The Hindu Business Line : Powered by the large-caps

With the market likely to operate in a narrow range — influenced by the unclear positions of the FIIs and mutual funds and retail players remaining on the sidelines — investors may be better off staying invested in large caps, playing the defensive sectors, and/or making prudent moves in sectors that may be influenced by interest rate and government policy moves.

India Inc is on a high over its stellar earnings show in the April-June 2006-07 quarter. With revenues and post-tax earnings growing 30 per cent, there is hardly any doubt about the impressive earnings performance in the latest quarter. Yet, investors are left wondering if corporate fundamentals will support stock prices in the backdrop of the May meltdown triggered by global variables, and the gathering clouds in the form of higher interest rates, commodity price hikes and uncertain crude oil price scenario.

Tracking earnings

Before jumping to any conclusion, we analysed the earnings performance of Corporate India for the past nine quarters to get a better perspective of the numbers and over a longer timeframe too. For the purpose of this analysis, we considered the aggregate earnings performance of 1,250 companies, for which comparable earnings were available for this period.

Second, we segregated the available data into five categories on the basis of market capitalisation: Large caps above Rs 10,000 crore; Rs 5,000-10,000 crore; emerging large caps, Rs 2,000-5,000 crore; mid-caps, Rs 500-2,000 crore; and small-caps, Rs 250-500 crore. Of the sample 1,250 companies, 480 fall within these market cap bands.

Finally, for the purpose of this analysis, we excluded the performance of oil companies as they have traditionally skewed the aggregate earnings picture. However, the overall earnings picture, including oil companies, has been indicated wherever relevant.

A quick tally shows that 475 companies (excluding oil companies) that account for over 90 per cent of the full market cap of the BSE recorded a 29 per cent rise in revenues and a 28 per cent growth in sustainable post-tax earnings.

The trends that emerge from an analysis of growth under different categories are:

Heavyweights dominate

Companies with market-cap above Rs 10,000 crore appear to have powered the growth of Corporate India in the April-June 2006-07 quarter. Forty-five companies fall within this category.

The revenues and post-tax earnings have grown by a creditable 32 per cent and 33 per cent respectively. Companies in this set have managed to maintain their operating profit margins at 28.5 per cent, down marginally from 28.7 per cent in the corresponding previous period.

Both interest cost and depreciation at 24 per cent and 10 per cent respectively were also pegged at manageable levels relative to the revenue growth. This is somewhat contrary to the trend in the January-March quarter, when the rise in expenditure, at 23 per cent, was way ahead of the revenue growth, at 17.6 per cent, contributing to an over three-percentage-point fall in the operating profit margin. That along with higher tax provisions depressed the overall post-tax earnings.

Companies that powered the earnings growth in the April-June quarter were mainly from the metals pack: Hindustan Zinc, Sterlite Industries and National Aluminium. They were supported by Gujarat Ambuja and ACC among cement companies; Infosys, Wipro and Satyam from the software segment; Cipla and Dr. Reddy's Labs from the pharma space, and Maruti Udyog, BHEL and NMDC among other sectors. Quite a few of these companies also recorded a sharp improvement in the operating profit margin.

Otherwise, across market cap categories, say, between Rs 500 crore and Rs 10,000 crore, the earnings performance in the April-June quarter was muted, largely because of the rising input and interest costs. Take, for instance, companies with market cap between Rs 2,000 crore and Rs 5,000 crore. Both expenditure and interest cost rose 23 per cent outpacing the revenue growth of 21 per cent. This contributed to a drop in both operating and gross profit margins by 1-1.5 percentage points. Since some of them are in the initial phase of the capex creation cycle, higher interest costs appear to have affected their performance.

The sole exception to this trend was the earnings card of small-caps, Rs 250-500 crore, with the post-tax earnings rising at over 48 per cent, almost 2.5 times higher than revenue growth at 18 per cent. The good participation of small-caps in the latest run-up in the broad market, evident from the BSE Smallcap Index move, can probably be traced to the earnings numbers declared by this set.

Waning fancy for mid-caps

If we examine the performance of emerging large-caps and mid-cap companies for three quarters between June and December 2005, it is obvious that they have enjoyed the beneficial impact of operating leverage. The operating leverage effect had helped them record a magnified rise in post-tax earnings for every percentage point increase in revenues.

For instance, companies in the emerging large cap segment have clocked a sizeable increase in bottomline vis-à-vis the growth in topline. In the April-June 2005 quarter, a 22 per cent rise in revenues contributed to a 33 per cent jump in post-tax earnings.

In the September and December quarters, 15 per cent and 10 per cent growth in revenues was accompanied by 27 per cent and 25 per cent increase in post-tax earnings. Apart from better control over costs, a soft interest rate regime prevailing during this period helped.

The swelling cash coffers contributed to high `other income' and low interest costs helped companies post robust improvement in the post-tax earnings.

The combination of these factors led to net profit margins improving in each of these quarters. Except for select companies, this trend, as we indicated earlier, has waned over the past two quarters.

Investment pointers

Despite corporate fundamentals staging an overall improvement in the latest quarter, the market sentiment continues to be weighed down by the recent hike in the prime lending rate by banks, the firm commodity prices such as that of steel and non-ferrous metals, as also the need to negotiate the highly volatile crude oil prices.

This is evident from the fact that though the Sensex has run up from 10,000 to 11,000 points in two weeks, the trading turnover has been relatively sluggish. Flitting in and out, the turnover of the foreign institutional investors has failed to provide any clear direction on the market movement.

With mutual funds and retail players also remaining on the sidelines, it appears that the market will operate within a narrow trading range, probably until the July-September quarter earnings are announced, in October. Till then, investors will be better off:

Staying invested in large caps, especially those with a market-cap of over Rs 10,000 crore.

The latest earnings score-card also supports this view. However, based on the latest quarter performance, entering select emerging large-caps may also be desirable.

Playing the defensive sectors such as software, pharma, FMCG or telecom as that makes greater sense in a highly volatile market.

Similarly, taking exposure to commodity stocks such as steel, non-ferrous metals, cement or sugar can be considered as firm prices and the growing demand-supply gap will help companies capitalise on this trend.

Exercising greater prudence in taking exposures in interest rate sensitive sectors, such as auto, or in government policy related sectors, such as capital goods or oil.

The margin pressures arising from higher input costs or policy intervention are likely to hit them hard.

Stock selection will hold the key. It may also be better to stay away from stocks that are in the incipient stages of a capex cycle, unless the valuations are compelling.