Virtually every research house worth its salt (including ours) has screamed itself hoarse, shouting over the rooftops that the markets are fairly valued/over valued. And this has been the case right since the time the BSE-Sensex has hit the 7,000-mark. However, backed by abundant global liquidity, the markets are currently in totally uncharted territory.
Historically, the Sensex has traded at around 17 to 18 times its trailing earnings. However, if we strip off the effects of the 1992 Harshad Mehta scam and the IT bubble, this average dips to around 14 to 15 times. Given that the earnings growth rate expectations are in this region, this is probably a reasonable level that the Sensex should trade at. At current levels, the Sensex trades at over 17 times its trailing earnings. If we consider an estimated growth rate of 15% over the next couple of years with an FY07 perspective, this comes down to 12.8 times FY07 estimated earnings. Undoubtedly, this is not 'cheap'.
In this write-up, we make an attempt to analyse some of the key macro factors that will play a major role in affecting the earnings momentum of India Inc (particularly the Sensex companies) over the next couple of years and make some sense of what this means for investors.
Straight to the bottomline...
The earnings growth for the Sensex companies has been fairly robust over the past few years, growing at a rate of over 25% or thereabouts. This has been driven by numerous factors, key among them being:
Increased capacity utilisation and operating leverage: Industries like steel had added significant capacity in previous years, but had low utilisation levels due to lower demand. An upturn in demand resulted in improving utilisation levels and as a result, better operating leverage, which is how these industries work, as increased volumes flow straight to the bottomline after recovery of associated fixed costs.
Firm commodity prices: Due to a huge surge in demand from China, commodity prices rose to virtually all-time highs. This led to companies in industries like steel and aluminium recording huge profit growth.
Cost rationalisation and restructuring: Companies almost across-the-board resorted to aggressive cost-cutting measures and debt restructuring. This led to tremendous cost savings and, coupled with the increased demand, resulted in a surge in earnings. This effectively offset the impact of high commodity prices for industries like auto, which are major end-users.
Lower debt levels and interest rates: As mentioned above, companies resorted to restructuring of their debt levels and coupled with the benign interest rate scenario, this led to a substantial reduction in interest costs, thus improving debt servicing capacity and return ratios.
Increased offshoring: The ever-increasing trend of offshoring to low cost-high quality destinations like India continued and this led to buoyancy in topline as well as bottomline growth for IT companies.
...but what now?
Operating leverage reduction: In industries like steel, capacity addition is expected to take place. Companies like
Tata Steel and SAIL have announced big expansion plans for the medium-to-long term. A part of these capacities are expected to come onstream within a couple of years. Given limited ability of these companies to meet additional demand through existing capacities (utilisation levels are over 95%), capacity additions are required. This will result in higher depreciation costs, lower operating leverage and thus, lower margins. All this will translate into lower earnings growth as compared to that achieved in previous years.
Lower commodity prices: Due in part to the Chinese efforts to cool the 'overheating' economy, the commodity cycle is expected to taper off. This will lead to lower realisations and, coupled with lower leverage and margins, a slower earnings growth.
Higher base: Given that earnings for the Sensex companies have grown at around 25% or thereabouts for the past few years, the base is obviously much higher. This will make it increasingly difficult for these companies to maintain the robust earnings momentum over the next two to three years.
IT companies are also expected to see slower revenue and profit growth than what they have managed to achieve over the past few years. Obviously, companies cannot keep on growing at 30% forever and at some stage, lower growth rates will kick in. A movement up the software value chain, resulting in higher onsite services (front ends) will also result in lower margins due to higher costs. Thus, the bottomline will also grow at a slower rate, due in part also to higher depreciation charges, given that these companies are acquiring land and building facilities at such a fast clip.
Higher crude prices: Needless to say, this has the potential to create a hole in the bottomlines of companies, ranging from sectors like automotive, aviation, FMCG, paints and oil marketing. Crude and its derivatives being key raw materials in many industries, higher prices will certainly result in higher costs. Given limited ability to pass on these higher prices to consumers due to competition pressures, this will impact profit growth.
Limited benefits from cost savings: There is a limit to the extent to which companies can increase profits by reducing costs. The benefits of restructuring and cost cutting appear to have been exhausted, reflected in the reduction of the proportion of costs as a percentage of revenues over the past 2 to 3 years. Thus, there is reason to believe that the incremental benefits are limited. As a result, any increase in raw material prices needs to be compensated by increased volume sales, which is clearly a more sustainable way of growing, as the ability to pass on these higher costs to end-users is limited due to competition. As a result, in the medium term, profit growth could take a hit.
It should be noted that we have not considered the oil companies while doing our analysis. The main reason of course, is the fact that oil companies' profits are determined arbitrarily by government policy and taking a call on this would not be appropriate and would, in fact, be fraught with high risk.
Given the current levels of the Sensex, we would say that it is certainly not 'cheap'. Finding stocks at reasonable valuations is becoming an increasingly difficult task. Clearly, return expectations need to be toned down at these levels. The Sensex companies may not grow at the scorching rates that they have maintained in the recent past. We are not saying that they will not grow. What we are saying is that they will grow, but probably at a slightly more muted rate than what has been seen over the past 2 to 3 years.
These are truly difficult times and we would say again at the risk of repeating ourselves, that buy into fundamentally sound stocks with good management teams and strong growth prospects that will stand the test of difficult times. The long-term story, we believe, is still intact and there are still opportunities to make good investments. One needs to be patient and the rewards will come.