Everybody knows the Indian market is expensive. The question is: Do the high rates of growth justify the high valuations? Which parts of the market are most expensive?
Here’s the data, culled from the Bombay Stock Exchange (BSE) indices and from the corporate results of the companies that make up the index. The chart shows the current price-earnings (P-E) multiple of the BSE sector indices, together with the growth in net profits in the September quarter of the companies that make up these indices.
The first thing to note is that the P-E multiples of almost all the sectors are higher than their year-on-year rates of growth, except for the IT sector. That’s an indication that the prices of some IT stocks, which have been hit badly by their being out of favour with the market at the moment, have fallen below their fair values.
The banking and real estate sectors have not been included in this analysis as the P-E multiple is not the right valuation tool for these businesses.
It could be argued the market is forward-looking, so historical rates of profit growth are not really relevant. That is correct, so we need to take a look here at whether profits have been growing. The problem is, if we compare the year-on-year rate of growth of the companies in each sector in the June and September quarters, we find that profit growth is slowing down in every sector, except for capital goods.
Here are the numbers. In the auto sector, profit after tax growth was 13.95% in the June quarter, falling to 10.75% in the second quarter. In consumer goods, 24.9% in Q1 and 12.31% in Q2; health care—down from 41.3% to 13.1%; IT—38.6% to 29.4%; metal—14.4% to 7.95%.
The capital goods sector, however, saw profit growth of 43% in the September quarter, higher than the 30.45% notched up in the June quarter. No wonder that it’s the capital goods stocks (together, of course, with the various Reliance pack of companies and the power stocks), that have been doing most of the running in the current rally.
Of course, there are other factors that could be trotted out for the high valuations —the “embedded value” in subsidiaries that could be listed in the future, the prospect of strategic investors buying into the company at a high price, or a re-rating of the Indian market. But these are post-facto justifications —in reality it is liquidity, not valuation, that is driving prices. As funds flows tracker EPFR Global points out, in the last week of October, “Investors parked another $1.91 billion (Rs7,525 crore) in Asia ex-Japan Equity Funds as India’s benchmark Sensex index broke through the 20,000 point mark and Hong Kong’s Hang Seng, Korea’s Kospi, Malaysia’s KLSE Composite and Indonesia’s Jakarta Composite all hit record highs.”
Mahindra & Mahindra Ltd shares dropped more than 7% after it announced lacklustre results for the quarter ended September. Net sales of the core auto businesses grew by 12.5% on the back of a 19% growth in volumes, but operating profit grew by just 4% owing to pressure on margins.
Average realizations were lower simply because of lower share of tractors in total volumes. Tractor sales have been on the decline for the whole industry—to M&M’s credit, its tractor volumes have declined at a lower pace. But falling sales took their toll on the division’s profit margin, which fell by 170 basis points.
Even the automotive division, which houses utility vehicles, light commercial vehicles and three-wheelers, witnessed pressure on margins. Although utility vehicle sales have been growing at fast pace, cost pressures led to a 70 basis point drop in margin. The company also had to contend with lower realizations for its exports due to the rupee appreciation. While operating profit rose marginally, higher interest costs led to a 9% drop in net profit adjusted for exceptionals.
While the drop in earnings wasn’t significant enough to revise earnings estimates downward substantially, the September quarter results did paint a bleak picture. Nevertheless, the core auto business now accounts for only about 45% of the firm’s total valuation.
A large chunk comes from the company’s holding in subsidiary companies such as Tech Mahindra Ltd and M&M Financial Services Ltd. Unfortunately for investors, investor sentiment is bleak for software stocks currently and Tech Mahindra shares, too, have underperformed lately. Tech Mahindra accounts for a large chunk of the subsidiary related valuation of M&M.
The company reported strong sales for the month of October, which helped its shares recover a bit (they’re still 5% lower compared with the levels prior to the results announcement).
The automotive division grew sales by 31%, excluding sales of Logan by subsidiary company Mahindra Renault. While growth of LCVs and three-wheelers was low, utility vehicles grew by more than 40%.
The worry, however, is the tractor division, which reported a 16% drop in sales last month owing to floods in certain parts of eastern India and because of a drop in retail sales in key states such as Uttar Pradesh and Karnataka.
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