Price lags earnings upgrade of stocks, leading to possible upside
Earnings revisions usually boost stock prices. However, many stocks have not behaved according to this expected fashion. Has that created opportunities for investors?
One of the most important factors that determine medium-term movement of stocks is earning revisions by analysts. When they downgrade expected earnings, stocks usually go down. When analysts revise the expected earnings upwards, stocks rally. Following their lacklustre September quarter results, analysts downgraded several stocks. You would expect the stock prices to underperform. But Bajaj Auto, Maruti Suzuki, United Spirits, Bharti Airtel and Idea Cellular have all bucked the trend. Similarly, analysts upgraded the expected earnings of Hero MotoCorp, ITC, Hindustan Unilever, Dabur, Reliance Industries, State Bank of India, ICICI Bank, Bank of Baroda, Larsen & Toubro, Adani Ports, Ambuja Cements, Infosys Technologies, Tata Consultancy Services, Wipro, and GAIL. Many of these stocks did not respond to the earnings upgrade. A Morgan Stanley Research report wonders whether there is an opportunity here.
The graph below shows the relationship between earning revisions and the share prices:
The technology sector has witnessed the highest disconnect. The sector has seen improvements in earning estimates but prices have failed to reflect the same continuing a downward trend. But this downtrend could be company specific and not an overall sector trend. Three companies that have shown the widest disconnect are Wipro, TCS and Infosys, whereas HCL Technology has moved up in line with the earnings upgrade.
In complete contrast to the movement of stock prices in the technology sector, a few auto companies have defied an earnings downgrade. Joining them are companies from the telecom sector, as well. The earnings of Bajaj Auto, Hero MotoCorp, Maruti, Bharti Airtel and Idea Cellular have all been downgraded but yet the stock prices have moved up. As for Tata Motors, despite an earnings upgrade the stock is flat. However, the stock price of Mahindra & Mahindra climbed with the earnings upgrade. As for FMCG stocks like Hindustan Unilever, ITC and Dabur, and pharma stocks like Sun Pharmaceutical, Cipla, Dr Reddy’s and Lupin, none of them had any strong reaction to the earnings upgrade.
From the banking sector, private sector banks as a whole have received an upgrade in earnings whereas for public sector banks earnings have been revised downwards. The stock prices of companies in this sector have moved more or less in line with the direction of earnings revision.
As you can see in the graphs, the disconnect between earning revisions and share prices is not a recent phenomenon, it has happened in the past as well. What could explain the reason for disconnect between revisions and share prices? The market is complicated and human evolution has not prepared us for forecasting stock prices let alone reaction to it. There could be major concerns around a particular stock or in some cases investor might have a positive macro outlook.
The simplest word to use would be that markets can sometimes (or most of the time, depending on how you see it) be irrational. Therefore, too much weight on expectations should be ignored. It is extremely difficult to forecast, at least over the immediate and short-term. If one is able to understand the fundamentals of a business model, one can perform well over the long-term, and simply ignore earnings revision, unless it is large enough to warrant an immediate decision.
So what should investors keep an eye on to profit from the irrationality? According to Morgan Stanley, investors should keep an eye on industrials and telecom. The report stated, “We would watch for sectors like Industrials and Telecoms—for the former, earnings seem to be turning up although the performance has not; while for the latter stock performance is seeing signs of improvement, although earnings have yet to respond.”
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