Sales of medium and heavy commercial vehicle have fallen for the third successive month. The only consolation is that combined sales of Tata Motors Ltd and Ashok Leyland Ltd fell 8.4% in September, slightly better than the 10% fall in sales in July and August. The markets weren’t impressed—Ashok Leyland shares fell 5.4% after its sales figures were released; Tata Motors followed suit with a 2.6% drop in share price.

But these stocks need to correct much more to reflect the change in underlying fundamentals for commercial vehicle manufacturers. At current levels, they are still trading at about 25% higher levels than their 52-week lows. And as the performance in September shows, demand continues to be lacklustre.

Sales of buses have, to an extent, propped up the overall sales numbers. Tata Motors doesn’t report sales of buses separately, but in Ashok Leyland’s case, sales of only goods carriers fell by as much as 28%.

Tata Motors had reported a single-digit operating margin for the first time since it returned to the black in late 2001. One analyst who does not wish to be named says that if the downtrend in sales continues, the company could soon report losses.

As things stand, an improvement in performance is nowhere in sight. Road freight rates are now lower on a year-on-year basis, having steadily declined since July this year. As a result, truck operators may be in no hurry to add capacity. It’s also important to note that sales started getting impacted only this year, which means the base would continue to be high and growth would be difficult to come by for the rest of the year.

But commercial vehicle stocks don’t fully reflect the problems being faced in the industry. While they have underperformed the market since the beginning of the year, current valuations indicate that there is room for further correction. Besides, one-year forward price-earnings (P-E) multiples are considerably high at around 13-15 times, considering that core earnings are expected to fall.

Mid-cap re-rating

Nifty Junior became the National Stock Exchange’s (NSE’s) first index to cross the 10,000 mark last week. Although the index has since underperformed the market, it still is the biggest gainer in the rally that commenced on 25 April 2003, compared with all non-sectoral indices published by NSE. The compounded annual return since then works out to 56.9%, nearly 10 percentage points higher than the returns delivered by the S&P CNX Nifty during the same period.

The Nifty Junior comprises the most liquid securities after the first 50 securities of Nifty. Back in 2003, before foreign institutional investors pumped serious money into the Indian market, most of their holdings were restricted to the most liquid stocks, such as those forming the Nifty. As their investments increased, so did the need for finding new avenues, and the major beneficiaries were the next best set of liquid stocks.

While underlying earnings grew at a decent pace (CAGR of 28.6%), supporting the rise in their share prices, Nifty Junior set of stocks also witnessed a massive re-rating.

The P-E multiple of the Nifty Junior has expanded by 148% to 21.5 times in the four-and-a-half-year rally. The Nifty’s P-E multiple has risen by a much lower 87% to 23.6 times now from 12.6 times in April 2003, although its earnings, too, grew at an average rate of 28%.

At current levels, their valuation discount to the Nifty is just 11%, down from 31% before the rally began. It must be noted that the earnings growth figures are derived from the respective index values and the P-E multiples for the two periods, and are hence an approximation, since the changes in the composition of the index would influence the P-E multiple.

There’s another group of stocks that has benefited thanks to a re-rating vis-à-vis large-cap stocks.

The CNX Midcap index has risen at a CAGR of 56.3%, almost as much as the rise in the Nifty Junior. Its valuation discount to the Nifty Junior, which used to be as high as 28.5% in April 2003, has currently dropped to just 7.4%. But unlike the stellar earnings growth reported by Nifty Junior stocks, underlying earnings of the CNX Midcap index have risen at a much lower rate of 21% annually.

Interestingly, however, their private equity expansion (at 213%) has been the highest. True, there would be some deserving stocks within the index but, as a club, the re-rating in mid-cap stocks vis-à-vis their larger peers over the past four years seems to be overdone.

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