BackPick quality stocks that sustain earnings
In a market rally, almost all stocks' prices rise; only ones with reasonable earnings growth last
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Equity markets rewarded the patient investor this year. Shares, which may have been sitting in your portfolio for months without much activity, seemed to get a sudden boost of life. Most of this can be attributed to the expectations built up on economic growth after the new government took the reins. Through the rally, almost all kinds of stocks across market capitalizations went up, but it was the quality companies that were able to sustain the gains in their stock prices. Others have fallen by the wayside.
Portfolio managers say earnings growth and the sustainability thereof ultimately gets reflected in the stock prices. Therefore, quality of earnings is important. This is the focus required for wealth creation.
In focus
Motilal Oswal Securities Ltd recently released its 19th Wealth Creation Study. It found that in the past five years, Tata Consultancy Services Ltd (TCS) has been the biggest wealth creator, Eicher Motors Ltd the fastest, and Kotak Mahindra Bank Ltd the most consistent. Not all of these stocks were the biggest gainers in the current rally; TCS went up 14%, Eicher 135% and Kotak Mahindra Bank 56%. Nevertheless, these stocks have shown a high ability to create wealth through stock market returns in the past five years and they have done so repeatedly and consistently. We invest in equity to create wealth. While the rally this year was thanks to a few events, which built up optimism, wealth creation or stock selection for creating wealth is not dependent at all on macro events and is linked to a company’s ability to grow earnings at a faster rate, consistently.
Ambareesh Baliga, an independent market analyst, said, “While quality stocks moved up in step with the market as a natural progression, some others also went up thanks to expectations. Then there were sections of the market that didn’t move up. The stocks that rallied and gave high returns without rationale, fell later. For example, there was a lot of interest in infrastructure and power stocks, which did well initially but have underperformed in recent months."
So, while many stocks rallied when the markets started to move up this year, not all have seen the rally last. If you look at how the Nifty 50 stocks have performed this year, there are at least five that went nowhere despite the markets moving up sharply. It’s the same with CNX 500 stocks—at least 16% haven’t rallied more than 10% or have, in fact, seen share prices fall in the past one year. Moreover, there are many stocks in the engineering and capital goods space that rallied in the initial part of the uptrend and have either stalled or fallen sharply since then.
According to P. Phani Sekhar, fund manager, Angel Broking Ltd, “Many of the low quality stocks rallied sharply in the beginning. However, soon it was clear that there is too much hope built into the rally and it doesn’t have a direct link with improvement in fundamentals. For example, the infrastructure space still has nothing to go for it and hence, there is no reason to continue backing a P-E (price to earnings) re-rating." In such instances, the rally doesn’t last and sharp price corrections aren’t surprising.
Expectations can only carry share prices up to a certain level; then actual earnings growth has to kick in. For many stocks, when the earnings visibility did not improve despite the green shoots in economic data, stock prices adjusted lower.
Prateek Agarwal, chief investment officer, ASK Investment Managers Pvt. Ltd said, “Quality stocks underperformed in bits at the start of the rally and beaten down segments went up sharply. But the latter was more on exuberance and the rally didn’t sustain where earnings failed to catch up."
Spot on
Sekhar advises to stick to high quality names and avoid capital intensive segments. There are many things that determine whether a stock is of good ‘quality’ or not. However, the primary determinant is the ability of the company to generate earnings growth in a sustainable manner.
“Measuring quality means a combination of financial health and management integrity. Good numbers can sustain only if the management is good. And growth is important too. Quality without growth won’t make money," said Agarwal.
One has to also consider whether the management will be able to maintain the rate of earnings growth and capitalize on market opportunities so that market share is also growing. However, this part is easier said than done as it requires investors to make a judgment about a management’s ability to run a company and to manage growth.
Another important aspect according to Baliga is to analyze the industry that the company operates in. If the fortunes of the industry aren’t looking up, even with quality management and strong financials, stock prices may remain subdued. Citing an example, Baliga said, “Stocks in the sugar industry aren’t likely to do well even with the backing of a good management."
Along with the management and financial performance, analyzing each company’s competitive advantage can set it apart from others in a segment.
Identifying quality companies is the first step. Then you have to be able to buy these ideas at a reasonable price. Once again, that can’t be restricted to a specific number and rather the valuation has to be seen in context of the overall business, the industry the company operates in and the people behind it. One may be willing to pay a premium for quality and growth.
Mint Money take
This year saw a great rally in equity, and much like other periods of market rally, quality stocks stood out as earnings growth underlined the faith. Investors should start 2015 with a conviction to invest in quality stocks. If you don’t have the wherewithal to filter the noise, entrust a credible fund manager with the job. It doesn’t end at buying quality stocks (directly or through mutual funds); one has to hold on till the time earnings growth is delivered at a pace faster than peers.
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