Defensive stocks back in vogue

After lying low for 3 months, IT, pharma and FMCG scrips made new highs last week; trend likely to continue

Is Dalal Street back in defensive mode? After a three-month strong rally in cyclical and high-beta stocks such as capital goods, infrastructure, metals and banks, defensive stocks are back in vogue.

Last week, as any as 11 top defensive stocks in the information technology (IT), pharmaceutical and fast moving consumer goods (FMCG) sectors made a new all-time high, while cyclical stocks saw a sell-off. The 11 stocks mentioned were Tata Consultancy Services (TCS), Sun Pharma, Colgate-Palmolive, Lupin, Cipla, Tech Mahindra, Cadila Healthcare, Divi’s Lab, Biocon, Torrent Pharma and Aurobindo Pharma.

In all, eight Nifty stocks made a fresh high in the past week, of which five were from IT, pharma or FMCG. The other three were HDFC, HDFC Bank and Tata Motors; though rate-sensitive, these are among the safest bets in their sector, with a strong balance sheet and earnings profile.

“The markets were rallying on expectations from the new government. Now that the two big economic and policy events — rail budget and general budget — are over,so has been the case for a hope-based rally. Going forward, fundamentals and corporate earnings will play a bigger role in markets than only expectations,” says Dhananjay Sinha, head of institutional equity, Emkay Global Financial Services.

On the fundamentals, there are few alternatives to top pharma and IT companies, with steady revenue and profit growth, driven by exports and negligible balance sheet risks. For example, TCS’ net profit was up 48 per cent and 38 per cent over a year during the fourth quarter and FY14, respectively. The corresponding number for Sun Pharma was 57 per cent and 7.4 per cent, respectively. Both made a fresh high last week.

In contrast, most companies in rate-sensitive sectors are still struggling with sluggish growth and poor profitability. Many also face the problem of high leverage, low interest coverage ratio and inadequate cash flows. This makes them a ripe selloff candidate when market sentiment turns weak.

Some believe this could be a catch-up rally by defensives, as they didn’t participate in the post-election rally.

“Most IT, pharma and FMCG stocks corrected in April and May, even as cyclical stocks were making new highs. This made their valuations attractive, prompting value buy from long-term investors,” says Devang Mehta, head of equity sales at Anand Rathi Financial Services.

For example, Sun Pharma was trading at around 26 times its FY14 net profit and 7.5 times its book value in early June. In comparison, Larsen & Toubro's valuation rose to 33 times its consolidated net profit and five times its book value (or net worth) when it made a new high on June 9.

Sun Pharma is debt-free and growing at 35-plus per cent plus year-on-year. L&T is growing at around 15 per cent and reported a debt to equity ratio of 1.74 on a consolidated basis in FY13.

Others see this as a classic case of asset rotation. “For nearly three years, defensives and cyclical stocks have moved in rotation, with the gains from the first nearly erased by the losses in others. Defensives rally when news flows gets negative and vice versa,” says G Chokkalingam, founder of Equinomics Research & Advisory.

He expects the trend to persist through the current earnings season, given the likelihood of a continued good financial performance by IT and pharma companies and earnings disappointments from rate-sensitive sectors.