The Hindu Business Line : Focus will turn to high-risk companies

If economic growth is going to be the next trigger, the stock market focus will shift to high-risk companies. These companies will record disproportionate earnings growth compared to sales growth. However, investors need to be careful, as the downside could be higher if growth does not materialise.

THE market is on a tight leash, waiting for the next trigger that could catapult it to higher altitudes. Growth in earnings is widely expected to set off the next round of rally. The present broad-based rally is expected to give way to a stock-specific one.

In the backdrop of a rebounding economy, the focus is likely to shift to stocks of high-risk companies, as these are likely to record relatively larger earnings growth. Investing in such companies brings with it its own set of risks. Specifically, the downside could be higher if the optimism on earnings growth proves unrealistic. Such optimism is fuelled by projections for the Indian economy to grow at about 6 per cent in 2003-04 with industrial growth contributing in no small measure.

Even better days are expected beyond March 2004. Higher industrial growth will boost sales growth. In such a scenario, companies with greater operating or financial leverage may benefit more.

Leveraged growth: When sales revenues rise, disproportionately large profit growth is expected in companies with high operating or financial leverage. Operating leverage will be higher if fixed costs — costs that do not change if sales rise — as a proportion of total costs are higher. There are quite a few capital goods companies, automobile and auto ancillary manufacturers that sport high operating leverage. Based on size and performance for year ending March 2003, here are a few of them:

Some large companies with higher operating leverage are BEML, Whirlpool of India, Bharat Heavy Electricals, Maruti Udyog and Crompton Greaves.

Some mid-size companies with high operating leverage are Indian Hotels, Bombay Dyeing, Blue Star, Thermax and Goodlass Nerolac.

Smaller companies such as Widia India, Alstom, Amararaja Batteries, BOC India and Elgi Equipments have high operating leverage.

In these companies, in the event of robust demand growth, earnings growth could be double that of revenue growth.

Financial leverage will be higher if debt as a proportion of total funds is higher. Typically, the financial leverage of banking companies is quite high. That is why they are expected to benefit if the economy grows. In fact, stocks of banking companies are likely to participate in the next round of rally too. A few such companies in the non-banking space are listed here:

Some large companies with high financial leverage are Whirlpool of India, Bharat Earth Movers, ITI, Jindal Strips, EID Parry and Century Textiles. Mid-size companies with high financial leverage include SRF, Arvind Mills, Titan Industries, Jubilant Organosys and Madras Cements.

Smaller companies with high financial levarage are Ciba Specialty Chemicals, Essar Shipping, Eicher Motors, Novartis and IPCA Labs. In these companies too, earnings growth will be at least double that of revenue growth if demand growth is robust.

Overall, keep an eye out on large companies such as Whirlpool of India, Bharat Earth Movers, Crompton Greaves, ACC and Jindal Strips. Among mid-size companies, Indian Hotels, Arvind Mills, Titan Industries, Jubilant Organosys and Madras Cements have the potential to surprise you. Among smaller companies, Timken India, Shree Cement, Welspun Gujarat Stahl Rohren, Widia and Seshasayee Paper could pack a punch.

For the nimble-footed: Some of these stocks have already risen sharply. They are not trading at prices that have already factored in some of the growth expectations. Markets expect a correction before these stocks resume their upward journey. Such a correction could be an opportune time to pick up exposures in these stocks. However, investors need to be cautious. First, they need to keep an eye out for industrial growth. If this proves elusive, the downside in these stocks could be substantial. In addition, valuation multiples calculated based on earnings growth during 2003-04 may prove misleading.

Multiples based on average earnings growth over a few years may present a more realistic picture. So, sell if such multiples are substantially higher than that of the market.

On the other hand, there is also the risk that they may sell too early if growth does pick momentum. These stocks are definitely for the nimble-footed among us.

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