What's Ahead in 2011?

2010 was not all bad, by any stretch.

Probably the best news of all was that problems that have been swept under the rug(s) for generations have now surfaced and are regular conversation topics. It is now quite apparent that the Western economies' love affair with entitlements may be coming to an end. They now know, as they should have known earlier, that there is simply no way these entitlements are affordable. That discussion is now front and center. That's good.

Public employees are finally coming under scrutiny as virtually every one of the 50 states in the United States faces bankruptcy under the weight of the benefits that have been promised to these public employees. Teachers, for one, have long been showered with guaranteed job security and extremely generous pension and health care benefits. All of these public employee benefits are now in play. Unions are in the middle of this because almost all of union organizing successes in recent years has been in the public employee sector. Unions are not really a factor of any significance in the private sector, since everywhere they have had a major presence, the companies have gone bust.

This is all good news, because failure to notice the impending disaster of entitlements and public employee largesse was moving the US and its 50 states into certain bankruptcy. Now, there is truly some hope. No solutions, but hope.

Other good news is that President Obama seems, at long last, to have awoken to the fact that his economic policies are a serious impediment to economic recovery. The tax agreement forged between the President and Senate Republicans was a foolish package, but better than the alternatives. For the first time since January, 2009, there was some recognition in that compromise that business matters. Finally!

So, there is hope that 2011 will be a better year than 2010. There will be continual reminders as 2011 unfolds that virtually every Western European nation will eventually default, in some manner, on their public debt and that several states in the United States are headed in the same direction. But, bankruptcy can be therapeutic; bailouts are never therapeutic.

Investing in High Interest Rate Environment

India is in a rising interest rate environment. We have already seen the RBI raising interest rates five times since March 2010. Last week, in its policy review, the central bank left rates unchanged, merely reducing the SLR to 24% from 25%. However, this is certainly not the end of the story. With the inflation showing no signs of easing in the medium term, raising interest rates is one of the most important tools in the hands of the government/central bank.

Rising interest rates are generally not taken well by the investors at large. Firstly because it directly hurts the pockets of the individuals. The interest rates are increased to suck money out of the system and to curb the inflation. As rates increase, banks pass on the increase in rates to its customers and consequently home loans become more expensive. People having loans have less disposable income as their monthly payments increase.

Let's see how this impacts the businesses. Companies need funds to operate and as Capital Structure Theories tell us, they should maintain a balance between debt and equity. As interest rates increase, the debt becomes expensive and companies incur more interest expense. In a competitive market, generally it is difficult to pass on the same to the customers. Consequently, the owners (that is, the shareholders) take the hit in the form of lower profits. Needless to mention that a company reporting lower profits become less attractive for investors and thus the stock prices fall.

Higher interest rates often leads to investors switching from equities to fixed income securities (e.g. bonds) as they now offer higher returns to investors.

What should an investor do in a rising interest rate environment?
There are some sectors that more sensitive to interest rates than others. Sectors such as Banks, Auto, Real Estate are more sentive to interest rate changes than sectors such as Pharmaceuticals, FMCG and Capital Goods. That is not say that these are 'not' affected by interest rate changes, but just to say that are "less" affected as compared to more sensitive ones.

Further, investors should grill down to companies that do not have a high amount of debt in their books. A company which is more equity-financed would be less affected by interest rate changes than the one that has a high amount of debt on its books.

It's just about how the investor diversifies his/her portfolio that can hedge him/her against adverse movement in interest rates.

Happy Investing !!

Sectors that have consistently outperformed the Sensex

With just 10 working days for the year 2010 to complete, here is a small analysis of the sectors that have consistently outperformed the Sensex over the last 6 years.

Average Yearly Return of the Sensex over from 2005 - 2010 = 29.0% [Max return in Yr 2009 - 77.3%]

Sectors that have outperformed the Sensex in terms of Average Yearly Returns:
Realty ........................ 98.6%  [Max return in Yr 2006 - 469.0%] (Realty Index introduced in 2006)
Consumer Goods ..... 51.5%  [Max return in Yr 2007 - 114.8%]
Metals ........................ 50.9%  [Max return in Yr 2009 - 220.4%]

Consumer Durables .49.1%  [Max return in Yr 2005 - 110.6%]
Auto ........................... 42.7%  [Max return in Yr 2009 - 200.5%]
Power ........................ 35.8%  [Max return in Yr 2007 - 125.0%]

Oil & Gas ................... 35.0%  [Max return in Yr 2007 - 112.8%]
Banks ......................... 32.5%  [Max return in Yr 2009 - 81.0%]

On a year over year basis, Consumer Goods (AAR 51.1%) and Consumer Durables (AAR 49.1%) have outperformed the Sensex in 4 out of last 6 years. However, both underperformed the Sensex in 2008 when the markets fell on account of global meltdown demonstrating vulnerability to adverse conditions.

Information Technology (IT) has consistently outperformed the Sensex in the last three consecutive years with an average return of 34.5% (including 2008 which saw the global meltdown when both Sensex and IT fell ~48%.

Now this is especially for long term investors who look for long term growth:
The following are the top 5 sectors that have demonstrated the highest growth in Investor value over the last 6 years (Sensex growth in 6 Years... 197%):
Consumer Goods .......... 408.5%
Consumer Durables ...... 289.1%
Banks ............................. 245.2%
Auto ................................ 241.2%
FMCG ............................ 233.0%

Top 2 Sectors to look for in 2011 - FMCG and Consumer Durables



*AAR = Average Annual Return

Reconciling Tax Cuts with Long Term Debt Issues

Hail to the Wall Street Journal! In one short paragraph the Journal has summed up the heart of the US debt problem and why keeping all of the Bush tax cuts in force make sense as well. In today's Journal and I quote:

"While in a hopey-changey mood, let's note for his (Obama's) benefit that the real fiscal problem today is not the immediate deficit, which does not call for radical action. The real problem is a system of health-care and retirement finance that deters us from saving and budgeting for our own needs while at the same time piling up disencetivizing taxes on those who work and whom we expect to pay for us in old age. Fix this and the government is solvent again."

Wow! The WSJ nailed it. .

A Beginning

The compromise between the President and Mitch McConnell on taxes represents a new beginning for the President and, perhaps, for the country. The compromise will definitely help the economy. The economy needs it.

There are still problems, especially on the unemployment front. Employees are still too expensive, laden down by government-imposed mandates and implied litigation liabilities for businesses. But capital expansion should pick up dramatically in 2011.

It's not perfect, but this deal is definitely an improvement over the policies of the past two years.

The looming debt problems are still there -- both for the US and for Europe. Hopefully, the idea of "workouts" and "defaults" will soon take the place of "bailouts." The debt problems have no easy fix.