One of the strongest arguments for investing in stocks is that they provide protection against inflation. Market observers have often said that Federal Reserve chairman Paul Volcker’s successful fight against US inflation in the late 1970s and early 1980s laid the groundwork for the huge bull run in the US stock markets in the 1990s.
Is there a similar correlation between inflation and the Indian stock market? Well, inflation based on wholesale price index (WPI) was at a very low 1.8% in March 2002, but that had no appreciable impact on the market—the Sensex was at 3,469 points at that time, marginally lower than in March 2001. Or, consider 1995-96, when the inflation rate had fallen to 4.5% by March 1996, after being as high as 16.9% a year earlier. Yet, between March 1995 and March 1996, the Sensex moved up just a tad, from 3,260 to 3,366.
Now consider periods of high inflation. In March 1995, WPI inflation was at 16.9%, rising from 10.6% in the same month the previous year. The Sensex fell from 3,778 to 3,260 over the period. But between March 1993 and March 1994, the Sensex rallied 65%, although inflation increased from 7.1% to 10.6%. The data seem to show that the Sensex has little correlation with WPI inflation.
Does the kind of inflation make a difference? The argument that stocks are an inflation hedge is based on the premise that companies are able to raise prices during inflationary times, protecting their earnings. On the other hand, if input prices rise more than that for manufactured goods, then margins will be squeezed. Well, fuel price inflation was at 10.4% in March 2005, but that had no appreciable impact on the bull run then under way. And back in 1993-94, in spite of big increases in inflation for primary articles and for fuel, the stock market rallied.
Clearly, there are more powerful factors than inflation that affect stock prices.
Could it be growth? Not really—gross domestic product (GDP) growth was 7.3% in 1995-96 and 8% in 1996-97, yet the Sensex went up all of 3% between March 1995 and March 1997. Yet, when GDP growth fell to 4.3% in 1997-98, the Sensex went up in that year.
Could it be interest rates? The 10-year yield on the benchmark government bond fell from 10.86% in March 2000 to 6.19% in March 2003, but the Sensex too fell during the period.
On the other hand, the 10-year yield went up from 5.15% in March 2004 to 7.93% in March 2007, yet that was the period that saw a huge rally in the Sensex.
However, it’s likely that the huge fall in interest rates from the late-1990s prepared the base for the big rally in stocks years later. And as we can see today, the lagged effect of rising interest rates did impact earnings in the interest-rate sensitive sectors, which affected stocks in those sectors.
In a recent note by Citi Investment Research’s global equity strategists, they looked at the relation between inflation and stock returns in global markets and concluded that “investors need three things to occur for equities to provide strong returns. First, inflation needs to be in the ‘not-too-high, not-too-low’ range. Second, inflation should be falling. Third, valuations should be reasonable.”
That last bit about valuations perhaps makes all the difference.
And as far as the Indian market is concerned, that valuation has usually depended on foreign fund inflows. Liquidity, rather than domestic fundamentals,has been the main determinant of returns in the Indian market.
Emami’s current growth reflects its hunger
Emami Ltd has grown its net profit by as much as 46.6% on a compounded annual average basis in the past three years, riding piggyback on a smart 38.7% average annual growth in sales.
The company’s acquisition of a large stake in Zandu Pharmaceutical Works Ltd at a premium valuation shows that it wants the growth momentum to continue. One analyst says it reflects Emami’s hunger for growth.
The company has bought out one of Zandu’s promoters at Rs6,900 per share, which works out to a valuation of over 30 times expected earnings for the year till end-March 2008 (Zandu is yet to report the results).
Emami itself trades at about 20 times trailing earnings, which signifies that it’s paying a high premium for gaining control of Zandu.
It has offered minority investors a slightly higher price (Rs7,315 a share). But another promoter group, which manages the company, is likely to stay put and the acquisition may not be smooth.
Even if Emami gets control, it’ll be after paying a substantial premium.
All this makes the acquisition look expensive. Not only is the price-earnings multiple much higher than peers, but even Zandu’s growth rate has been rather sedate at 4% for the first nine months of financial year 2007-08.
But, since Zandu fits almost perfectly into Emami’s plans, based on its product portfolio and its digestible scale of operations, the latter’s willingness to pay a significant premium is understandable.
Emami operates with negligible debt (Rs38 crore at the end of March 2007), generates strong cash flow and should therefore manage the acquisition cost fairly well.
But the key issue is whether shareholders will be willing to budge. The Zandu stock trades at Rs9,509, about 30% higher than the open offer price.
From a minority shareholder’s perspective, however, current prices seem like a great level to exit with valuations being as high as 40 times earnings.
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PTI contributed to this story.