The Sensex finally breached its 22 January lows on Thursday, but it’s still well above the depths it plumbed last August when the markets first woke up to the credit crisis. The Sensex had plummeted to a low of 13,779 points at that time. The Indian market had been one of the last to crumble, overshooting way beyond the “fundamentals” on the upside. A similar overshooting on the way down is also very likely.
One of the comparisons often made to justify our valuations a few months ago was to point to the Chinese market, which was even more wildly overvalued. How do our markets compare now, after having been beaten black and blue? Well, China’s Shanghai Composite Index has fallen 35.2% from the highs it reached last October. In contrast, the Sensex is off 27.6% from its January highs. We seem to be faring better, but then we were less outrageously valued. However, we’ve also been falling faster since January, making up for lost time.
Recall how equity strategists said our markets would continue to command a premium because the Chinese market commanded a higher one? Well, as the valuations came off the Chinese markets, so did ours, albeit with a lag. The Shanghai Composite Index currently quotes at a price-earnings (P-E) multiple of about 36, while the Se-nsex trades at a historical P-E of 19.4. That’s a big fall for the Shanghai index, which was at a multiple of 52 in October. In contrast, the Sensex valuation has fallen from 28.5 in January to 19.4. The coincidence is that both the markets have maintained about the same relative valuations—the Shanghai index having a P-E multiple of about 1.8 times the Sensex— both during their peaks and at present. Perhaps that’s because they face the same headwinds—global turbulence, slowing growth and inflation.
Tata Steel: the risk from leverage
Tata Steel Ltd’s consolidated numbers for the December quarter were much lower than expected, awakening investors to the risk of the high operating and financial leverage involved with the Corus acquisition.
The company’s profit before tax from overseas subsidiaries stood at a mere 1.7% of turnover. Operating profit of these subsidiaries fell to 6.9% of sales, from 9.8% in the September quarter and 11.8% in the June quarter. Corus accounts for about 90% of sales from overseas subsidiaries and almost the entire profit from overseas operations.
Despite initial scepticism after the Corus acquisition, Tata Steel shares had rallied on hopes that higher steel prices would benefit it, thanks to the high leverage at which Corus operated. The robust results in the June quarter had reinforced this theory, as overseas subsidiaries accounted for as much as 50% of consolidated profit before tax.
But, as this column pointed out early last month, leverage can cut both ways. In the December quarter, profit from overseas subsidiaries accounted for just 22% of consolidated profit. Considering that about 85% of the firm’s turnover now comes from overseas operations and that most of its resources are deployed in them, the profit contribution is insufficient. What’s more, profit before interest and tax stood at Rs1,175 crore, just 1.6 times the interest burden. There’s little margin for error.
And while Tata Steel’s domestic operations will certainly benefit from the buoyancy in steel prices, thanks to its captive iron ore and coal capabilities, Corus isn’t that lucky. The price increases it has taken largely offset the price increases it has granted to its iron ore and coal suppliers.
Thankfully for Corus, steel is expected to be in short supply in the near term, because of the shortage in raw material and on account of a drop in China’s net exports. Last quarter’s lacklustre performance was owing to a build-up in stocks in the European market, which led to a fall in sales in Corus’s key market. This should correct, but the possibility of a recession in the US could well keep price increases under check. A few months ago, Tata Steel’s share price seemed to reflect the large upside from high leverage. Having fallen about 33% from its peak, the worst may not be priced in, but investors have at least given more weight to the downside risk of high leverage.
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