Short-termism takes centrestage

S. Vaidya Nathan

IT HAS become a quarter-to-quarter existence, as far as stock valuations are concerned.

The valuation of any stock hinges critically upon the performance of the company in the latest quarter. This has been the trend in the US markets too, for a long time now. There, quarterly earnings calls, earnings expectations, consensus estimates, earnings whispers and whispers, on whispers and how actual earnings fare, in relation to these myriad `expected numbers' have become a critical factor in the stock valuation commanded by stocks.

This trend is catching on in the Indian market too though it is still a question of a comparison between just expected and actual earnings. May be over time, as selective disclosures become more rampant, aspects such as whispers and whispers on whispers (which is supposed to be closer to what companies have told the analysts in private than any other number) may also take hold.

More frequent, the better: It is now two years since the Securities and Exchange Board of India moved to a system of quarterly earnings announcements, rather the once-in-six months routine that was in vogue till then. Of course, there can be little doubt that quarterly earnings announcements are better as otherwise insiders and informed investors (who have access to selective disclosures) have a field day for a longer period, based on unpublished price-sensitive information.

Though mischief on this score is still rampant, at least the duration on offer has been cut down. One may argue that front-running linked to earnings announcements now takes place at least four times a year against twice earlier. But this is more than neutralised by the fact that the contraction of time reduces the scope and degree of mischief, due to cosy relationships between institutional investors and insiders.

Smaller degree of surprise: While on balance, quarterly earnings announcements are good for the market and investors, market response to such announcements has changed and hence this is a variable that has to be factored in while timing investment decisions. Due to the higher frequency, the degree of earnings surprise (positive or negative) is smaller than in the past.

However, the market response to even this smaller degree of earnings surprise is exaggerated. For instance, take the case of Cadbury India. When it announced higher-than-expected earnings growth accompanied by topline growth for the fourth quarter of 1999, there was a sharp re-rating of the stock in a flat/declining market. It moved up from around Rs. 700 to Rs. 980 in a short time frame.

But the earnings announcement for the first quarter which saw the company post a modest 13 per cent rise in its bottomline, and a healthy 20 per cent rise in its topline, has led to a decline in the stock price. There have been several Cadburys in the last one year since quarterly comparisons are now possible.

Short-termism: This short-termism in the market response to earnings announcements has led to periods when volatility levels are high, especially around the earnings announcement day. Of course, this short-termism in the market behaviour can and may already have an impact on the way the managements approach their business.

Delivering a good quarter and on the expectations may take precedence over everything, even if it means doings things that are not desirable from a long-term perspective. Also with top management incentives linked to performance (especially stock options and bonuses), the need to turn in a good quarter may indeed be a pressing one.

Though this has been a problem in the US, what is clear is that most companies (keen as they are on the immediate quarter) have not lost sight of long term imperatives. How the managements of Indian companies would approach this aspect may become clearer as more quarters roll by.

Allow advance warnings: To some extent, the expectations put out by various institutional investors (most of it are based on informed opinion obtained from companies) and the manner in which companies tend to just exceed, meet or fall short of these numbers has a tempering influence on the stock price trends. Otherwise, it is quite possible that the price movements may be sharper than is the case now, irrespective of whether it is a negative or a positive surprise.

The market response may get further smoothened if companies are allowed to provide advance warnings of any major factor that is likely to impact the earnings stream in between two earnings announcements. This is a common practice in the US. In recent times, companies such as Coca-Cola and Gillette had come up with warnings on the negative side, much in advance of the earnings announcements. And there have been occasions in the last two years when the likes of Microsoft, Intel and CISCO Systems have publicly revised earnings estimates upwards.

If such a facility is allowed, there could be scope for mischief. But by making it mandatory for any such advance warning to be made public to all investors through the Internet, wire services and media, this aspect can be taken care of, to some extent. Expectations may get altered by such warnings and this may lead to a less volatile process of price formation.

Just to ensure that this is not misused, the facility can be extended to the S and P CNX Nifty and S and P CNX Nifty Junior stocks, for a starter, and see how the process works. This need not be a mandatory requirement, but if any company wants to issue warnings due to sudden unanticipated changes, they should be allowed to do so. This facility may also reduce the degree of sharp impact in the short term that is now the trend.

Window of opportunity: There is also the aspect of a build-up in price ahead of the announcement due to speculative interest linked to the earnings. Because of these two factors, from an investment point of view, it may be better to contemplate investment decisions, after the quarterly earnings announcement effect sinks in. Of course, it is also possible that the prices may move up after the announcement. But in such cases, much of the uptrend usually takes place ahead of the announcement, driven by informed investing and what comes afterwards, is a small residual one. In many cases, the declines that take place after the earnings announcement, may offer

long-term investors a good opportunity to take exposures, especially in such quality stocks as Infosys, Wipro, Hindustan Lever or Cadbury.