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Earnings – Afterall, it’s the bottom line that counts

Jun 27, 2022

The long earnings season has ended with decent performance amid challenging market conditions. The outlook, though, remains mixed as companies battle high input costs and supply-side issues.

Total sales for the Nifty 200 universe grew 21% YoY, primarily led by Oil & Gas, Metals, Financial Services, and IT. EBITDA ex-BFSI increased 11.1%, marred by intense input cost pressures across industries. Consolidated net profit, however, grew by a robust 23% YoY, led by Financial Services, as banks saw the benefits of lower provisions and writebacks.

For the quarter, the aggregate net profit of Sanctum Indian Titans’ portfolio companies grew 28.8% YoY despite no exposure to metals, which we categorically avoid in our PMS strategies, but the sector continued contributing significantly to index earnings.

As we are on the topic of earnings, we decided to dig deeper into how important earnings are for the long-term performance of the markets. Though it’s been repeated several times, we thought it’s worth iterating as amid too much information and noise on interest rates, wars, recession, and other nail-biting stories, investors tend to forget about absolute basics like earnings.

Some History

If we look at the performance of the Nifty 200, which comprises of the top 200 listed companies by market cap, the index has delivered a robust 86% return in 5 years till March 31, 2022, a respectable 13% CAGR return over five years.

During this period, we had a market boom followed by a massacre in small-and-mid cap space, a rate hike cycle, a once-in-a-century global pandemic, supply chain issues, and an ongoing war. Despite all the stumbles, the market stood up, dusted itself each time, and kept marching on.

If we break down the index’s performance at the aggregate level in this period, it was entirely driven by earnings growth, as the aggregate valuation multiple (TTM PE in this case) has compressed (chart below).

Over 80% of the index performance during this time was led by the top 6 sectors: Financial Services, IT, Metals, Consumer Durables, and FMCG.

As seen in the table above, the financial services sector delivered market returns, despite the sector seeing significant derating over the period on account of multiple sector headwinds, higher beginning valuations, and credit loss concerns from the pandemic. Earnings growth, though, ensured an in-line sector performance.

The star performer of the period was IT, which witnessed more growth out of multiple rerating than from earnings growth. It’s worth noting that the valuation rerating in the sector has also happened due to the robust earnings growth in FY22 and the expected continuation of growth.

The FMCG sector lagged the index despite posting decent earnings growth in the period, primarily because of very high beginning valuation multiples.

It’s evident from the table that, in most cases, earnings growth had a significant bearing on sector performance. Of course, the cocktail of earnings growth and multiple rerating displayed better results, but earnings (both recent and expected) were a significant factor for multiple rerating.

Another key takeaway from the above analysis is that the sectors that started with unjustifiably high valuations failed to hold on to their valuations and delivered sub-par returns despite decent earnings growth. For precisely this reason, we don’t chase recent stories with more gas in them, led by excessive investor enthusiasm. The most recent example is IT. We were underweight in IT in late 2021 because the stocks were trading at extremely high valuations, with a low margin of safety. The sector has since seen a harsh derating.

Back to the index performance, we discussed the top three-fourths of the markets (by weightage) in the earlier section; let’s look at the other fourth, which may bring out a few exciting storylines.

The sector that stands out, in this case, is consumer services which comprises the likes of DMART, IRCTC, NAUKRI, Trent, Jubilant Foodworks, and Indiamart. Zomato and Nykaa are a couple of new entrants to this club. The sector saw an absolute market cap growth of over 600%, and it was the space that created many multi-baggers in this period; almost all of it was earnings growth. Multiples also expanded, albeit at a slower pace.

Another exciting space was Chemicals, which saw an absolute growth of over 200%, almost all of which was led by earnings growth.

Many great opportunities lie in the long tail of the index, as these smaller sectors are home to new, less tracked companies that are snowballing. This setting is a great hunting ground for companies seeing explosive earnings growth. As they see such growth, price-performance ensues, and they get included in the index as many of the names in the consumer services sector did in the last five years.

How we approach earnings at Sanctum

Our investment philosophy revolves around identifying themes that witness or shall witness decent earnings growth but are still not rewarded appropriately by the markets. In other words, the valuations haven’t caught up or are reasonable.

In the current context, some sectors that fit the bill are Banks, Media & Entertainment, and Autos, while the sectors that look risky are Metals due to the threat to earnings. IT stocks still trade higher than historical multiples, which will put the performance onus entirely on earnings growth.

Once we have the theme that fits our philosophy, we go bottom-up in the theme to identify the best bets using our earnings and growth filters. After eliminating all the noise from the results, we arrive at a focused list of a few stocks.

The list gets pruned further as we dig deeper. After checking for all other quality parameters, we pull the trigger and wait for the stock to deliver or prove ourselves wrong. With our robust risk management framework, we hope and gun for the former but continue to be prepared for the latter.

Quoting from the great stock market trader Mark Minervini’s book, “In real estate, the mantra goes “location, location, location. In the stock markets, it’s earnings, earnings, earnings; after all, it’s the bottom line that counts.”

Life is so much easier when we focus primarily on this one parameter.

Performance of In-house PMS Strategies

We calculate performance using Time Weighted Returns, net of fees and expenses (charged till 31st May 2022). Returns over one year are compounded annually; returns for less than one year are absolute. Please note that SEBI does not verify the performance information provided above. Please note that past performance is not a guarantee of future performance.

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