Will the stock market party end?

• Part I: Bull Run? Beware of being scammed!
• Part II: Is the Sebi doing enough?

India's corporate elephants are certainly nifty dancers. The aggregate performance of the 50 companies comprising the S&P CNX Nifty, accounting for a little over 50 per cent of total market capitalisation, is truly impressive. In the past two years (until 2004-05), net sales (Rs 5,57,740 crore -- Rs 5,577.40 billion) have grown at a CAGR of 15.3 per cent while profit after tax (Rs 74,147 crore -- Rs 741.47 billion) has grown at 34.5 per cent.

Smaller companies have also done well. The market has been generous with its valuations. The market capitalisation of the Nifty-50 has grown at a CAGR of 61.93 per cent since March 2003.

Will the party end? Market gurus are confident that 2005-06 will also be strong; sales should grow at 15-20 per cent. But sales and profit growth rates have slowed in the last three quarters. Experts suggest that the deceleration is to be expected due to the higher base effect.

Explains Nilesh Shah, CIO, Prudential ICICI AMC: "It is humanly impossible to grow at higher rates. Corporate profitability had secular and cyclical factors favouring it in the last few years. The secular factors are productivity growth, economies of scales, rising demand and global aspirations. The cyclical factors were falling interest rates, falling tax rates, falling inflation and good monsoons. Now, the cyclical factors are deteriorating; interest rates have risen and capacity utilisation has peaked; you have to invest to set up capacity, and commodity prices have started rising too."

Adds Tridib Pathak, CIO, DBS Cholamandalam: "The last four quarters have seen a deceleration in growth rates. But even now, growth remains at a respectable 12-15 per cent."

Concerns ahead: Key concerns include rising input and interest costs. Net profit growth is slower due to increases in interest and depreciation charges and lower other income growth (See below: Corporate Growth Rates).

The net profit growth for S&P CNX 500 companies declined to a mere 0.3 per cent in December 2005 quarter, thanks to the poor show by oil marketing companies. For smaller companies, higher growth in expenditure and lower growth in other income has led to net margins declining in the last three quarters.

Interest rates are expected to rise further. Explains Deepak Jasani, head - retail research, HDFC Securities: "If the rise is limited to 100-125 basis points, it should be fine. But, if it goes up sharply to about 12 per cent, there could be problems in banking and capex/working capital heavy sectors." Jasani also suggests that since larger companies have already improved working capital management, there is limited scope for further squeezing it, though there is higher scope for this in the case of small/mid-cap companies.

The other worry: after softening in 2005, input costs have been rising for some time. Prices of metals and commodities like cement, etc., are on an upswing. Simultaneously, personnel costs (10 per cent of sales for Sensex companies and 7 per cent for S&P CNX 500 companies) are growing.

On the positive side, there is scope for productivity gains elsewhere. Explains Shah: "Companies can absorb the cost increases. Look at cars. Steel prices have moved up substantially but car prices haven't doubled. Productivity growth has come from economies of scale and cost management. By improving supply-chain efficiency we can absorb costs."

Adds Raamdeo Agrawal, managing director, Motilal Oswal Securities: "Every company will have to innovate to manage costs. To give an example, telecom companies have brought down the tariffs from Rs 16 to Rs 1 per minute and they are profitable." But the ability to improve productivity and absorb costs will vary across companies.

Capex blues: Future growth rates will also be determined by spare capacities, which are shrinking. Companies are undertaking expansions. But to do this, they must raise cash and this will impact earnings and return ratios. Explains Jasani: "Return ratios for corporates could deteriorate due to higher net-worth or capital employed. The impact of higher depreciation and interest costs will not happen simultaneously for all companies. But at some point of time, when this could coincide, net profit growth may be lower than sales growth."

According to Agrawal: "Project execution capability varies across companies. For instance, Tisco is in a better position to stabilise production from new capacities compared to smaller players." For the time being, the impact of capex plans is reflected in lower growth in other income. Companies are using surplus funds to set up new capacities.

Rich valuations: Valuations have increased rapidly. Adds Pathak: "Risk levels have risen. The rally has been driven completely by liquidity from a PE of 12 a year ago, to a one-year forward PE of 18 now. The growth in market values has been faster than earnings growth."

Shah justifies this: "Valuation is a function of demand and supply and not fundamentals. As long as there's cash powering it you can have rich valuations. Today, sentiment is strong, FII money is coming in and this is leading to rich valuation. People are paying higher prices because they are comfortable with long term growth prospects."

What next? Even if valuations are above fair levels, it's not like the 1999-2000 bubble. Despite lower growth, larger companies should report profit growth of 14-16 per cent and mid-sized companies, 18-20 per cent in 2006-07. But caution should be the watchword. Investors will have to look at companies with visionary managements, robust business models, strong pricing power and good financials.

Another route is to be contrarian view and buy underperforming, investment-worthy stocks or defensive plays, to reduce risk.

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