Tuesday, January 14, 2014

Indian Rupee and Company earnings


THE RUPEE DEPRECIATION AND EARNINGS IMPACT

(This article published in latest Moneylife) The Indian rupee should normally depreciate at around six percent per annum against the big currencies like the US Dollar, Euro etc. I am simply using the difference between the inflation in India and the inflation in those nations. Just to give a backdrop, the US $ was worth Rs.7.50 in 1970. If I took an average inflation differential of 6% annual between India and the US (naturally, India with the higher inflation figure), the dollar should mathematically have been worth around Rs.92 by end of 2013.At a 5% differential, it should have been around Rs.61. In reality, the rupee has been cushioned to a large extent by the inflow of foreign currency through foreign remittances, FII and FDI inflows etc. If we look at our foreign exchange trade, we are consistently net importers. So we are always short of foreign exchange. We have survived due to these not trade flows that have propped up the rupee. Interestingly, if I take the 2002 average rupee to dollar rate of 48.23 and apply a 3% per annum depreciation, the rupee should have been worth around Rs.66 to the dollar by end 2013. I do not say that my method is the best or the only method, but I trust this. Purchasing power does not make sense to me, when our per capita is so poor and the day to day expenses are all globally price linked thanks to open economies. Subsidies if any come through only in petrol, diesel and kerosene. And the demand for and supply of foreign exchange is the other key determinant which can impact the rates. For the rupee to be stronger, we need to have an economy where more people want the rupee as opposed to foreign currency (exports plus remittances plus FDI/FII greater than imports & other outward flows).

This slide in the rupee can be used as an additional determinant in deciding an investment strategy.

The universe of listed in India can be broken down in to:

i) Operations in India, no imports and no exports- 100% domestic;

ii) Operations in India, net regular importer – Import intensive;

iii) Operations in India, net regular exporter- Export intensive; and

iv) Global operations- net foreign exchange earner- Global earners.

Given our expectations of foreign exchange flows, if we expect rupee to weaken over the near term, it makes sense to pick up those companies that are net earners of foreign exchange and vice versa. This is not to rule out fundamental analyses, but the foreign exchange factor would be useful in our stock picking.

At the present juncture, there is not much to move the rupee except some FII flows. FDI flows would be impacted by policy changes. The forthcoming general elections and its outcome will definitely have a bearing on this. Right now, the government is trying to restrain demand for dollars by putting curbs on dollars and providing greater incentives for exports. A falling rupee should logically help exports or earners of foreign exchange. If we were to get policy decisions that facilitate FDI in a big way, then it would be best to bet on those who are net users of foreign exchange.

As a strategy, in the near term, I would bet on foreign exchange earners- IT sector stands out as one clear winner. Yes, competition would perhaps lower the dollar pricing power to some extent, but not immediately. The momentum is clearly with the companies now. On the other hand, net users of foreign exchange- whether in capital goods or in petrochemical based commodities would see some squeeze in their margins. The ability to pass on cost increases is never unlimited.

Whilst looking at a company’s annual report, there is a table that shows the earnings and outgo of foreign exchange. Here it is best to focus on trade or business related outflows and inflows. A one off capital goods imports or dividend outflow to foreign shareholders should not be looked at. Similarly, those companies that have a high amount of foreign debt, will have higher rupee outflows. There may be some companies that have global earnings and they would be better placed if they have foreign currency debt. I ignore dividend outflows because dividends are fixed in rupee terms. It does not impact the margins or pricing power in any manner.

There are companies in commodity exports. Unfortunately, many of them could be in gem and jewellery or rice exports which are really trading on the margin rather than producers. Mining companies could gain if they are exporters. My expectation for the near term would be to bet on IT, Pharma companies with large exports, some engineering companies that have consistently growing exports. There would be some positive surprises from these sectors.

This is simply an additional input for constructing your portfolio. Fundamental analyses based on earnings and Return on Equity remains the key selection criteria as far as I am concerned.

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