Sense & Sensex

If equity researchers have their way, the markets would never go south. Every time the Sensex crosses major resistance levels, equity analysts tend to revise their estimates upwards by at least 15 per cent.

In the beginning of 2003, most analysts put out a Sensex target of 4,200 by the year-end, and as soon as they sensed the Sensex breaching that level, targets were revised to 5000. Come 5000, and it was time to raise the bar again. The 'high' achieved in the last boom will be tested again, they said. And now, all one hears is that 7,200 is a certainty!

A correction of up to 15 per cent, however, is also a distinct possibility, they would add to hedge their bets. Simply put, the market offers a risk-reward ratio of 1:1, making it a less attractive bet that most market players would like the world to believe.

The hard reality is that the equity markets are highly sentiment-driven and no one can ignore it without the risk of underperforming at least in the near term. But if one were not to get swayed by the action and retain elements of sanity, it would be a worthwhile exercise to look at the markets after stripping off this sentiment factor.

Where will the Sensex be if one were to focus only on the growth of corporate earnings? Will one still find value in stocks? The Smart Investor studied the valuations of the 30 stocks constituting the Sensex based on consensus earnings projected for fiscal 2005 by analysts.

We considered a simple average of earnings estimates for fiscal 2004 and 2005 provided by HDFC Securities, Kotak Securities, Enam and Pioneer Intermediaries for all Sensex companies and looked at the contributions of each of these stocks to the Sensex's total earnings growth after accounting for free-float.

Besides, we also studied the sensitivity of the Sensex to each of these stocks by looking at the stock's contribution to total Sensex earnings and its weightage in the index. The following are our key findings:

The Sensex is trading at 15.07x fiscal 2005 earnings and 16.6x fiscal 2004 earnings. Total Sensex earnings are projected to grow by 10.58 per cent in fiscal 2005 after concluding a growth of 20.48 per cent for fiscal 2003-04.

Based on the weightage of stocks in the Sensex and their expected contributions to earnings growth, Reliance, Infosys, ICICI Bank, SBI and ITC will hold the key to the Sensex.

Nearly half of total earnings growth for fiscal 2005 is expected to come from Reliance (18 per cent), SBI (9 per cent), ICICI Bank (8 per cent), Infosys (7 per cent) and Hindalco (7 per cent).

MTNL, ONGC, Tata Power and HPCL will be drags on the Sensex. Earnings growth will be lower by 5 per cent because of these companies.

Possible upsides to the Sensex include positive earnings surprises from Hindustan Lever and a further P/E expansion in SBI.

Earnings boosters

Sensex heavyweight Reliance Industries will be the biggest contributor to fiscal 2005 earnings growth. The company is expected to contribute 18.37 per cent to earnings growth. Given that it has nearly 14 per cent weight in the index, Reliance will be the most influential candidate on the Sensex.

Analysts expect Reliance to post an earnings growth of nearly 20 per cent in fiscal 2005. There are multiple triggers for the stock. Firstly, its staple business - petrochemicals, which accounts for 50 per cent of its operating profits and 45 per cent of gross sales - is set to perform well on the back of a cyclical upturn.

A look at petrochemical prices reveals that their current prices are at nearly a 50 per cent discount to peak levels. Analysts believe that this itself lends scope for a rise in product prices given that demand in both domestic as well as international markets is quite buoyant.

Another trigger is Reliance's telecom business, which has finally kicked off and gained market share rapidly. With the company expected to break even in fiscal 2004, the market eagerly awaits the Reliance Infocomm IPO.

This again will give a boost to the Reliance counter. Currently, the stock trades at 14.87x fiscal 2005 earnings, which is close to fair value based on sum-of-the-parts valuations, according to some analysts.

Banking stocks State Bank and ICICI Bank are also likely to be big contributors to earnings growth. The two stocks are likely to contribute about 9.24 per cent and 8.21 per cent respectively to the Sensex's earnings growth for fiscal 2005. Analysts expect an earnings growth of 13 per cent for SBI and 14.60 per cent for ICICI Bank.

The valuation gap between ICICI Bank and SBI still remains, though it has declined after the sharp run-up in SBI's share prices. Analysts reckon that ICICI Bank is fairly valued at its current price, while SBI could see further a re-rating, especially if the foreign holdings limit in public sector banks is raised.

Other big contributors to the Sensex's earnings growth will be Infosys (6.99 per cent), Hindalco (6.52 per cent), ITC (6.46 per cent), and Dr Reddy's (6.17 per cent). Infosys is likely to clock an earnings growth of 20.58 per cent for fiscal 2005, and end fiscal 2004 with a growth of 25.52 per cent.

What surrounds Hindalco is the expected upturn in commodity prices. The company has completed its capacity expansion project (by 50 per cent), which will show benefits in the coming quarters. Also, India is a net importer of aluminium, which means there is enough demand to absorb the additional capacity, says an analyst.

Dr Reddy's is also likely to be one of the fastest in terms of earnings growth, with growth being projected at 56.39 per cent for fiscal 2005. Other companies, which are expected to grow earnings fastest are Bharti (113 per cent), ACC (68.61 per cent), Wipro (34 per cent) and Tata Motors (32.84 per cent).

Earnings poopers

ONGC is likely to show a 4.65 per cent decline in earnings. Analysts say that the projections are based on the assumption that crude prices could fall. The current oil prices are at $31 per barrel.

And the average crude price this year has been about $27.8 per barrel. "We expect a decline in oil prices by at least 10 per cent which will consequently result in a decrease in standalone earnings for ONGC," says Anish Desai, research analyst with HDFC Securities. Currently, the stock trades at 12.34x fiscal 2005 earnings.

Even in the case of refining and marketing company HPCL, analysts do not expect zippy growth. "Gross refining and marketing margins will be flat," says Desai. Analysts do not expect any significant upturn. The stock currently trades at a P/E of 10.77 based on FY 2005 earnings.

Click to view a detailed table of:
Earnings forecast for fiscal 2005

Interestingly, Tata Power is also expected to see a marginal (1.20 per cent) decline in profits. Analysts expect that Tata Power could see pressure on revenues as BSES (which buys power from Tata Power) may cut down on its purchases as it increases its own capacities.

MTNL is likely to record a 24 per cent decline in earnings. Analysts say the company will suffer as it continues to lose market share to players like Reliance. Other stocks in which analysts expect low earnings growth are Rabaxy, HLL, Hero Honda, L&T and Tata Steel.

Tata Steel is likely to show an earnings growth of 3.37 per cent. Analysts are assuming that the spike in steel prices will not be sustained and could fall through fiscal 2005.

Interestingly, analysts expect HLL's bottomline to grow by only 6.56 per cent in fiscal 2005. Though it is more than double the earnings estimated for fiscal 2004, it is much lower than most of the companies in the pack. The stock, however, continues to get a premium valuation at the bourses with an earnings multiple of 24.45x.

What about stock prices?

Based on current earnings estimates, Sensex stocks do not appear cheap. Barring SBI, all stocks in the Sensex are trading at double-digit earnings multiples. If one were to assume that interest rates were to be sustained at current levels, stocks look fairly valued. Any increase in interest rates would only make them look unattractive.

Based on the weightages that individual stocks have in the Sensex and their contribution to total Sensex earnings (note that this is adjusted for free-float - only earnings attributable to free-float equity have been considered), Reliance and Infosys will be the most influential stocks on the Sensex. HLL will be relatively less important even though it has a weightage of 7.36 per cent in the index.

Stocks with lower weightages than HLL like ICICI Bank (6.02 per cent), SBI (4.44 per cent), ITC (5.59 per cent), Hindalco (3.35 per cent) and Dr Reddy's (2.6 per cent) will be far more important for the Sensex.

Put differently, the market will be far more susceptible to sentiment in these stocks. Disappointments in these stocks will have a larger impact than one would imagine by simply looking at their respective weightages in the index alone.

That's because the higher earnings expectations in these stocks have been priced in and are reflected in Sensex valuations currently. On the contrary, any earnings surprise from HLL will also have a disproportionately positive impact on the Sensex on the upside. Similarly, Tata Steel could surprise on the upside if steel prices defy expectations of a flat to falling trend.

How do these stocks stack up based on valuations? Reliance's price looks fair based on current valuations. Any upside could emanate from the unlocking of value in the telecom business. Infosys is likely to post an earnings growth of 20 per cent in fiscal 2005 and is trading at 25.83x earnings.

Assuming that Infosys will be able to clock 20 per cent on an average for the next couple years, valuations do not look very expensive. But they are not cheap either. Similarly the earnings growth in ICICI Bank and SBI also seems to have been priced in. Ditto for the rest, and none of them look ripe for a re-rating due to any other reason, say analysts.

In sum, any possible upside to the Sensex will primarily have to come from positive earnings surprises from HLL or a P/E expansion in SBI, which appears to be a distinct possibility. Positive earnings surprise in case of Tata Steel, HPCL and Ranbaxy will also add fervor to the Sensex.

Notwithstanding the 'sentiment factor', the stocks will be extremely vulnerable to earnings disappointments in fiscal 2005.

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