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22 companies’ EPS downgraded in last 4 quarters; should you buy, sell or hold?

The December quarter earnings were largely in line with estimates. Financials led the earnings growth in Q3 due to rise in credit yield and improvement in credit cost along with industrials, while energy sector was among the laggards largely on account of lower GRMs due to inventory losses, along with metals and IT.

Auto companies reported stress on earnings due to poor volumes, high input costs and JLR write-off in Tata Motors. Lower operating leverage, high discounts/incentives and commodity costs being on the higher side somewhat hampered margins, suggest experts.

Among the Nifty50 names, SBI, ONGC and HDFC Bank were major contributors to PAT growth in the December quarter while HDFC, IOC, and Infosys were major laggards, Elara Capital said in a report.

The report also highlighted stocks which saw a consistent upward revision in FY20 earnings (three out of the past four quarters and upgrade in the current quarter) were Havells India, DLF, Nestle India, Tech Mahindra, HCL Technologies, Wipro, Dr. Reddy’s and Titan.

There are as many as 22 stocks highlighted by Elara Capital that saw a consistent downward revision in FY20 earnings (in the past four quarters) including Sun Pharma, UltraTech Cement, Cipla, Maruti Suzuki, MRF, PNB, Tata Motors and Vedanta.

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For the index, Elara has downgraded Nifty 50 EPS for FY19E to 501 (down 5.9%) and for FY20E to 626 (down 4.9%) from the past quarter, primarily led by energy sector due to lower GRM on weak crude oil outlook and financials which may face headwinds in the form of elevated credit cost in the near term due to private bank exposure to IL&FS holding companies turning sub-standard.

In an economy like India, where domestic and global investors have essentially been betting on growth, the impact of growth works both ways.

Theory suggests that while upgrades tend to see a positive re-rating of the stock price, any earnings downgrades see consistent fall in stock prices. The price of the stock is normally a derivative of the P/E ratio which is determined by factors like earnings growth, ROE, qualitative merits, etc.

How should investors approach earnings downgrades in the Indian context?

To answer this question, Angel Broking research team puts out 4 distinct scenarios:

Structural Downgrade: Best to avoid

The more serious type of a downgrade is the structural downgrade, which has been seeing in pharma companies. As global buyers consolidate and low-cost competition emerges, Indian generic pharma companies are struggling to maintain margins.

Companies like Lupin, Sun Pharma, Cipla, and Cadilla Healthcare have seen consistent downgrades in earnings and in ROE. This is a structural issue and such stocks are best avoided till the basic structural issues are addressed.

High Valuations: Can be good bets at reasonable valuations

There are cases where valuations (P/E) expanded at a pace much faster than earnings. As the size impact began to kick in, these companies found it hard to sustain P/E ratios.

Stocks like HDFC Bank and Maruti Suzuki belong to this category where downgrades are more due to the size effect. These stocks can be good bets at more reasonable valuations.

A shift in market place: Active decision making required

Then there are companies where earnings have been downgraded due to big shifts in the market place. Motherson Sumi has seen earnings downgrade due to a weak Chinese car market and falling diesel car sales.

Power companies like Tata Power and NTPC are caught between input pressures and PPA issues with states. There are also mineral companies like Vedanta where the downside in the metals cycle is taking its toll on earnings. In all these case, your investment decision will have to sync with the problem life cycle.

Slowdown in growth: Good bets at reasonable valuations

Finally, there are companies with strong brands where the brand value could act as a base for valuations. This is despite a slowdown in growth. Stocks like Grasim, HDFC Bank, and MRF belong to this category. These stocks make a good base case for buying at lower levels due to relatively reasonable valuations.

Conclusion:

While earnings upgrade downgrade could be one parameter for filtering stocks, investors should make use if other parameters before they press the buy button especially when you plan to hold the stock for the long term.

Where investors can seriously look at companies with earnings downgrades for investing is either companies with strong brands or merely a problem of over-expectation. But, can we say that stocks which have seen EPS upgrades become top stocks to buy? Well, maybe not. This valuation matrix at best can be used to filter stocks.

Experts say that the extent of upgrades has to be evaluated along with management commentary and strategy to understand the sustainability of earnings.

“There are numerous factors which need to be evaluated before decision making apart from EPS upgrades or downgrades. EPS upgrades are “neither necessary nor sufficient” to evaluate Company for investing,” Vineeta Sharma, Head Of Research, Narnolia Financial Advisors told Moneycontrol.

“Upgrades and valuation Matrix helps in picking stock for further research for investment purposes. On a broader sense, one has to see first the business, then the management strategy, financials, and valuations before investment. One important parameter may be high and/or sustainable Return on Equity or Return on Capital Employed of the company,” she added.