The Hindu Business Line : Sizing up stocks through the risk prism

CLOSELY linked to an investor's assessment of a company's sales and profit growth is the perception about the likelihood of such an outcome — or what financial management pundits call the `risk'. Everybody is, for instance, agreed that Tata Motors will become a Rs 50,000-crore company in five years. But where they once thought that this outcome was certain (100 per cent probability), they now think there is only a 70 per cent chance of this happening.

Whether a 70 per cent probability for a Rs 50,000-crore turnover is the same as a 100 per cent probability for Rs 35,000 crore is a matter of debate. But the moot point is this: If that perceived `risk' goes down, stock prices go up, and vice-versa. It does not matter that the event that triggered a change in the perception of `risk' may not actually be material in causing a change in performance. As long as investors believe in its potency, that is all that matters.

October and November provided tangible evidence of events shaping a layered perception of risk and its rather rapid dissipation. Pressure on the external value of the rupee quickly sucked out investors' enthusiasm for stocks in October. As quickly, the pressure eased and the appetite for equity increased, pushing stock prices up and away.

It is, thus, clear that only if you are alert to the risks would you be able to gauge the winds of change with a reasonable degree of certainty. However, that is easier said than done. It is almost impossible for retail investors. What can be done is to have a view on risks over a slightly longer term than a month and weave that into your portfolio strategy.

What is this risk?

The word `risk' conjures up images of loss. It is often equated with fluctuation in prices. Risks faced by companies are measured differently. But risk can also add value and not necessarily mean losses.

Two measures closely watched for their effect on earnings growth are the volume of investments a company has made and the variability in sales. The interaction of these two forces is dubbed the `operating risk'. Often, variability in sales turns out to be crucial.

Over the past couple of years, the interplay of risks, their implications and stock price changes were discernible. When the pressure on the rupee increased, investors quickly sensed that interest rates would rise, pinning down economic growth and leading to a decline in sales. Companies whose sales fall when economic growth is hit are affected the most, while those whose sales remain stable even during a downward growth spiral escape relatively unscathed.

A few months after the rally in 2003, many analysts realised that the market focus would turn to stocks of companies considered highly risky. The rationale was that if industrial growth rises these companies would benefit more. Business Line made an analysis in September 2003 on the earnings risk of companies. Trawling through the numbers, it was clear that companies such as Bharat Earth Movers, Maruti Udyog, BHEL, Crompton Greaves, Thermax, Indian Hotels, Bluestar, Goodlass Nerolac, BOC India and Elgi Equipments have high operating risk.

This meant that given an upswing in economic activity, earnings of these companies would rise more rapidly than the rest. Industrial activity did gather pace. The stock market focus turned to these leveraged companies and these stocks went on to deliver returns that were several times better than that of the market.

Investors game for risks

The period between March 2003 and November 2005 turned out to be one in which investors seemed to welcome risks. Parallels can be drawn with 1994, when expectations of earnings growth drove stock prices to all-time highs. A comparison with 1994, however, may not capture the trends fully. Investor focus this time around has been on a much larger set of sectors and had more depth in terms of the number of stocks. Specifically, top performers were essentially those that had high operating risk. That is, companies with fluctuating sales and high fixed costs did quite well, with Balkrishna Industries, JSW Steel, Sesa Goa, Bilcare and Taj GVK Hotels among the top gainers.

Economic growth led to a huge spurt in the sales values of these companies. Such a big jump led to an even larger increase in profits as high operating leverage kicked in. Leverage refers to the higher proportion of fixed costs. As costs do not rise when sales rise, profits rise faster than sales.

The next best set, in terms of price performance, were companies whose losses turned into profits. The two-digit industrial growth turned non-performing companies into star performers virtually overnight. Bhansali Engineering, Greaves Cotton, Texmaco, Esab India and Voltas were some of the main gainers in this list. Companies with stable sales but high fixed costs also did well. Jyoti Structures, Manugraph India, Aegis Logistics, HCL Infosystems and Bharat Earth Movers fall in this category. As sales rose at a steady rate, profits rose faster as the proportion of fixed cost came tumbling down.

The rest of the market too did well. They, however, generally under-performed. Even low-risk companies — those with stable sales growth and low level of fixed costs — under-performed the market. Prominent in this lot include Britannia Industries, Micro Inks, BASF India, Essel Propack and Neyveli Lignite.

Companies with high sales variability but low fixed costs account for one-third of the market capitalisation. This segment too under-performed. Laggards in this category include Asian Paints, Paper Products, Century Enka, Hindalco and Cipla.

What lies ahead?

After heady two years, it is obvious that more sobering times await us. What is not so obvious is to which stocks to park your money in. Should you over-weight risky stocks or would a flight to safety be more appropriate?

This inevitably calls for clarity on growth expectations. If you were a bear, you would over-weight stocks with low variability in sales and low fixed costs. If you continued to be gung-ho on the economy's prospects, you would continue to court risks.

Understandably, the challenges facing an investor are far more difficult than they have ever been. An easy way out would be to take a sufficiently long-term view. Over the long term, the economy can be expected to deliver fairly high industrial growth. Earnings growth, too, would be in double digits.

If such a scenario appeals to you, you can continue to over-weight the portfolio with stocks of high leverage but lower sales variability. And one can expect returns superior to those from debt and also in the process beat inflation. This portfolio would also include low-risk stocks as a sort of hedge. This approach would also require investors to hold through several ups and downs. Changes in composition of the portfolio every six or 12 months would also be necessary.

Few investors, however, want to take the easy way out. They want to maximise returns as much as possible. These investors would continue to prefer stocks with high sales variability and high proportion of fixed costs. Some stocks with negative profitability will also figure in their list in anticipation of a turnaround. This approach would require investors to engage in tactical shifts in stock allocation in accordance with changing risk perceptions.

A possible easy-way-out portfolio would be: ABB, Asian Hotels, Bharat Electronics, Blue Dart, Coromandel Fertilisers, HDFC, IVRCL Infrastructure, Mahavir Spinning, Reliance Industries and Ramco Industries.

A more aggressive portfolio would include: Kirloskar Oil Engines, Goodlass Nerolac, Bharat Forge, Tata Steel, Sundaram Clayton, Hindustan Zinc, Taj GVK Hotels, National Aluminium, Glenmark Pharma and BOC India.

Sifting through valuations

It is highly likely that the majority of stocks in the easy-way-out portfolio will be stiffly priced. For instance, HDFC, ABB and Bharat Electronics do not come cheap. That could impart a sense of large downside. But it is illusory. The rich valuation is merely a reflection of the low operating risk faced by these companies.

In contrast, most of the stocks in the aggressive portfolio may actually turn out to be attractively valued. That could suggest low risk. That is, however, not the case. Take Tata Steel, for instance, which is trading at a PEM of less than 5. If sales growth dips 10 per cent, profit growth could drop as much as 40 per cent. Sensitivity of earnings to a decline in economic growth is high in these companies. Understandably, valuations are also more modest than the rest of the market.

It is another matter, however, if you think sales growth would not dip at all. If you are uncomfortable paying a stiff price for a low level of uncertainty you have another option. You can sift for stocks that trade at reasonable valuations but also have low sales variability. Some candidates are GIC Housing Finance, Mercator Lines, Orient Abrasives, Numeric Power Systems and Grasim Industries.

Invariably, many such stocks would be in the mid/small-cap space, exposing investors to another set of risks. Those who make money, however, consider these risks as opportunities, try to come to grips with them and make the most of the bargain.

More Stories on : Insight | Stock Markets

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page