The earnings season is upon us once again. Expectations are high and so is the market, which seems to be trying to break out of its range. With the Sensex at around 17 times FY11 earnings, good results are essential if the market is to stay at current levels.
Corporate results for the March quarter are expected to answer a host of questions. Is demand improving and is it becoming more broad-based? Will we see private consumption becoming the engine of growth once again as the government stimulus winds down? Are higher input prices starting to hurt margins? Will we see a revival in capital expenditure, reflected in the order books of engineering and infrastructure firms? Most importantly, will earnings growth surprise on the upside, leading to analyst upgrades, thus providing a justification for the next stage of the rally?
The mood is certainly optimistic. Macro numbers and industry data indicate that recovery continues, although the most recent Purchasing Managers’ Index and Index of Industrial Production (IIP) data suggest that momentum may be flagging a bit. Both the export and non-oil import numbers imply strong domestic as well as external growth. Firms see a revival of pricing power and plan to expand capacity.
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In fact, the fourth quarter is expected to be one of the best quarters for Indian firms after a long time, at least so far as year-on-year numbers go. Broker Motilal Oswal Securities Ltd puts year-on-year growth in profit after tax (PAT) for the Sensex firms at 33% for the March quarter, up from 14% in the December quarter. The brokerage expects 25 of the 30 Sensex stocks to post positive earnings growth, the laggards being BhartiAirtel Ltd, Reliance Communications Ltd, Hindustan Unilever Ltd and Sun Pharmaceutical Industries Ltd. Sequentially, too, growth is expected to be robust. Citigroup Inc. forecasts a year-on-year PAT growth of 34.9% for the Sensex firms and a PAT growth of 16.5% over the December quarter.
But while analysts agree on the good numbers for Q4, they talk, in the same breath, of several bumps on the road. These include high inflation and the rise in commodity prices, especially oil; monetary tightening by the Reserve Bank of India (RBI); worries about whether the next monsoon will be good; and rupee appreciation. This is the wall of worry that the market has had to climb. Putting it another way, the question is whether the momentum in earnings can be expected to last.
Some believe it may be a trifle early to start asking these questions at the current stage of the recovery. After all, the capex cycle is yet to kick in, and interest rates, although headed north, are still low. Motilal Oswal builds a case for continuing foreign investment inflows on the basis of compounded annual growth rate in Sensex earnings of around 23% over the next four years. Angel Broking Ltd forecasts Sensex earnings per share to grow by 25% in FY11 and 17% in FY12. The implicit assumption is that after two years,during which Sensex earnings stagnated, we’ll be going in for a boom similar to the one we had during 2003-07.
The more pressing concern, though, is whether the good Q4 numbers will translate into earnings upgrades. This is what Citigroup’s Aditya Narain and Tirthankar Patnaik have to say: “So, is the earnings upgrade cycle upon us? While there is plenty going for it—strong quarter, little aggregate earnings change since July 2009 (been a while now), stronger-than-expected demand and relative commodity price firmness—we think not. We are confident of strong growth (18-22%), but distinctly less so of strong upgrades (at least over the next quarter). Interestingly, recent upgrades are for companies that made large global acquisitions: swinging from losses to profit. Could this be India’s earnings story vs global markets—no big pain last year, so no big gain this year?”
It’s very likely, though, that a combination of good growth, liquidity and currency appreciation will continue to favour emerging market assets, although there will certainly be alternate periods of over- and under-weighting a particular country. Despite the surge in US yields and worries over Greece, emerging market credit spreads have continued to narrow.
In the near term, there is a concern that supply-side problems are beginning to re-emerge. For instance, HSBC Holdings Plc economist Robert Prior-Wandesforde says the drop in the IIP number reflects supply rather than demand constraints.
The silver lining, though, lies in rising infrastructure spending and in the continuing strength of capital expenditure. Data from the Centre for Monitoring Indian Economy shows that gross fixed asset growth of the manufacturing sector fell to 8% in 2003-04, at the fag end of the last business cycle. In contrast, even in 2007-08, fixed asset growth was 13.3% and it was 14.6% in 2008-09. Looking ahead, fixed capital growth is likely to be much stronger, giving an added boost to growth.
It’s the interim period, though, that’s a worry. As Prior-Wandesforde points out, “The bad news for RBI is that it will take some considerable time before the extra capacity comes on stream and in the meantime the increase in capex is using up resources which are already in short supply. The net result is likely to be higher underlying inflation which is already looking troublesome.” That explains the marked lack of unbridled optimism in the market.
Manas Chakravarty takes a weekly look at trends and issues in the financial markets. Your comments are welcome at email@example.com