Drought-proofing your portfolio

With weather officials finally conceding that the south-west monsoon has failed in 2009, should investors look to “drought-proof” their portfolios? The stock market certainly seems to think so. On evidence of a faltering monsoon, the stocks of FMCG and select automobile and two-wheeler makers — all of which rely largely on rural consumption — have been battered.

Stocks of agricultural input makers have been trimmed and substituted by sugar and rice processors who are seen to reap windfall gains from rising commodity prices. But analysis suggests that such a reaction to Monsoon 2009 may be premature. Investors can reduce the impact of drought on their portfolio by simply exercising greater selectivity in choosing stocks, rather than by giving entire sectors a wide berth.

Companies that rely on rural consumption may see the impact of lower farm output cushioned by higher agri-produce prices and counter-cyclical government spending. For agri-input companies, the impact of the deficient south-west monsoon would at best last through this quarter.

Muted market impact


For cues to future earnings, the key to stock valuations, investors need to watch prospects for the coming rabi season and beyond. (Kharif describes the cropping season from April-September, while rabi is the post-monsoon season, October-March). To begin with, a drought may not have a calamitous impact on either the economy or the stock market in today’s context. With agriculture contributing 17 per cent to India’s current GDP, economists expect that a 3 per cent decline in agriculture will shave about 0.50 percentage points off the annual GDP. If manufacturing and services stage a strong revival (helped by global cues), significant downgrades to GDP estimates may not be necessary.

Both manufacturing and services actually did rev up in 2002-03, the previous year when India witnessed a drought of worrying proportions. That suggests that the ripple effect of a poor monsoon on the rest of the economy isn’t very high. A drought may also not cause significant upheavals in the earnings of the listed universe. Sectors that have linkages to agriculture or rural consumption contributed only 6 per cent to the aggregate profits of the CNX-500 basket in the latest financial year.

Agri-input companies


Manufacturers of agricultural inputs — fertilisers, pesticides, seeds and tractors — are perceived to be the most direct victims of a deficient monsoon, going by the logic that lower crop coverage immediately trims their consumption. Fertiliser and tractor sales did, for instance, dip by 7 per cent and 25 per cent respectively in 2002-03. However, 2009 may be quite different, owing to three factors.

One, the failed monsoon of 2009 follows four consecutive years of normal or above normal rains. Two, unlike 2002, rural purchases have remained strong in the first few months of this fiscal, helped by a a robust 2009 rabi crop and upward-bound market prices for agri-produce. Take fertilisers. Sales have already expanded by 9 per cent in the April-August 2009 period, despite the erratic monsoon. DAP and complex fertilisers saw scarcely any impact, with sales volumes expanding by 46 per cent and 12 per cent respectively in this period (urea sales fell by 6 per cent).

Given the substantial 25 per cent shortfall between domestic demand for and supply of fertilisers even this year, fertiliser makers appear well-placed to deliver volume growth in 2009-10, provided the rabi crop turns out reasonably well. Investors in fertiliser stocks should, therefore, pay closer attention to factors such as international price trends and subsidy disbursals, as also the Rabi season, while selecting stocks.

Crop protection companies may be more vulnerable to a poor monsoon than fertiliser makers (given that pesticides are applied at a later stage); but the saving grace lies in the 17 per cent expansion in the acreage under cotton, the key target crop for pesticides.

Of the listed players, investors should best take a cautious stance on players with a significant domestic presence — Rallis India and Monsanto (both closed the June quarter with flat sales). Investors in other agri-input companies such as makers of seeds (Advanta India and Kaveri Seed) may not have much to worry about from the monsoon. Not only have seed sales remained quite strong in previous drought years (2002-03, for instance), the substantial shortage of hybrid seeds, the likely government push to seed sales and buoyant trends in agri-commodity prices may support volumes.

If the impact of a drought on agri-input companies is direct and immediate, its impact on consumption is more difficult to quantify. Yes, a poor monsoon is bound to dent consumer confidence in rural India and may cause deferred purchases.

Whither rural consumption?




That is worrying, given that rural India’s spending spree has been a key driver of growth for sectors ranging from FMCGs, to consumer durables and motorcycles in the slowdown-hit economy of last year. But whether the failure of this south-west monsoon will prompt rural consumers to tighten their belts over the next year or two, really hinges on three factors.

One, while farm output may shrink on lower crop coverage, this may be partly or entirely made up by the higher agri product prices. In this respect, 2009, where global trends are supportive of higher farm product prices, may be a much better year than 2002, when the dip in farm output was accompanied by muted (3 per cent) inflation in agri product prices.

Two, splurging by the government on rural infrastructure building schemes such as Bharat Nirman, JNNURM and NREGA, not in the picture in 2002, may help soften the blow from a poor crop in 2009.

Three, the big push to agricultural credit and lower interest rates may continue to make big-ticket purchases more affordable for rural consumers.

There is also no evidence from the sales trends over the past 10 years to suggest that sectors such as commercial vehicles, FMCGs or even two-wheelers face an impediment to volume sales in a drought year; each of these sectors expanded by healthy double digits in 2002-03. While volume sales may not be impacted much, the possibility of consumers turning more value-conscious and downtrading to cheaper products cannot be ruled out.

Consumer durables and tractor sales were the only ones to suffer that year (sales down by 6 and 25 per cent respectively). However, purchases in both these segments, being credit funded, have displayed an increasing sensitivity to the availability of finance and interest rates in recent years.

Having said this, investors should note that FMCG companies are trading at rather rich valuations after leading the recent stock market rally. This may make stock prices vulnerable even to a small blip in their growth rates. Seen in this backdrop, it may be best for investors to avoid companies in these sectors with a sizeable rural footprint, until clarity emerges on spending.

In the FMCG space, Hindustan Unilever and Dabur India (nearly 50 per cent rural sales), Colgate Palmolive (35 per cent) may be more vulnerable than Nestle India, Marico or GSK Consumer (less than a fourth). In addition, investors should also take care to avoid users of agri-products such as sugar, milk and coffee, as they have spiralled on the poor monsoon. In the auto space, Hero Honda and M&M may be more vulnerable to poor rural demand than others such as Maruti Suzuki or Bajaj Auto.