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Suresh Krishnamurthy

Earnings shocks and surprises influence stock price movements greatly. Tracking performance using the PEM for expected earnings growth can help investors buy under-valued stocks and sell over-valued ones.

INFOSYS Technologies said last Thursday that its profits would grow at 25 per cent in FY 2006. By Friday, the stock had declined 7 per cent . This investor response, however, could be rationalised. The stock was trading at a price-to-earnings multiple (PEM) of about 30 times its latest earnings per share — meaning growth expectation of at least 30 per cent was factored into the stock price. With the guidance coming in below that expectation, investors responded by pulling the stock price down.

This is, however, not an isolated response. Studies in developed markets have shown that earnings shocks and surprises have a considerable influence on price movements. Earnings surprise refers to announcement of better-than-expected growth in earnings while lower-than-expected growth is categorised as earnings shock. It has been found that stocks of companies that deliver `surprises' outperform the market; those that deliver `shocks' lag the market.

Given that it is the earnings season, investors could use this technique to see if the performance measures up to the valuation and the expectations built into it. That could help them deal with a market that has turned volatile after two years of a largely secular up-trend.

Not simple at all: Tracking shocks and surprises is, however, not a simple exercise. A stock may be trading at a PEM of 5. This does not mean that the expected earnings growth is only 5 per cent. The company's earnings may grow at 50 per cent in the first year and decline 27 per cent in the next to deliver annual earnings growth of 5 per cent. In that context, earnings growth of 50 per cent may not be a surprise.

This is particularly true of companies in cyclical industries. For instance, cement and steel stocks could rise sharply one year and plunge equally sharply the following year. The verdict on earnings performance, thus, needs to be delivered with great care.

Retail investors, however, lack access to the necessary information and the skills to make accurate predictions. They have no option but to use the PEM as their starting point. Taking the PEM for expected earnings growth, investors can identify stocks that have shocked and surprised. They can also assess if the performance was sustained for more than a quarter. Further investigation on the reasons behind the earnings growth or decline could help them learn more about those stocks. Used in tandem with other investment tools and information, this strategy can help investors buy under-valued stocks and sell over-valued ones. Given that mid-caps and small-cap stocks are under-researched, this tool could be particularly handy.

Earnings surprises: In the first nine months of FY 2005, a number of companies delivered earnings surprises. Companies from sectors such as oil refining, steel, hotels, shipping, cement and fertilisers, in particular, delivered strong earnings growth, which is way out of line with their PEMs.

Some prominent mid-cap stocks that delivered such earnings surprises are: Mercator Lines, Navabharat Ferro Alloys, Ingersoll Rand, Astra Microwave, Praj Industries, Hindustan Oil Exploration, Chemplast Sanmar, Balkrishna Industries, KEC International and Electrosteel Castings. Large-caps that delivered earnings surprises include Larsen & Toubro, BHEL, Container Corporation, Cipla and Siemens.

Some of these stocks are already trading at rich valuations and this surprise may have to be sustained to make the stock attractive from an investment perspective. Thus, it may be in order to find out if these companies have sustained the momentum in the final quarter of this financial year.

Earnings shocks: Textile and packaging companies are among those that have shocked the market with below par performance in the first nine months of FY 2005. The earnings growth of mid-cap companies such as Munjal Showa, Rain Calcining, Moser Baer, Colour-Chem, Phillips Carbon, Polyplex Corporation, Raymond, Himatsingka Seide, PTC India and Thermax have been disappointing.

Below par earnings growth, in the case of large-cap stocks, has come from stocks such as MTNL, Tata Power, NTPC, Bajaj Auto and Sterlite Industries.

By and large, the earnings growth story and valuation appear attractive in the large-cap stocks. On an average, stocks with a market capitalisation in excess of Rs 5,000 crore are trading at a PE of 15 but have delivered average earnings growth of 28 per cent. They could prove a safe haven in this choppy market.

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