Should you speculate in cyclicals?

The reforms drive has given a fillip to some sectors which are going through bad times. Things will improve for them

In just two weeks, there's been a sea-change in the environment. All of a sudden, after three years of inactivity, the UPA is hell-bent on driving through a reform agenda. This is backed by a flood of liquidity from Europe and the US and it has led to a jump in equity prices.

All the enthusiasm for reforms could be derailed if the government falls. It's a moot point anyway if it can push through the requisite legislation for hikes in sector-specific FDI limits. Even if it does, it will take months if not years before there are significant inflows. Nor will these measures necessarily boost growth in the short run.

Nevertheless, it's nice to know that there is some action on the policy front. It's led to a change in equity price trends and we'll just have to wait and see if the current bullishness is sustainable. While this uptrend is great for traders, it creates a conundrum for value investors.

The market was already over-valued by any standard metric at the Nifty 5300 levels, which prevailed in early September. The PE ratios (17.5 at 5300Nifty ) were much higher than justified by either growth rates or prevailing interest rates. The Price-Book Value ratios (2.9 at 5300) were higher than comfort levels. Value investors had to be picky to find stocks that justified buy and hold strategies.

At Nifty 5700, the market is seriously over-valued with a PE of 19-plus and a PBV of 3-plus. What's more, this has been a broad movement that has pushed up stock prices across the board. That makes it even more difficult to find stocks using value investing methods.

At the same time, the policy changes haven't affected growth yet and they won't in the short-to-medium term. Nor has the RBI seen fit to cut policy rates, which would have changed the valuation metrics for the better.

So let's abandon the value investing mindset and look for industries where there will be some perceptible improvement in the operational environment. The most obvious one is oil and gas. The hike in diesel prices will not pull the oil-marketing PSU companies (OMCs) out of the red. But it will cut their losses to some extent. The rise in the rupee's value also effectively cuts down import costs. The cap on the number of gas cylinders available at subsidised prices, whether its 6,9, or 12, will also reduce subsidy burdens. More freedom to set a market-related price to unsubsidised gas cylinders will also help.

A lower oil and gas subsidy requirement helps government finances as well as easing pressure on OMC balance sheets. It also substantially helps PSU oil and gas producers since they have to share the subsidy burden with their OMC siblings.

That sector could see a partial turnaround in the next quarter and a market, which is driven by optimism is likely to offer a bigger bounce to turnaround stocks. While ONGC, Oil India, Petronet and GAIL are much sounder propositions in terms of balance sheets and overall prospects, BPCL, HPCL and IOC could be the better performers in terms of share price gains over the next quarter.

There will also be an interesting impact on the aviation sector, which is another loss-making area. The easing of restriction on foreign airlines taking stakes in Indian carriers seems just a token move at the moment with zero impact. The FDI cap stays at 49 per cent, and the lack of a controlling stake will remain a deterrent to takeover bids.

More importantly, the sector has accumulated huge losses. But the freedom to import aviation turbine fuel (also known as kerosene) could significantly reduce carrier costs. On the flip side, the major metro airports are all going to be charging high user development fees and that will hurt.

If there's a turnaround in the aviation sector, there will be interest from strategic investors. But there is need for much more in the way of reform and coherent policy-making. Also, in the bluntest possible terms, it needs the government to take tough decisions about Air India. While there is a loss maker with 18 per cent traffic share playing the role of price warrior with utter disregard for rational economics, the other airlines are hobbled in their attempts to run profitable businesses.

These aren't sectors that any value investor would touch with a bargepole. They are loss-making, debt-ridden, highly cyclical and victims of poor policy making, political interference and populism. But if you're willing to speculate stocks in these businesses could see a phase of share price outperformance. Things will improve for them even if it won't be enough to wipe red off the balance sheets.