Market fundamentals remain weak

Sensex remains ahead of the underlying earnings and dividends, giving upper hand to the bears

The sharp fall in the market was in the making for some time. The gap between the Sensex and the underlying fundamentals widened further after the fourth quarter corporate earnings were announced, giving bears an upper hand.

The combined earnings (net profits) of the 30 Sensex companies are almost stagnant on a year-on-year basis and down from the level after the end of the third quarter earnings season. The Sensex’s underlying earnings per share (EPS) is now Rs 1,385, from Rs 1,425 in February after the third quarter results and Rs 1,355 in June 2014. This has widened the gap between the long-term trend in the index companies’ underlying earnings and their market valuations.

Bulls have also come under pressure from the cut in equity dividends by top companies after their lower than expected profits in the March quarter and poor earnings visibility for FY16. Combined equity dividend by the Sensex companies, excluding those in information technology (IT), declined by 10.1 per cent in FY15 over FY14.

The analysis is based on the end-of-day valuation ratios of the Sensex, the price to earnings multiple and dividend yield, provided by the exchange. The ratios were inverted to get the index’s underlying EPS and equity dividend.

Historically, there is a close correlation between Sensex growth and that in underlying earnings and equity dividends. Whenever the Sensex trails or overshoots the underlying trends in corporate earnings or equity dividends, the market corrects subsequently, suggests data since 1991. This seems to be on.

Analysts agree. “Corporate earnings (excluding financials and oil & gas) was down 11 per cent in the March quarter, the worst in the last 15 years. However, this doesn’t reflect in the broader market and the benchmark indices such as Sensex and Nifty continue to trade at valuations that assume high double-digit growth in corporate earnings,” says Dhananjay Sinha, head of institutional equity at Emkay Global Financial Services.

The BSE Sensex is currently trading at 19 times the underlying EPS in the past 12 months. In the past, the Sensex valuation had fallen to as low as 11x in late 2008 and early 2009, and 17x during the market selloff in May-June 2013, following a sharp depreciation in the rupee.

The post September 2013 rally, dubbed a Modi rally, was supported by a strong uptick in the earnings, led by IT and pharmaceutical companies, which benefited from a sharp depreciation in rupee earlier that year. Bulls’ hands were further strengthened by the gains from a fall in international prices of crude oil and commodities that accrued to manufacturing companies.

This trigger began to peter in September last year and corporate earnings are on a downward trajectory since then. The Sensex’s underlying EPS peaked at Rs 1,462 in September 2014.

For a while, the market was supported by higher dividend payment by cash-rich companies. Sensex companies’ payout ratio (share of net profit distributed as dividend) had shot up to a decadal high of 34 per cent at the end of the third quarter earnings season, as many large companies such as Coal India, Oil and Natural Gas Commission and Tata Consultancy Services paid hefty interim dividends in FY15. This supported the valuation for a while, even as earnings growth was slowing.

The trigger is now missing, as many top companies either cut dividends in the fourth quarter or skipped it altogether. In all, nine Sensex companies, including big market movers such as Tata Motors, Sun Pharma, Hero MotorCorp, Coal India, GAIL, Mahindra & Mahindra and NTPC have either cut their dividend for FY15 or decided to pay none at all, due to poor profitability. Another four companies kept their dividend payout unchanged, belying the hopes of the bulls.

IT companies were outliers, stepping up their dividend payments in FY15 over the past year. The combined dividend outgo by the top three IT companies — TCS, Infosys and Wipro — more than doubled in FY15 over the previous financial year. Analysts, however, doubt the sustainability of this trend, given the poor show by IT majors in the March quarter.

This means there is a chance of a further slide in the market, unless corporate earnings and dividends rise in FY16, like the one seen in 2013 or post 2008 global financial crisis.

Other analysts point at the poor market sentiment, driven by a flood of bad news flow, rather than poor fundamentals. “Forget the fundamentals, there is a fear psychosis on the Street right now. Investors have a lot to fret about, be it the negative impact of bad monsoons or FIIs shifting their money to China or the solvency of highly leveraged companies and their impact on public sector banks and the banking sector as a whole,” says G Chokkalingam, founder and chief executive, Equinomics Research & Advisory.