Financial Daily from THE HINDU group of publications
Sunday, Jun 02, 2002
Markets - Commentary
Fundas tell only half the story
LOSSES in portfolio value in recent years are testimony to the fact that, even at the best of times, predicting stock price behaviour is not easy. And these are anything but the best of times. The global outlook post-September 11 and local uncertainties in the South Asian region have combined to make this so. Even in ordinary times, investor-expectations play a strong role in price formation.
As expectations do not always spring from robust past performance, enterprise fundamentals have only a marginal role. A study of the price patterns using sector-specific indices over a four-year period shows that fundamentals, such as earnings, influence price trends only to some extent. Expectations on their future, rather than past, performance, seem to be the dominant factor. Random price movements are also crucial.
Of the six sectors analysed there is some linkage between financial performance and stock price behaviour in five. But only in two of the four years were the trends in fundamentals in line with those in the stock market. If the trend in fundamentals was bullish, the stock market trend too was so.
It was also found that stock prices are more reflective of future earnings than past performance. In most cases, the stock price movements generally factor in the prospects for the sector rather than its past earnings. Overall, we conclude that while the fundamentals as represented by specific accounting variables do, to some extent, help explain valuations, one cannot rule out the role of random movements in stock prices.
Uncertainty, a key factor
The study showed that one cannot attribute the movement in stock prices completely to the fundamentals. It is just one of the many factors affecting prices. To understand this better, it would be worthwhile considering the performance of individual sectors over a period.
Automobiles: The automobile sector is a traditional old economy area. This means exponential growth rates can generally be ruled out here. Therefore, one would expect fundamentals to play a greater role in explaining stock prices than in the case of sunshine industries, such as technology. However, the opposite is the case.
The analysis showed that the automobile industry is the only one where the fundamentals never moved in line with the stock prices. This is true for all the years analysed. It is also important to note that, in general, over a period, a stock may have been bearish, indicating that returns were negative. But, at the same time, the fundamentals were positive.
One reason for this could be that in the period analysed there was a shift in funds from traditional old economy stocks to new economy stocks, anticipating higher returns. This could have led to a decline in the fund inflow into the sector. Hence, the general shift in market interest could have led to lower valuations in these stocks. But this does not mean that fundamentals do not play a role.
Consider this. The three companies in the automobile sample Bajaj Auto, Hero Honda and TVS Motor recorded very good performances in the last two quarters and expect good demand growth. The stock prices started factoring in the demand potential and the three companies have gained substantially since January.
Between April 2001 and March 2002, the two- and three-wheeler index actually outperformed the BL-250 index by around 54 per cent. This suggests that earnings potential has kept the market interest alive in these stocks.
Banking sector: The banking sector represents a more balanced picture than automobiles. In the last two years stock returns in this sector moved in line with that of enterprise performance, as also with economic fundamentals.
The sample companies in this sector generated a negative return (to the market portfolio) in the first year of only around 1.76 per cent. Overall, valuations in the banking sector do have a firm undercurrent in enterprise or macroeconomic fundamentals. But banking, again, is a traditional sector where expectations cannot go dramatically wrong.
Pharmaceuticals: The pharmaceuticals sector gives us a clear indication that fundamentals do matter. The analysis revealed that in three of the years positive excess returns were matched by positive fundamentals. Even in the year when it did not match, the excess loss was just around 2.05 per cent whereas the fundamentals were positive. Here, again, stock prices related more to future rather than past earnings.
Consider the returns generated by the BL Pharma index in 1998-99 and 1999-2000. In 1998-99, the pharma index outperformed the market by 157 per cent while it underperformed the market by 2.05 per cent in the subsequent year.
While sales and operating profit grew 31 per cent and 21 per cent respectively in 1998-99, it was only 15.5 per cent and 6 per cent respectively in 1999-2000. The earnings pattern confirms that current stock prices factor in the expectations as well, indicating that the market seems to be able to discern value from the fundamentals in pharmaceutical stocks.
Technology: Over the last two years the technology sector has been going through a rough patch. Before 2000, technology stocks were much in demand. Exponential growth rates were projected and IT stocks rose in value, to fancy multiples of current earnings during this period. In 2001, companies started coming out with poor earnings forecasts. From the highs of February 2000, valuations in the sector dropped sharply, giving in to the global slowdown. The market quickly reacted to the changing business environment.
Though the technology sector reported good growth rates, they do not match the market expectations. This and the general downward bias to the industry have led to excess negative returns over the last two years. The market started factoring the impact of the slowdown into IT stock valuations even before it was evident in the books.
The BL Technology index underperformed the market by around 29 per cent in the year to March 2001, though the earnings performance for the year does not reflect this. This could only mean that the stock prices had already taken into account the sluggish prospects for the sector. This signals that valuations depend on earnings potential and not just on past performance.
What the trends mean
While at times fundamentals do give us a fair idea on future valuation movements, stock price movements are often unexplainable. Expectations and the "animal instinct" do distort valuations. This is likely to be higher in new economy stocks. Given that they are relatively new, their financial statements only give an idea of what happened in the very recent past. Therefore, investment decisions cannot be based solely on financial performance as stated by the annual reports. This information can be used to frame a general opinion of the company.
At the end of the day, understanding the business, its prospects, earnings potential and the general environment that would affect the business in future will be a better guide in assessing an equity investment. Thus fundamentals explain only half the story. The rest is told by market expectations, individual investor behaviour, and intuitive decisions on when and what to buy and sell at various points in time.
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