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Business News/ Opinion / Time to realign stock returns with actual earnings
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Time to realign stock returns with actual earnings

While earnings growth is expected to pick up slowly, the recent correction factors some concerns

Shyamal Banerjee/MintPremium
Shyamal Banerjee/Mint

It is now common knowledge that India is among the worst performing markets in the world. The critical element that’s missing from a market that was among the best performers last year is a follow-up on earnings growth. Indian markets have entered a phase of consolidation. From the peak in April 2015, the CNX Nifty and CNX Midcap indices have fallen by 10% each. While many factors are being attributed to the sell-off in the markets, the underlying reason behind the fall in stock markets is consistent and continued downgrades in earnings estimates. For instance, at the beginning of the year, we were expecting earnings of large-cap stocks to increase by 12.6%. The actual increase is only likely to be 5.5%. A similar trend has played out in mid-cap stocks as well.

Though earnings have been elusive, stock markets have been hoping for a much delayed recovery. At the turn of an economic cycle, markets generally hope for a sharp increase in earnings. This holds true especially for mid-cap stocks, which are expected to benefit from an improvement in demand, which will lead to increase in profitability due to operating leverage and pricing power. This is the reason why while Nifty has given a return of 21% in the past one year, the CNX Midcap index has returned 40%. Many mid-cap stocks now trade at higher than 25 times one-year forward earnings estimates. There are stocks such as Motherson Sumi Systems Ltd whose current market capitalization almost equals that of Hero Motocorp Ltd and Bajaj Auto Ltd. Stocks in the consumer discretionary segment, such as Havells India Ltd, Voltas Ltd and Symphony Ltd, and in the home improvement segment, such as Kajaria Ceramics Ltd and Century Plyboards India Ltd, trade at price-to-earnings (P-E) multiples that are significantly higher than the broader market. Mid-caps have been so much in flavour that many foreign institutional investors (FIIs), too, actively invest in Indian mid-caps.

The outperformance of mid-cap stocks was justified by earnings momentum seen in these stocks up to the September quarter of financial year (FY) 2015. Profit after tax of mid-cap stocks (adjusted for volatile oil and gas stocks) increased by 17% in the March quarter of FY14 and gained further momentum to grow by 30% in the September quarter. However, earnings momentum slumped in the December quarter (profits declined by 9% in the third quarter of FY15), largely explained by a decline in margins. While early results for mid-cap stocks are much more promising at 14%, revenue growth has been subdued at less than 5%.

Even earnings growth of stocks was ahead of expectations only up to the June quarter of FY15. For instance, actual profit growth of stocks covered by IDFC Securities Ltd excluding oil and gas stocks at 16.2% was ahead of the earlier estimate of 15.4% in the June quarter; for the September and December quarters, profits missed estimates by 3.4% and 7.6%, respectively. Profit after tax is expected to decline by 4.6% for these companies.

While profit growth missed expectations, the hope of a sharp earnings recovery has increased. During FY16 and FY17, profit growth of CNX Midcap index is now pegged at more than 20% compounded annually, over the estimate for FY15-17.

For large-cap stocks, the hope of earnings recovery is even higher. As a result, both the mid-cap and large-cap indices are now trading at 15 times P-E ratio of FY16 earnings, which is at the higher end of the trading band.

The hope of sharp acceleration in earnings is based on a rebound in economic activity. But there are significant headwinds. With poor global demand and relative appreciation of the Indian rupee, exports are struggling to grow. In fact, non-oil exports have declined by 6% in the January-March 2015 period compared with an increase of 5% in the April-December 2014 period. At the same time, domestic consumption has suffered from a deficient monsoon last year and the recent unseasonal rains. Government estimate is that as much as 30% of area under rabi cultivation has been affected by the unseasonal rains. This, in turn, will impact consumption demand in FY16. This year, too, the India Meteorological Department has predicted below-normal monsoon. Two back-to-back poor monsoons will substantially affect consumption and farmers’ ability to pay back their loans. On the supply side as well, indicators are pointing towards a downtrend. The core infrastructure index, which comprises of sectors such as cement, steel, coal and electricity, has increased by only 1.1% in the March quarter compared with an increase of 4.4% in the previous three quarters. Even bank credit to industry and services (which together comprise more than 80% of India’s gross domestic product) increased by only 5.6% as of March 2015. With capacity utilization at low levels, industrial capital expenditure is likely to remain muted in the near term.

On the brighter side, the central government’s revenue is likely to increase at 16% in FY16 (after increasing at less than 10% in the past two years) on the back of a hike in excise duty on petrol and diesel, and service tax.

Low revenue mop-up along with fiscal consolidation by the government, dragged growth in the past two years. With government revenue looking up, government spending is expected to drive growth. But the pace of recovery may not be in sync with earnings expectations of mid-cap and large-cap stocks.

The current consolidation is very healthy for the markets and adjustment of stock prices with actual earnings growth will lead to more sustainable returns in the long run.

While earnings growth is expected to pick up slowly, the recent correction factors some concerns. However, markets are expected to consolidate around these levels for the next few months. Nearly 70% of Nifty stocks traded below 200-day moving average while just about 50% of stocks in mid-cap indices traded so. It would be prudent to pare some holdings in mid-caps and move to large-caps.

Anish Damania is co-chief executive officer and head-institutional equities and strategy, IDFC Securities Ltd.

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Published: 28 May 2015, 07:08 PM IST
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