Favouring business risks

The story of Tata Motors and CEAT amply reflects the investor preference for business risks as opposed to financial risks. This is despite the fact that higher economic growth could theoretically benefit both sets of companies.

GE Shipping, Indian Hotels, Grasim Industries, Hindustan Zinc and BHEL are some operationally risky companies whose prices surged in 2003-04.

Engineers India, TN News Print, 3M India, Chambal Fertilisers and Bluestar are some financial risky companies which under-performed the universe.

Rationalising returns

In hindsight, the preference for operating leverage over financial leverage can be rationalised. In the past three years, the environment was right for reducing financial risks.

Many companies did just that over the past three years. Several banking sector honchos have indicated that working capital requirement has gone down by 40-60 per cent as companies started to use capital more efficiently. In this scenario, the companies that still did not reduce financial risks may have been viewed in less favourable light by investors.

Firms with financial leverage of between 0 and 1, signifying low risks, recorded higher returns than companies with financial leverage of over 1, signifying higher risks.

Companies with low financial risks that fetched above average returns include ABB, Sundram Fasteners, Hero Honda Motors, Alfa Laval and Monsanto India. The market, however, distinguished between banks and non-banks. Stocks of banks with high financial leverage, however, were lapped up by investors.

Rewarding profit growth

One factor that stood out in the analysis was the importance of profit growth. Stocks of about 500 companies with profit growth of over 10 per cent recorded average returns of 108 per cent. In contrast, about 500 companies with profit growth of less than 10 per cent, including companies with negative growth, registered average returns of about 76 per cent.

Clearly, a yawning gap exists between companies recording profit growth and those that did not. This is evident even in the analysis of excessively risky companies. Such companies that saw profit growth recorded average returns of 93 per cent while those with negative growth recorded returns of 62 per cent.

In the low-risk category, companies with profit growth recorded returns of about 93 per cent while the ones with negative growth registered 72 per cent. Again, higher profits translated into above-average returns.

Leverage is the key

Does this mean profit growth is more important than leverage? Not at all. Companies with moderate risks and profit growth recorded average returns of 112 per cent. This is higher than what stocks of excessively risky or low-risk companies delivered.

The average profit growth of excessively risky companies in the past three years was, however, 160 per cent as opposed to 40 per cent for moderately risky companies. Low-risk companies recorded average profit growth of 10 per cent. Leverage, a measure of risk, is more important than profit growth in 2003-04.

There was also no bias towards size. Large returns for moderate risky companies were not due to size.

Large-cap companies were not uniformly categorised as less risky, nor were the mid-caps termed risky. Large companies categorised as risky include IPCL, Grasim Industries, ICICI Bank, Dr. Reddy's Labs and Tata Steel. Some mid-cap companies categorised as low-risk include Welspun Stahl Rohren, Micro Inks, Glenmark Pharma, Gujarat Gas and Pidilite Industries.

Some very risky stocks that gained handsomely in 2003-04 include Hindustan Sanitaryware, Polyplex Corporation, Orient Abrasives, Tata Metalliks and Bharat Earth Movers.

Some moderately risky stocks that outperformed include Lupin, Kochi Refineries, Balkrishna Industries, Tata Steel and Asahi India Glass. Some low-risk stocks that gained include Tata Power, Cadila Healthcare, Concor, Shanthi Gears and National Aluminium.

Defining risks

FOR the analysis, a company was considered risky if the ratio of change in profits to change in sales was more than one. A ratio of between one and minus one would mean the risks are low.

A ratio of between one and ten means the risks are high. A ratio of more than 10 implies that the risks are substantially high. The ratio is referred to as total leverage.

If the ratio of change in operating profits to change in sales were more than one, that would be a company that is exposed to business risks. This ratio is referred to as operational leverage. If the ratio of change in net profit to change in financial costs were more than one, that would be a company that is exposed to financial risks. This ratio is referred to as financial leverage.

The ratios were the average of such changes for the three-year period March 2001 to March 2003.

In terms of profit growth, risky companies recorded higher average profit growth in the past three years, compared to excessively risky companies. The latter, however, recorded higher profit growth than their less risky counterparts. Risks here refer only to the incidence of fixed costs and financial costs.

Risks stemming from factors such as volatility in sales growth, the state of the industry and government regulation are not captured.

In effect, a company that may be viewed as risky by the markets may be categorised as low-risk for the purpose of the analysis if the ratio of fixed costs and financial costs are low.

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