How to choose the safe ones -- The problem of uneven information flow

Sanjiv Shankaran

THE EQUITY market has seen radical changes since 1992, but not in one important aspect -- the varying nature of information, with uneven flow across different categories of investors. Retail investors who depend only on public information run the risk of acting on a certain piece of information long after the better-informed investors have. Thus, they run the risk of taking exposures in a stock at the wrong time.

Clearly, there is a case for retail investors to tailor their investment decisions to reflect this situation. Profit announcements by companies are good cases in point.

This article examines the strength of the relationship between a company's net profit -- probably the most closely tracked announcement -- and the stock price, and look at the investment opportunities available for retail investors. Companies forming the S&P Nifty index were considered for the analysis (see Box for methodology).

Results of the study

A striking trend emerged from the study. For 17 companies, there was a close link between the net profit and the average stock price. These companies shared a common trait -- their businesses were relatively insulated from economic cycles -- and were thus easy of prediction. Most of the 17 companies were from the fast-moving consumer goods (FMCG) sector.

FMCG companies

Among the FMCG companies, Hindustan Lever, ITC and Nestle have long been market favourites, primarily because of the lower volatility associated with their businesses, a factor captured by the stable revenues and profits since 1994 (data between 1994 and 2000 was analysed for the study).

A look at their net profits over a six-year period suggests that there is a higher degree of certainty vis-a-vis traditional manufacturing companies.

In the list of Nifty companies, one that stands out because of the steady increase in net profits since 1994 is Reliance Industries. While the Reliance net profit trend mirrors that of top-rung FMCG companies, its average price fluctuated over the period.

One explanation could be that the company relies on commodities for revenue, while FMCG companies look to brands. Commodities, by description, are more susceptible to price volatility. This, in turn, has a significant bearing on the value investors may attribute to the company's stock when commodity prices are weak.

If this explanation holds good, it implies that net profit has a closer link to stock price for FMCG companies. This is plausible in the light of the conventional wisdom that controlling powerful brands provides a cushion in an age when technology and features are easily replicated.

Non-tech stocks

This brings us to the next lot of stocks -- the ones not in the New Economy category -- that showed a statistically significant relationship between net profit and stock price.

It is a mixed bunch -- pharmaceutical giants such as Cipla and Glaxo, auto major Hero Honda, and Hindustan Petroleum -- whose profit performance and share prices exhibit a robust link.

Of these, Hindustan Petroleum is difficult to explain in terms of any significant feature. The company's net profit, however, does seem closely linked to the average stock price.

Glaxo and Cipla, are from the pharmaceutical sector, often mentioned in the same breath as FMCG stocks, though recent financial performance suggests that pharma company earnings are, indeed, susceptible to volatility.

Yet, in the category of pharmaceutical companies, Glaxo and Cipla are among the more competitive ones. Cipla's net profit grew every year of the period under consideration, while for Glaxo it was a mixed trend.

A look at Glaxo's financial statements since 1994, in conjunction with the stock price, suggests that the premium investors are willing to pay over the year's net profit falls in a predictable band. That is, the premium (in terms of aggregate market capitalisation) may be in line with the last available net profit, because the top-end pharmaceutical business is believed to have stable revenue and profit streams. This makes the company almost FMCG-like.

Cipla does not quite fall in the same category. The scrip's average price increased sharply over the past couple of years -- almost as if investors suddenly woken up to the stock's potential. The sharp rise in the average price coincides with the phase in the equity market when pharma stocks, as a group, were better rated. The rise in Cipla's price over the past year seems to have come about largely due to the re-rating of the company's research potential. Cipla's business seems relatively unaffected by the ups and downs in the sector. The company's financial statements suggest stability in the underlying business, almost as for an FMCG company.

Hero Honda's presence among the 17 is not a surprise, though it is an automobile company. The company is primarily a motorcycle manufacturer and, in that category, the market leader. A dominant position in the least volatile segment of the automobile market, again, indicates of stability in the underlying business, an aspect reflected in the company's financial performance.

The common thread running through most of the above companies is that there appears to be some sort of stability in the valuations investors fix. The premium the market seems to be willing to pay for the net profit of select companies is relatively more predictable when the underlying business is stable.

Tech companies

Technology players that figure in the list of 17 are Infosys Technologies, Satyam Computers, NIIT and Zee Telefilms -- companies that have seen marked growth in net profit as well as a consistent increase in the average share price since 1994.

As with Cipla, the growth in the average price in the past two years was high. This period coincided with a higher profile for technology stocks and a higher flow of institutional investment into the sector. As the trading volumes in these stocks suggest, the higher flow of institutional investment triggered greater retail interest too.

The volatility in the valuation of technology stocks may have been caused by the novelty the industry holds for equity investors and the difficulty in getting a realistic picture of the potential. As investors get a better fix on the industry, the premium paid on the net profit could stabilise.

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Predictability premium

There appears to be an element of consistency about the premium investors generally pay for an indication of some firms' net profit. A look at the companies suggests that they come from industries where volatility, which is associated with performance, is relatively lower. At this point it may be better to exercise caution when taking a decision on the technology sector, as investors' understanding is still tentative and incomplete.

If the market's premium for a company's net profits falls within a predictable band, retail investors may be better off sticking to that company, as the danger associated with taking an exposure at the wrong time appears lower.

It is unlikely that the flow of information to different categories of investors will ever be even. Thus, retail investors may try to stick to companies where the danger of a long-term downside risk to their exposure is low, and the underlying business has a higher degree of stability.