Fairval

Notes on Indian equities, sectors and economy

Share prices may get heavily event driven

Posted by fairval on October 14, 2007

At various points in this four year bull run, investors have wondered where and when would a bubble situation arise. Last week showed the first clear signs of irrational exuberance. While a Sensex level of 17000 was a itself bit of a stretch, the rise thereafter has been very crazy. Fundamentals would hardly explain the kind of frenzied rise.

At these levels the Sensex is trading at a trailing PE ratio of around 25x. Once again, this is not sustainable, since earnings of Indian corporates cannot rise at 25x over a sustained period. Over the last 5 year period beginning FY03, earnings have risen by around 35% annually. This performance is getting increasing difficult to continue. The first quarter of FY08 saw net profit growth of only 8%, if you stripped out other income. Investors, and even broking firms, seem to have missed or ignored this altogether. The second quarter results, many of which will come this week onwards, will finally set the tone for FY08, but drastic improvements are unlikely.

The reasons for likelihood of earnings growth slowdown in FY08 aren’t hard to see. Interest rates now are about 20-40% higher than say 3 years ago, when corporates weren’t borrowing anyways. Earlier an average corporate could borrow at 7-8%, now they need to pay over 10%. While this looks like only 200-300 basis points, investors to look at it in proper context. A 3 divided by 7 is 43%. So if interest rates go from 7% to 10% for a corporate (or a home loan), cost of borrowing is up 43%, not 3%. Higher interest costs are affecting profitability, as well as causing demand slowdown. It is very visible in two wheelers, and will become visible in housing, cars and durables if interest costs remain high.

With this background, lets pose two key issues – why did the market run up so fast, and from here, how to find outperformance. In both of these, deals or the rumours of them have a key role.

The market’s run, post-Sensex levels of 17000, appears partly speculative, and partly deal news driven. Most of the scrips which have led the rally seem driven more by deal news, rather than changing perceptions of earnings growth. Both Bharti Airtel and Reliance Communications seem to have benefited from tower business hive off. There is something brewing in R Comm’s subsidiary Flag Telecom as well.

Reliance Energy (REL) has gone from around Rs 600 levels to around Rs 1700 levels in maybe a month. This surge seems driven by the listing plans of Reliance Power, where REL holds 50%. While there’s been no specific news in Reliance Industries, rumours abounded last week. One such has a possible large float from the retail business.
The same pattern may persist if market stays around these levels. With little hope of earnings driving outperformance, new triggers can best come from news flow.

Saturday’s papers for example had an announcement of a massive $9bn investment plan from Reliance Industries. Reliance Industries Chairman and Managing Director Mukesh Ambani said that the company will invest $8-9 billion in the next three to four years in the Jamnagar ‘Super Site’. It was not clear whether this is a new announcement or a reiteration of an earlier plan. Mr Ambani also talked about plans for “acquisition mode of growth” and “forging new partnerships”. In other words, organic growth alone would not be suffice for Reliance going forward.

Investors may take a cue from this line of thinking as well. Organic growth will rarely lead to earnings growth beyond 25%. In sectors which are growing faster than this, like telecom, growth is anyway priced in. Bharti Airtel is quoting at 43x trailing P/E, for example. Corporate action – either an acquisition/divestiture, or entering a new area – may be necessary to generate market excitement from hereon.
The reverse of this logic also appears visible. The scrips which have lagged in the last month or so, are perhaps which haven’t made any great announcement to catch the shareholder attention. ICICI Bank, another index biggie, for example, has lagged in this recent surge. A lot of corporate activity happened in this stock around time of its follow on issue in June. Since then, things have quiet on this counter. There were an announcement of a large infra fund, but perhaps this wasn’t dramatic enough for the market.

The bottomline for investors – absolute returns may be hard to get for sometime, unless they are event driven.

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