Views | The Indian markets -- the good, bad and sad

It is difficult to say anything good about Indian markets these days but one such feature is easy to find in attractive valuations. As a matter of tautology, valuations improve as markets head southwards.

But that’s not all.

Surprising as it sounds, corporate earnings seem to indicate good tidings, at least on first glance. Two-fifth of the BSE-500 companies are yet to declare their earnings for the March quarter but there are some broad trends that are unlikely to be reversed by the end of the earnings season.

As the chart below shows, the net profits of 223 firms in the BSE-500 universe (for which data is available for the past 27 quarters) grew by 3.7% in the March quarter, whereas in the past three quarters, profits of this set of firms fell by an average of 11%. Margins seem to show a sign of bottoming out too.

But before the champagne bottles are uncorked, here’s the party pooper: the rise in profit margins is driven by a lower denominator. The March quarter saw a sharp drop in sales growth over the corresponding period in the previous year. Companies are protecting margins at the expense of sales. As the chart below shows, the sales growth of Indian firms is the slowest in 10 quarters at 12.5% and nearly half the average in fiscal 2012.

The really bad part is what is going to come next: muted sales growth in the coming quarters as the economy slows, putting pressure on pricing power. The era of 20% plus sales growth seems to have ended. And unless sales revive, investors might not even bother to look at other indicators.

Isn’t there any hope of a revival soon? Yes, there is. But there lies the sad part of the market drama: the theory of revival is built atop a number of heroic assumptions.

The first assumption is that the Eurozone remains intact and even if it doesn’t, the ECB has enough firepower to stem a crisis. The second is that despite expectations of further rupee depreciation, foreign investments will still flow in. The third heroic assumption is that the government will initiate bold reforms to put the fisc in shape. The fourth and crucial assumption behind a revival has to do with the investment cycle. The optimists expect companies to raise investments in the next couple of quarters despite falling interest coverage ratios and shrinking room for rate cuts.

The saddest part though is that several investment banks who are peddling dreams of a revival are not recommending stocks in sectors such as banks or automobiles which move up the fastest in a rally. Instead, their ‘buy’ calls are largely in defensive sectors such as pharma and consumer goods. That alone says a lot about the chances of an imminent and sustained revival.