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Aarati Krishnan

HOW cut-and-dried stock market investing seemed in the late 1990s. Then, there seemed to be two clear categories of stocks for investors to choose from: "Growth" stocks (typically used to describe stocks in the IT, FMCG and pharma industries) which were seemingly insulated from the ups and downs of the economy and supposed to deliver consistent earnings growth.

And, the "cyclicals" (stocks of commodity-oriented companies, capital good makers and banks) whose financials were supposed to move up and down violently depending on the level of economic activity.

Blurring divide

So, if you were good at timing your entry/exit and monitoring commodity prices, you could risk investing in "cyclicals". But if you wanted consistent performance without the bother of tracking macro-economic trends then "growth" stocks were your cup of tea.

But some three years after the collapse of the tech-stock bubble, these black-and-white definitions of growth and cyclical stocks have blurred.

IT is cyclical too

The turmoil in the economy and the stock market over this period has revealed the chinks in the conventional growth stocks. In the IT sector, earnings growth at some of the top-rung companies are down to single digits, with a few actually talking of a drop in earnings.

IT companies attribute this to a cutback in spending due to the economic slowdown, pricing pressure, excess capacity and rising costs. Do these terms have a familiar ring to them?

These are precisely the reasons that "cyclical" companies used to give to explain poor earnings performance during an economic downturn. This makes it clear that while Indian IT companies may not be susceptible to a slowdown at home, they are certainly vulnerable to business cycles in the key markets they target. The IT business is cyclical too.

FMCGs are not recession-proof

Cut to the FMCG sector, which was for long touted as a sure-fire option for "defensive" investors. The argument was that since FMCG products are objects of daily consumption, even an economic slowdown will not force consumers to cut their usage of these products.

The FMCG companies were supposed to have the pricing power to pass on all cost increases to consumers. But for a couple of years now, the FMCG majors, such as Hindustan Lever, have been grappling with slowing or shrinking offtake in key product categories.

Many are offering price discounts to lure consumers. Of late, even profit growth has dwindled to the single digits, leave alone sales. And the reasons offered for the slowdown are: A cutback in consumer spending due to the industrial slowdown, poor monsoons and consumer downtrading. This demonstrates that consumer-oriented companies may hold out longer than those who cater to industrial consumers during an economic downcycle. But if an economic slowdown is prolonged or particularly severe, it impacts consumer-oriented companies, too.

Pharma: Promising but volatile

Pharmaceuticals is one sector which continues to be less vulnerable to economic cycles. But this does not necessarily ensure consistent or high earnings growth. Over the past couple of years, pharma MNCs have found revenue growth slowing to single digit, due to price competition from a host of look-alikes. And the earnings of Indian pharma companies have turned quite volatile as they rely increasingly on litigation, to gain short-term marketing rights for generic versions of patented drugs. Dr Reddy's Labs managed a threefold growth in profits in 2001-02 after it received approvals for marketing its brand of Fluoxetine in the US that year. But earnings for 2002-03 have declined 28 per cent, as effects of this breakthrough wore off.

If the earnings performance of the "growth" companies has turned less consistent, stock prices of these companies have suffered sharp swings. The Infosys stock dropped by 40 per cent in just two days after its financial performance turned out to be less impressive than expected by the markets. The Dr Reddy's stock fell by 20 per cent over just a week in July 2002, when Novo Nordisk decided to suspend clinical trials of the company's diabetes drug. In fact, as the realisation about the vulnerability of the "growth" stocks has grown, the stock market has steadily marked down the valuations of the FMCG, pharma and IT stocks over the past couple of years.

Conversely, some of the companies operating in cyclical businesses have proved exceptions to the rule that their financials are inextricably linked to economic cycles.

Non-ferrous metals player, Hindalco, has registered a steady year-on-year rise in earnings through the worst of the slowdown from 1998 to 2002. So have ABB and Alfa Laval. This only goes to prove that cyclical stocks can deliver consistent performance. And growth stocks can turn cyclical too.

New rules of the game

ALL this calls for a review of conventional investment strategies that investors used for picking stocks. The following appear to be the new rules of the game:

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