and a few cities in Gujarat) and
enhance presence in cities where it is already present. This will drive
growth in the next phase."

Mahindra Lifespace Developers:

The company is engaged in development of residential as well as large
projects such as business cities, industrial parks and special economic
zones.
It registered a net profit of Rs 41.78 crore in quarter ended December
2014, up 37.89% from Rs 30.30 crore in the corresponding quarter a
year ago. The stock has risen 29.13% this financial year and was at Rs
477.55 on February 16. Sandipan Pal, real estate analyst, Motilal Oswal
Securities, says, "After a difficult period, Mahindra Lifespace is
benefiting from new operating cycle in the residential vertical and
improving macro outlook. Likelihood of around five million sq ft
launches over the next 12 months means sales momentum will continue.
This should improve operating cash flow and return ratios between
2015-16 and 2016-17. We believe the stock can touch Rs 596 in the next
few quarters."
4. CONSUMER DURABLES
Lower interest rates will push up demand by encouraging people to take
loans for buying products such as air conditioners and refrigerators. The
BSE Consumer Durables index has risen 57% since the start of the
financial year. It was at 10,430 on February 16. Symphony and
Whirlpool of India shares rose 215% to Rs 2,226.35 and Rs 692.60,
respectively, during the period.
"The consumption sector will get a fillip from fall in interest rates as
people are left with more money for discretionary spending. As EMIs
(equated monthly instalments) on mortgages, car and other loans fall,
makers of white/brown goods and automobiles will get a boost.
Consumer finance companies will also gain," says Bodke of Prabhudas
Lilladher.
INVESTMENT OPTIONS
Symphony:
Mahindra Lifespace

The
company
has 50%
share of the
domestic
air-cooler
market. Its
strengths
are assetlight
business
model and
cash &
carry
strategy
that ensure
negative
working capital and good returns. It has reduced the impact of
seasonality of the business by venturing into different geographies. It
exports to more than 60 countries.
IIFL says exports have got a big boost from the acquisition of IMPCO, an
air-cooler company based in Mexico. Symphony is using IMPCO's tieups with large modern retail stores such as Wal-Mart, Home Depot and
Lowes to sell its products. It exports around two lakh units a year. The
size of the global market is seven million. Other things that make
Symphony attractive are debt-free balance sheet and good financials and
management.
The stock has risen over three-fold in a year. It was at Rs 2,226.35 on
February 16. As on June 2014, its return on equity, or RoE, was 47% as
against 37% and 36.75% at the end of June 2013 and June 2012,
respectively.
According to an ICICI Securities report, between 2010-11 and 2012-13, it
was at an average one-year forward earnings multiple of 15 times with
annual revenue and earnings growth of 14% and 8%, respectively, and
average RoE of 30%.

The company will post annual revenue and earnings growth of 28% and
33%, respectively, between 2013-14 and 2016-17. Considering the
continuing strong performance and expectation of strong returns, the
stock can touch Rs 2,764 in the next six months.
Voltas:
Symphony
The
company is
one of
India's top
makers of
room air-

conditioners with 20% market share. According to a report by ICICI

Securities, it is set to benefit from changing demographic profile and
revival in India's investment cycle.
The revenue of the unitary cooling products (UCP) division grew 16% a
year between 2009-10 and 2013-14, mainly due to the change in focus
towards premium products.
The stock has risen 57% this financial year till February 16. ICICI
Securities is bullish on the company. "With sustained demand from TierII and Tier-III cities and rising urbanisation, the UCP division will
witness 8% annual volume growth (as against 5% industry growth)
between 2013-14 and 2016-17. Voltas' strategy to focus on profitability by
bidding for small and high margin projects and timely execution will

help it expand margins. The stock can touch Rs 348 in the next 12
months."
5. CAPITAL GOODS
The net profit of capital goods companies fell over 44% in the five years
till March 2014. Sanjeev Zarbade, vice president, private client group,
Kotak Securities, says, "The capex cycle has been stalled due to a number
of factors, one of them being the series of interest rate increases by the
RBI. Thus, a cut in rates could boost the investment cycle, helping capital
goods companies."
Since 1 January 2014, the BSE Capital Goods index has risen 65% (till
February 16). BEML rose 303% to Rs 955 during the period. It was
followed by Bharat Electronics (259% to Rs 3,664), Sadbhav Engineering
(232% to Rs 316) and VA Tech Wabag (190% to Rs 1,625).
Zarbade says, "The rise can be attributed to factors like thrust on
indigenisation in defence equipment manufacturing, interest rate cuts
that may boost the investment cycle, government initiatives to address
the logjam in coal mining and announcement of the civil-nuclear deal
that may spur investment in nuclear power."
Larsen & Toubro, Pipavav Defence and Offshore Engineering Company
and Sadbhav Engineering had consolidated debt-to-equity ratios of 2.25,
2.36 and 4.65, respectively, at the end of March 2014. For Crompton
Greaves, Bharat Electronics and Va Tech Wabag, the figures were 0.66, 0
and 0.19, respectively.
INVESTMENT OPTIONS
Larsen & Toubro:
Voltas

It the
largest

engineering & construction company in India with a wide sector and

geographical spread that protects it during periods of slowdown.
Piyush Jain of Morningstar India says, "L&T has a robust order book
with 90% revenue visibility for 2015 and 2016. Heavy government
spending on infrastructure should help the company meet its 2015
guidance of 20% growth in new order inflow and 15% in revenue. Rate
cuts will reduce interest costs and improve margins."
According to a report from Credit Suisse, L&T can touch Rs 1,975 in the
next few quarters. On February 16, the stock was trading at Rs 1,650 on
the BSE. For year ended March 2014, the company registered a
consolidated operating profit of Rs 11,736 crore, up 7% from Rs 10,984
crore a year ago. It had a total debt of Rs 59,888 crore on March 2014.
*This story appeared in Money Today March 2015 issue, which hit the
stands before the interest rate cut by RBI on March 4, 2015.