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Does stock price trace fundamentals?

Jan 10, 2005

It has been often being said in the stock market circles that stock prices (read valuations) reflect the long-term earnings prospects of companies. Is it always true? Where do we stand at the current juncture and what are the growth prospects in the future? Based on our 'Quantum Universe', we did a special study of the last ten years' corporate performance and whether the benchmark index (the Sensex) traced the fundamentals (read net profit) over a period of time? The results are intriguing.

To start with, a brief introduction about this study will be of significance to investors. What we have done here is consolidate the net profit of 260 companies over the last ten years i.e. FY95 to FY04. We have calculated the rolling compounded average growth rate of net profits (i.e. CAGR of net profits between FY95 to FY99, CAGR between FY96 to FY00 and so on). At the same time, we have calculated the compounded average return of the Sensex and BSE-100 (a broader index) for the same period to analyse the comparison. Here are the study results.

The graph above shows the CAGR of net profits, the return on BSE-Sensex and the BSE-100 over the last six years. We have also calculated the last ten-year net profit CAGR (the last three bars in the graph). Clearly, there is a strong co-relation between earnings growth and stock market performance. As against the ten year CAGR in net profit of 16.0% (FY95-FY04), the return on Sensex stands at 8.7% and that of the broader index (BSE-100) stands at 12.2%.

Though the co-relation seem to have weakened in the closing years of 1990s, investors have to bear in mind that the stock market witnessed a huge correction, after the tech bubble burst. Another interesting aspect to note is that the 'broader index has outperformed the Sensex every year during the period of study'. There are two reasons for the same. Firstly, the Sensex is skewed owing to higher weightage towards particular sectors like software and PSUs.

Secondly, one of the fundamental aspects of stock market investing is diversification. Since the BSE-100 is lot more diversified in nature, the outperformance is not surprising. But this is not to say that investors should buy 100 stocks to diversify. Depending upon the 'invest-able' surplus and the age profile, investors may choose to invest anywhere between 10 to 15 stocks across sectors to adhere to the concept of diversification i.e. not to put all eggs in one basket.

Having understood the fact that the stock market performance is determined by earnings growth in the long-term, where are we now? Few months before (September 2004 to be precise), we had written an article highlighting our three big assumptions as far as our research is concerned. We would like to re-iterate our view on this front.

  • Capex recovery in sight and debt will rise: While net sales of the universe has grown at a CAGR of 11% over the last five years, growth in net fixed assets stood at just 6%. This means that without adding to capacities in a big way, corporates have been able to utilise their assets efficiently in the last five years. We believe that capital expenditure from corporates is likely to gather pace. To fund these expansion plans, corporate borrowing is likely to rise.

  • Cash reserves are healthy now but working capital cycle will reverse: We believe that corporates have built up significant cash reserves. When current assets rise at a faster rate (of which cash is a component) than current liabilities, working capital to sales ratio increases. This is considering a sales growth of 11% in FY04, which is the denominator. But during an economic upturn or expansion phase, working capital requirements tend to rise. Barring few companies, on a broader basis, we have increased the working capital requirements of companies under our research coverage.

  • Average interest costs have bottomed out: Barring few companies that are either debt free or have further scope of debt retirement, we have assumed a higher interest cost beyond FY05 (around 100 to 200 basis points higher). There are two reasons. Firstly, working capital requirements are mostly met by short-term borrowings and secondly, the incremental cost of borrowings beyond FY05 is likely to be at a higher rate. Having said that, we do not expect average interest cost to increase very dramatically.

To conclude, despite the stock market optimism about the Sensex touching 8,000 by year end and so on, from a retail investors perspective, the risk-return matrix is skewed towards risk in the short-term (one year) and in favour over a two to three year period. Economy goes through cycles and the stock market will follow suit, though at its own pace. But fundamentals do matter!

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