Events to drive the markets rather than earnings?

At various points in this four-year bull run investors have wondered where and when a bubble situation would arise. Last week showed the first clear signs of irrational exuberance. While the Sensex level of 17,000 was itself a bit stretched, the rise thereafter has been 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 past five-year period, beginning FY03, earnings have risen by around 35% annually. This performance is getting increasingly difficult to continue. The first quarter of FY08 saw a net profit growth of only 8%, if you stripped out other income.

Investors, and even broking firms, seem to have missed 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 a likelihood of earnings growth slowdown in FY08 aren’t hard to see. Interest rates are now 20-40% higher than three years ago when corporates weren’t borrowing anyway. 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 should look at it in proper context. A 3 divided by 7 is 43%.

So if interest rates go up from 7% to 10% for a corporate (or a home loan), cost of borrowing is up 43% and not 3%. Higher interest costs are affecting profitability and causing demand slowdown. It is visible in two-wheelers, and will now become visible in housing and cars 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 do we spot outperformance? In both the cases, deals or rumours play a key role. The market’s run, post-Sensex level of 17,000, appears partly speculative, and partly deal news driven. Most of the scrips that have led the rally seem driven more by deal news, rather than the changing perception 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 to Rs 1,700 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 was a possible large float from the retail business. The same pattern may persist if the market stays around these levels. With little hope of earnings driving outperformance, new triggers can best come from news flow.

Saturday’s newspapers, for example, had an announcement of a massive $9-billion investment plan from Reliance Industries. Reliance Industries chairman and managing director Mukesh Ambani said the company will invest $8-9 billion in the next three to four years at its 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 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 that 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. Scrips that lagged last month or so are perhaps the ones that haven’t made any great announcement to catch shareholders’ attention. ICICI Bank, another index biggie, for example, has lagged in this recent surge.

A lot of corporate activity happened in this stock around the time of its follow-on issue in June. Since then, things have been quiet on this counter. The bottomline for investors: absolute returns maybe hard to get for sometime, unless they are event driven.