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Stock market: Caveat emptor!

Nov 18, 2004

It's above 6,000 levels again and the mood among investors seems to be very buoyant. But if one were to rewind to January 2004 when the Sensex touched 6,000 levels the last time, by now, based on expectations then, the benchmark index should have been above 7,000 levels! In the last eleven months:

  1. A new government (Congress led coalition) has come to the power in India. In January 2004 when the Sensex was around 6,000 levels, everyone was expecting the then ruling party, BJP, to come back to power again easily. Stock markets actually wanted BJP to come back to power. Despite the change, the stock market seems to be happy now!

  2. Against market expectations, there has been continuity in policy decisions in India, despite a change in the government. In fact, the new government has taken bold moves on various aspects, which is heartening.

  3. The situation in the Middle East has not improved, if not worsened even more.

  4. Crude prices have skyrocketed led by continued rise in demand for oil and few supply led concerns. Globally and in India, inflation expectations have been beaten. In fact, in India, the forecast for GDP have been revised downwards.

  5. Globally, interest rates have risen in the last one-year (Australia, UK, USA, China, India to name a few).

Of all the factors mentioned above, the full impact of the rise in crude prices on the Indian economy and on corporate profits is not yet reflected. We believe that there could be some negative surprises as far as earnings growth in the second half of the fiscal year for the stock market. The reasons are clear.

  1. While crude price increase and firm commodity prices reflected in higher inflation at the wholesale level (wholesale price index crossed 8% levels), at the consumer level, inflation was hovering at around 3% to 4% because price increases in petroleum products was largely absent. But with the recent price increase and the government's directive to raise LPG prices by Rs 5 per month per cylinder, the consumer inflation will soon start heading northwards. Unless income levels grow faster than the rise in prices of goods, demand for good is likely to be affected. Almost 70% of Indian populace is dependent on agricultural income.

    Net profit grows slower than topline…
    (% YoY change)SalesNet profit
    Financial Institutions-10.0%-40.4%
    Consumer Products2.2%-26.7%
    Textiles9.9%-16.2%
    Tyres7.0%-9.0%
    Banks6.2%-4.5%
    Pharma1.0%-3.5%
    Energy14.5%-1.3%
    Power22.9%1.8%
    Packaging25.4%4.6%
    Automobiles27.7%20.3%
    Aluminium32.4%26.7%
    Software37.3%36.2%
    Net profit grows faster than topline…
    (% YoY change)SalesNet profit
    FMCG12.3%18.6%
    Paints9.3%20.9%
    Energy10.4%22.0%
    Auto ancillaries28.1%27.2%
    Chemicals51.7%42.4%
    Media32.7%52.2%
    Fertilisers17.4%56.3%
    Engineering19.8%85.5%
    Shipping33.1%111.8%
    Telecom13.4%117.2%
    Steel44.7%201.8%
    Cement29.8%616.0%
  2. Higher commodity prices are likely to squeeze corporate profitability. Our interaction with corporates suggest that they have not been able to pass on the rise in input cost to consumers proportionately owing to stiff competitive pressure. As our results monitor shows, as compared to the June quarter, sectors like automobiles, auto ancillaries, banks, chemicals, consumer durables, FMCG, energy have witnessed lower growth in net profits as compared to the topline growth. Our interaction with one of the leading mutual fund houses in India also suggests that there is a need to downgrade earnings estimate for FY05 and beyond. A sign of things to come!

  3. With interest rates on the rise in key global markets, the relative attractiveness of Indian markets is likely to be affected. Though too early to judge, FII inflow has not been that strong like last year. FII data on the SEBI website suggest that off late, FIIs have been net buyers in debt market in a noticeable way. We suggest investors not to buy stocks/sectors because FIIs are buying.

  4. Rupee has appreciated in the recent past. Though the economy is likely to benefit from such a trend (we import almost 70% of our crude requirements), export-oriented sectors like software, auto ancillaries, and commodities are likely to face pressure. Most of the software giants are also index heavyweights.

We believe that investors need to exercise caution at the current valuations level. As an investor, if the target price is achieved, we suggest to book profits instead of waiting for the next 100 points upside. Though the long-term story of higher GDP growth, rising income levels and positive demographic changes still exist, we believe that the stock market is underestimating the impact of the rise in crude prices on the economy.

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