8/4/12

HVS International - Global Hospitality Consulting

Bulls Eye Opportunities in the Current Sensex Run-up

For the last two years, the Sensex has been driven by good monsoons, the metal commodity cycle and foreign investments. Hotel stocks and real estate not only offer an opportunity to ride the Sensex euphoria in India but also to hedge portfolio risk. By Gunjan Bahl, September 6, 2005 If you don't know what is happening in the equity market in India, chances are you've already missed an opportunity to double - or even triple - your money in the last two years. India's bourses have seen hectic, rather, unprecedented activity in recent times: the National Stock Exchange (NSE) is presently hovering around the 2,400 mark, against a level of 985 two years ago (April 1, 2003). Even mutual funds have been boasting of a Compound Annual Growth Rate of 80% in the last 2 years. So, is now a good time to invest in the country's equity markets? Are the economy's fundamentals indeed strong enough to sustain investor confidence, or are we looking at a scenario of inflated expectations, where too much liquidity is chasing too few assets. The indications are mixed. Some analysts argue the rally is liquidity driven and it is the new Japanese money making the rounds in India. Others justify the Sensex run up with the fact that 'Corporate India' has posted a year-on-year net profit growth of over 50%1 for the second year running. In the present day scenario of political and economic stability in India, investments are flowing in. More and more new companies are opening their offices in India and the existing companies are expanding. The IT-ITES industry alone is expected to grow at a level of 29% annually2 , from its present level of US$28 billion to as much as US$60 billion by 2008. Tourism also looks promising: in the first two quarters of 2005, international arrivals are estimated to have increased by 15.87% over the same period last year. Increased commercial activity and tourism, quite naturally, leads to heightened hotel and real estate activity. This leads me to the objective of this article: given a rapidly rising Sensex, which is scaling a new high everyday, are there any opportunities left in the Sensex? Specifically, does it make investor sense to put money in hotel stocks and real estate? The Investor Needs to Check-In - A Case For Hotel Stocks It is common knowledge that hospitality is a cyclical business, highly dependent on macro economic factors. The macro economic environment currently in India is favorable for hotels to flourish. Revenue per Available Room (RevPAR), which is achieved using the market-wide occupancy and average room rate (ARR), increased by 8%, 13% and 35% in 2002/03, 2003/04 and 2004/05, respectively (the average for eight cities in India). Increase in room supply puts downward pressure on RevPAR and increasing demand boosts it. Hence, RevPAR gets adjusted for demand and supply. For the purpose of this article I'll call this phenomenon as 'adjusted RevPAR'. The hospitality industry experiences a demand-supply gap on an ongoing basis. With increased demand of hotel rooms in a city, the occupancy rises. A stretched period of high occupancy is followed by high ARR. The inflated average room rate then makes more hotel projects feasible. When supply starts entering the market, occupancy and ARR start plummeting. Equilibrium is rarely established because supply tends to continue even after the demand is satisfied. This is because of imperfect information and construction lag. The above is the business cycle of favorable times. Also, another interesting feature of hotels is that they are a lot like manufacturing units!! Hotels are capital intensive and can't alter much of the costs, depending on the occupancy. So in times of high adjusted RevPAR, as is typical of manufacturing companies with high fixed costs, every Rupee added to the top line, beyond a point, more or less goes to the bottom line. Thus, it is a good idea to invest in hotel stocks if the adjusted RevPAR is projected to increase. Research conducted by HVS International indicates that the existing inventory of hotel rooms in India, within 5 years, will increase by approximately 70% of the current base. Prima facie, it looks as though the adjusted RevPAR might be headed for a correction. However, new inventory will not be entering the market all at one time but in phases. For example, in the National Capital Region (Delhi, Gurgaon and Noida), the bulk of expected new supply would enter in and beyond 2008/09 (refer Table 1). This is the case with almost all cities in India. Thus, there would be no immediate pressure on RevPAR and, given the robust demand, one could expect further appreciation in
www.hvs.com/StaticContent/Library/090605/ 1/4

8/4/12

HVS International - Global Hospitality Consulting

RevPAR. It may be noted that industry analysts are already projecting a 25% increase in RevPAR for the coming season, that is, for the third quarter of 2005/06. Table 1 Year 2006/07 2007/08 2008/09 2009/10 2010/11 Percentage-wise break-up of New Supply to enter NCR (2006/07 to 2010/11) 20% 13% 47% 13% 7%

From a demand and supply point of view, it make a lot of sense to invest in hotel stocks. But, how do hotel stocks fair on the portfolio management criterion? A correlation study between the Sensex and two most liquid hotel stocks, Indian Hotels (IHCL) and East India Hotels (EIH) - reveals the relationship between the Sensex and hotel stocks (See Table 2 and corresponding chart). For the purpose of comparison, I have used the closing levels of the Sensex and the above-mentioned companies' stocks from 1st January 1996 to 31st March 2005. The chart clearly shows that while the NSE has almost tripled from the 1996 levels, the hotel stocks are more or less at the same level. Table 2 : Correlation Study of Sensex with Hotel Stocks

Correlations Sensex Close Sensex Close EIH Indian Hotels 1.00000 -0.19515 0.01532

EIH -0.19515 1.00000 0.87773

Indian Hotels 0.01532 0.87773 1.00000

The above table elucidates that hotel stocks have little or negative correlation with the Sensex but very high correlation (.87) with each other. We can make three deductions from this correlation study: If one is holding stocks, which have high correlation with the Sensex, hotel stocks can actually be used to diversify the portfolio and reduce risk. If one assumes that this is peak of the Sensex and there are only specific sectors that offer opportunities for investment returns then, probably, this is a good time to buy hotel stocks. Because of their high correlation with each other, one hotel stock in a portfolio (of the two used in the study) is as good as the other. All in all, given the growing demand for hotel rooms, inadequate supply for at least next two years
www.hvs.com/StaticContent/Library/090605/ 2/4

8/4/12

HVS International - Global Hospitality Consulting

and underperformance of hotel stocks relative to the Sensex, there is a good case to buy and hold hotel stocks for at least the next two years. RealTY Bytes - A Case For Real Estate A robust economy leads to demand for commercial space. In turn, every square foot of commercial space induces demand for residential space. One sector, specifically, that is driving the commercial boom in India is the BPO sector. According to industry estimates, approximately 110 million square feet of commercial space will be required for the BPO sector alone in the next five years a huge level of demand, especially when compared to the existing absorption levels. Club this with low interest rates and the resultant burgeoning housing loans and increase in bank lending to corporate and developers to buy land. Rentals and capital values have been showing an upward bias in the past one-year in various cities in India. Again, from a demand and supply point of view, real estate is a good bet. Investing in land comes with its own frills. Firstly, land is not as liquid as stocks. Secondly, it is more prone to speculation because of lack of transparency. Then there are legal hassles associated with the purchase of land. Given these concerns and the search for the best use of money, considering the favorable macro-environment, why not park the funds in equities. A correlation study of the Sensex with real estate prices actually shows results similar to the previous study, that is, the correlation between Sensex and hotel stocks - only, this time, the results are quite stark. Due to lack of data points for property prices, the study is done using the annual Sensex average and the average annual property prices in four regions in India, from 1995 to 2004. Table 3 summarizes the correlation study: Table 3 : Correlation Study of Sensex with Property Rental Values Correlation Study Sensex Average Sensex Average CBD (Nehru Place, New Delhi) Secondary Micromarkets (New Delhi) CBD (Nariman Point, Mumbai) Non CBD (Worli, Mumbai) 1.00 -0.50 -0.56 CBD (Nehru Place, New Delhi) -0.50 1.00 0.85 Secondary Micromarkets (New Delhi) -0.56 0.85 1.00 CBD (Nariman Point, Mumbai) -0.64 0.83 0.94 Non CBD (Worli, Mumbai) -0.49 0.88 0.91

-0.64 -0.49

0.83 0.88

0.94 0.91

1.00 0.94

0.94 1.00

The first row of the above table highlights that real estate has a negative correlation with the Sensex but there is a high correlation between all the four regions used in the study (second row). We can make following deductions from the above analysis: If one has invested in equities as an asset class, real estate can be used to diversify the portfolio. If the Sensex is touching its peak then, given the above correlation, this is a good time to take some money out of stocks and invest in real estate. The Reserve bank of India (RBI) has already increased the real estate bank lending risk rating by 25 basis points in its latest credit policy review. Given the hassles of investing in real estate, the best option for a small investor is to invest in a Real Estate Investment Trust (REIT). A REIT trades on the Sensex like a regular stock and the shares can be bought online or from a regular broker. There are real estate funds in India, like HDFC India Real Estate Fund, but no REITs. The current conditions in India present a good platform for the launch of a REIT. For the last two years, the Sensex has been driven by good monsoons (in 2003 and 2004 and a reasonable monsoon this year), the metal commodity cycle and foreign investments. The existing high returns in equities are not sustainable in the long run. Rising oil prices are posting a high inflation risk. RBI is currently sticking to its inflation target of 4.5% to 5 % for the year but is willing to increase the interest rates, when finally there is pass-through of international oil prices to domestic prices, to control inflation. In the present Sensex euphoria, where some key macro indicators are
www.hvs.com/StaticContent/Library/090605/ 3/4

8/4/12

HVS International - Global Hospitality Consulting

being ignored, hotel stocks and real estate not only offer an opportunity to ride the commercial boom but also to hedge portfolio risk. The article is b ased on the author's own research work. Reference: 1. Corporate India on a high, BusinessStandard May 30, 2005. A total of 1325 companies polled, in 2004/05 posted a 54.8% growth in net profits over previous year and in 2003/04, the year on year growth in net profits was 59.1%. 2. Nasscom IT-ITES industry fact sheet.

www.hvs.com/StaticContent/Library/090605/

4/4