The Hindu Business Line : Shocks and surprises: A take on Q3 earnings

Earnings of companies that account for 90 per cent of market capitalisation either equalled or surpassed expectations built into stock prices. Valuation levels are rich. The earnings performance does, however, make a case for staying invested in equities.

FOR investors who have been mauled by the bear market earlier, the prevailing rich valuations and reports of a slowdown in earnings growth rate are just the kind of signals that make them want to run away from equities. But they shouldn't go away yet.

A majority of companies were able to either equal or beat expectations in the quarter ended December 2005. Engage in profit-booking, but do stay invested in equities. Another couple of quarters of robust earnings growth and the stock prices may get more resilient.

More surprises than shocks: The aggregate profits of 1900 companies grew 12 per cent in the quarter ended December 2005 over the corresponding previous quarter. Given that the PE multiples of most companies are above 20, such a low rate of growth in profits could suggest that listed companies may have disappointed. That, however, is far from the truth.

Companies that account for 60 per cent of the total market capitalisation of Indian stocks have either equalled or surpassed expectations. Specifically, 52 out of 77 large-capitalisation companies and 119 of the 195 mid-cap companies matched or exceeded the expectations from stock prices. This set of about 250 stocks accounted for 90 per cent of the total market capitalisation of all listed stocks.

The performance of large-caps was better than that of mid-caps. Profit growth, on an average, was about 10 percentage points above expectations. Mid-cap companies reported profit growth that was, on average, 5 percentage points higher than expected.

Large-cap companies that did better than expected include Suzlon Energy, Satyam Computer, BHEL, Larsen & Toubro and Tata Tea. The mid-caps that surprised include Jindal Saw, Raymond, LIC Housing Finance, Nirma and Ingersoll Rand. A number of public sector and old-generation private sector banks also figure in this list.

Those that shocked include Ranbaxy Labs, Jet Airways, Neyveli Lignite, Hindalco and IDFC in the list of large-cap companies. In the mid-cap space, Nicholas Piramal, Timken India, Sundram Fasteners, Gammon India and Novartis India disappointed.

Measuring expectations: How were the expectations measured? Expected earnings growth was linked to the price-earnings multiple and price-to-book value.

For companies trading at a price-to-book value of more than 5, expected earnings growth was assumed at 0.8 times the PE multiple. For companies trading at price-to-book value of between 2 and 4, expected earnings growth was equal to the PE multiple. And for companies whose price to earnings growth was less than 3, expected earnings growth was equal to 1.2 times the PE multiple.

Companies that trade at high price-to-book values are expected to show stable growth in earnings. Expected earnings growth from such companies can be lower than the PE multiple. This would include private sector banks, IT companies, healthcare companies and fast moving consumer goods.

Earnings of companies that trade at low price-to-book values are expected to be cyclical. So earnings growth needs to be higher than their PE multiples to offset the expected decline later. This includes public sector banks and companies in the commodity, textile and mid-cap IT sectors.

Stronger foundation: The method adopted to measure expectations does have its limitations. Numerical analysis is no substitute for company-specific research. This method is, however, an improvement over merely comparing profit growth over the various quarters. Linking profit growth to valuations is a better tool to assess corporate performance.

That tells us that the performance in the quarter ended December 2005 has put valuations on a stronger foundation, especially in large-cap stocks. Investors would, however, need to exercise greater caution in mid-cap stocks. Their performance was mixed.

Taking forward the earnings analysis, investors could stay invested in stocks that surprised and pare exposures to the ones that shocked. While this may not be a foolproof method to outperform the market, it would be more than useful given the prevailing rich valuations. If you want to stay invested in the shockers, they will need to backed by better information.

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