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Thursday, April 2, 2009

Interesting opportunities are opening up in a few sectors

While one knows how sustainable the current rally is, given the continued onslaught of negative economic news, some sectors are showing strong promise. The two sectors that come to mind are cement and metals. The logic for zeroing on these two cyclical counters is obvious. Both are a play on their product prices rather than volume (unlike other manufacturing sectors) and their industry dynamics are easier to understand and decipher. Besides, the financial fortunes of companies in both the sectors are closely linked to the overall macro-economic situation.

While the rally formally ended in January 2008, most cement companies hit their peak in January 2007, an entire 12 months before peers in other sectors. The cement companies did participate in the 2008 rally, but most of them (especially the smaller players) could never scale back their peak. So in that sense, the sectors did give an early warning of the upcoming tsunami.

Cement stocks are once again in the limelight. Since the middle of last year, the sector is probably the only cyclical and interest-rate sensitive counter to have outperformed the benchmark indices. And in fact the frontline stocks in the sector have shown an even greater promise.And the stock price of sector bell weather, ACC, is now at a higher level than at the beginning of the period. What's more, investors who showed their faith in the sector at its worst time in October and November last are now sitting on a tidy profit of 40-50%.

Cement's stellar rise was not without substance though. It was supported by better-than-expected financial performance of the cement makers in the past two quarters. The cement prices have not collapsed as predicted. Instead, many regions have in fact witnessed a marginal rise in the prices. Meanwhile, the sales volumes are growing at a steady pace thanks to the rising cement demand from rural areas and government projects. This doesn't mean that everything is fine with the sector. The company's profitability has been hit by higher power and fuel costs, which it has been unable to pass on to the consumer because of the relatively weak demand environment. And in some cases, the impact has been quite severe. However, all said and done, cement makers have done much better than market estimates.

This brings us to the metal companies such as Tata Steel, Sterlite Industries, Hindalco, Nalco and Hindustan Zinc. These have been among the worst performers in the current bear phase, having lost nearly 80% of their market capitalisation on an average from peak to trough. And most of them are still trading near their 52-week lows. The fall was triggered by the market's fears regarding an adverse impact of the meltdown in metal prices on the country's primary metal producers. This fear is not entirely unfounded. Many metal producers including Tata Steel, SAIL and Hindustan Zinc, reported over 50% decline in net profit during the December 2008 quarter. However, the ground situation may turn out to be much better than the worst case scenario built into the low stock prices of metal producers.

For instance, the steel prices have stabilised at levels seen three years ago. Although they are down 50% from their peak, they are still high enough forintegrated steel producers to remain comfortably profitable. Besides, the demand volume in India continues to be positive. Both the leading steel producers have reported higher production and sales growth in the first two months of 2009. The story is similar in the nonferrous space, including aluminium and zinc. Though metal prices are way below their peak, they are still high enough for Indian base metal producers to make a reasonable profit. Throw volume growth and it translates into top line and bottom line growth in the new financial year.

This makes a case for a near-term recovery in metal stocks on the lines of what happened to cement stocks in the latter part of the past year. There are early signs that this is already happening.But what about the other sectors and market in general? Unfortunately, we can't be so definitive about other sectors given their far more complex dynamics. Auto makers reported encouraging numbers in this year, but it's still too early to say whether the good run will last. In capital goods and construction, the worst is still to come. It's a similar story with banks, which may report higher non-performing assets in the future. Given this situation, it is difficult to guess the future trajectory of the broader market. However, interesting opportunities are opening up in quiet a few sectors and investors should take advantage of the same.

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