Earnings diversions


Treading the fine line between execution and value underscores our superior upside/downside capture.  While there is little doubt that Nifty constituents (collectively) represent the most solid execution stories in India, they are also significantly pricier than their small and mid-cap peers in India and nearly all peers outside India.  As a result, solid execution by itself is unable to propel these benchmark names further.  Our history corroborates this – While Nifty constituents have reported better earnings growth vs. our long book in 8 of the prior 9 quarters, our long book has outperformed during most of these quarters.  The key reason is that our names aren’t bid-up and priced for unreasonable consistent execution.  Notice how despite reporting lower (but above expectations) growth, our book has fared better than benchmark constituents (Minerva Underserved’s long book has outperformed Nifty during 70% of the quarters since inception; Minerva Undervalued’s long book has outperformed during 56% of the quarters since inception).  Furthermore, the magnitude of our outperformance quarters overwhelms the magnitude of our underperforming quarters, creating an extremely favorable up-down capture (see Exhibit 1, which shows Nifty earnings misses vs. Minerva earnings misses and our long book alpha in respective quarters).  To be clear, we are talking about our long-book performance only.  At a portfolio level (i.e. taking net exposure into consideration), our book has outpaced Nifty in 7 of the last 8 quarters.  We note how Indian investors almost always choose to irrationally bid-up execution stories and eventually end up paying the price for such wastefulness.  Current valuations of benchmark private sector financials and consumer staples demonstrate such revelry these days – These names make up only about 16% of benchmark constituents, but 40% of the group that has averaged 20% or higher earnings growth over the past 8 quarters.  Consequently, they are now priced, by some distance, as the most expensive of their class in the world.  Amazingly, despite alarming valuations, they still continue to be darlings of nearly all Dalal Street analysts.


While execution remains highly priced in India, earnings expectations across Indian benchmark constituents continue to trend lower.  Despite that, the rate of earnings disappointments for Nifty constituents remains elevated.  There is little sense in recent earnings misses getting increasingly dour responses, particularly for widely followed Nifty constituents.  The likely reason is the broader step-down in emerging markets’ volatility.  While earnings misses remained elevated in India for Dec 2012 quarter (see Exhibit 1), Nifty and other EM benchmark constituents exhibited near record low volatility during the earnings season (see Exhibit 2b on next page).  Given what is clearly a weak environment, it’s probably not a great bet to expect this low volatility to last.

Volatility continued to drop during earnings season.  Nifty constituents are the most widely covered benchmark names in the world (average name has 50+ opinions).  Consequently, earnings diversions (reported vs. consensus) have been among the lowest in the emerging world (second only to Taiwan, among major emerging markets – see Exhibit 2a).  What is counter-intuitive however is the associated volatility during quarterly earnings season, especially during panic periods.  In most quarters over the last decade (until mid-2011), Indian equity volatility  was at or above emerging market average during earnings seasons (only Russia and Turkey, whose market concentration and breadth is hardly comparable) were as consistently volatile.  Take the last 3 quarters of F2009 for instance – While more than 2/3rd of all major emerging markets reported higher earnings diversions, Nifty constituents trailed only Russian and Brazilian equities, in so far as underlying volatility is concerned.  Price performance during this period exhibited sharp disconnects with underlying earnings.  While volatility has come down across emerging markets, few emerging market benchmarks are now less volatile than Nifty (during earnings announcements), and rightly so (see Exhibit 2b).  Investors seem to be pricing an imminent earnings turnaround across emerging markets, despite clouded visibility.  In our view, the basis for such expectation is weak at best.



Note: Big earnings diversions refer to 10%+/- diversions vs. consensus estimates; Earnings of last 4 fiscals were used for analysis.

Source: Bloomberg; Thomson Reuters

Mid-cap volatility led Nifty’s volatility in 1Q13; Short-term valuations for bottom-up stock pickers get attractive within small and mid-caps.  One unique aspect of Indian equities is how volatility transitions during earnings and non-earnings seasons.  While it is well documented that small and mid-caps tend to exhibit higher volatility vs. large-cap benchmark constituents, few appreciate how the situation is different during earnings announcements.  More often than not, Nifty constituents exhibit higher volatility vs. the rest during earnings season (see Exhibit 3).  That isn’t particularly surprising, given that several non-benchmark names in India either don’t have earnings estimates or are sparsely covered.  The differential in “anticipation” is material and drives volatility differential between benchmark names and others during earnings season.  However, expectation of an earnings turnaround inexplicably expanded the volatility differential between large-caps and mid-caps in 1Q - For the first time in recent memory, earnings season was particularly more volatile for mid-caps than large-cap benchmark constituents (see Exhibit 3).  That ensured that bottom-up stock pickers were well positioned by the time earnings season concluded at the end of February.  We are up +1.7% since the end of February, vs. -3.7% decline in BSE 500.

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Piyush Sharma, born and raised in India, is investment manager of the Globe Minerva Fund. Having spent time with Citigroup and Bombay Stock Exchange in India, he moved to United States in 2002, where he covered stocks within Business Services, Autos, Consumer Products and Financials with Sanford Bernstein, Longbow Research and Avondale Partners, working in teams that received accolades by leading institutional research arbiters , including Institutional Investor (II) and Greenwich Associates. Piyush received an MBA from University of North Carolina at Chapel Hill, MS from MNNIT, and BS in Accounting from University of Allahabad.  Piyush will be sharing his fundamental views periodically.


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