January 24, 2010

life in financial markets: fundamentals versus market prices

The financial system was in a deep crisis in 2008 and using taxpayers' money governments (including Indian government) rushed to bail out the banks and other investment firms either directly or indirectly. As a result, liquidity in the global financial system was very high in 2009 and that led to a 60-100% rise in equity prices worldwide.

I think the bailouts were un-necessary and will only encourage reckless leveraging and mis-behaviour among the large market participants.

Anyway, late last month (December 2009) I contributed a news analysis story on the Indian listed companies' fundamentals not keeping pace with the sharp rise in market prices. Last week has seen much-needed correction in stock prices but it is still not enough.

Here goes:

Will India Inc. chase the market rabbit?

Barring the scary late-October crash, the last three months has seen the stock market on an automatic gear driving the steady flow of foreign institutional investor (FII) investments. But the second half of this month (i am referring to January as readers would be reading our new issue not before 1/2 Jan) will see fundamentals come in to the limelight once again as the listed companies' financial results for the December 2008-ended quarter start pouring.

Valuation of stocks by FIIs and domestic institutional investors have risen sharply and sustained ever since net profits and earnings per share rose sharply in the last quarter of the 2008-09 financial year.

The Price to Earnings ratio of the 50-stock S&P CNX Nifty index shot up by 40% during April-June this year after the previous quarter's (January-March 2009) Nifty stocks' aggregate EPS grew by a healthy 7.8% over the October-December 2008 quarter (see table) and aggregate net profit grew by a hefty 28% in the same period.

(click on the image to see it enlarged & clear)

The first two quarters of the current financial year (2009-10) have bought out the difficulties India Inc is having in sustaining high growth in profits as they stuttered. Yet the Nifty P/E has continued crossing 23 on Christmas eve. In the last five years (see graph below) it had peaked at 27.9 on 11 January 2008 before the big crash of that year. Global liquidity has prevented prices from falling but it has also meant that valuations have got stretched.

"What we believe is that that most of the consensus earnings upgrade forecasts for next 2 years is based on looking at sharp revival of growth in second half of the current financial year and that is why the December 2009 quarter figures will be watched very closely," says Gaurav Dua, head of research at Sharekhan. Dua is clear that these results will not only have to meet Dalal Street's expecatations but also be much ahead.

(click on the image to see it enlarged & clear)

That the Indian equity market, like a few other emerging markets in Asia, has always been considered expensive have never deterred FIIs. "Global investors focus more on their confidence back home in their western economies and if that is good they come to emerging markets notwithstanding high P/E ratios," says Saurabh Mukherjea, Bombay-based head of India equities at Noble Group.

But if corporate earnings falter, or do not meet street expecation, then any liquidity-driven sustained rise in prices will lead to the Nifty P/E touching stratospheric leves of 25 and above. In its October 2009 India Strategy report, Enam Securities had looked at what can happen next and indicated that the Indian market would see a sharp upward spike "if global liquidity continues to seek strong domestic growth and 'thematic investing' starts overlooking valuations."

The suspense will be over once the Q3 results start coming in.

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