Why markets are betting high on corporate earnings

Double-digit earnings growth in few corporate sectors will cheer markets in mid-term.

Despite a massacre in the equity and currency markets earlier this week, the view on India remains healthy.

While 2015 is expected to have risks, the acceleration in earnings and domestic investments is expected to keep the markets well-oiled.

Strategists are believers in the mean reversion theory.

So, when something declines sharply, the assumption is it will reverse. The market is betting on this for corporate earnings, expected to see a pickup in FY16. A cyclical pickup in the economy is expected to drive earnings upgrades the next financial year.

Over recent years, operating margins and the net profit growth of India Inc have declined to a 15-year low. The net debt-to-equity ratio has hit an all-time high.

The return on equity has halved from FY07.

Analysts are assuming earnings are set for a pickup. Goldman Sachs says a cyclical recovery has begun and demand is picking up, while high inflation is trending down.

Also, a sharp fall in commodity prices will help India save $30 billion, equal to the current account deficit of FY14, say analysts.

They expect the demand to pick up for steel, cement, aluminium, petrochemicals and coal.

The demand for most has remained flat or contracted, as the industrial output contracted. But most sectors are expected to see five to seven per cent growth in demand.

According to IIFL, only 273 companies were part of the BSE 500 index 15 years ago and it is a fair representation of the investible universe for foreign and domestic investors.

The brokerage says for these, yearly sales growth has fallen to single digit, from 20-25 per cent during much of the decade. Operating margins and the net profit have fallen sharply.

The return on equity has halved to 12.1 per cent, from a peak of 21.5 per cent in FY07.

IIFL expects earnings to accelerate for 159 companies under its coverage from the nine per cent compound annual growth over three years to 18.6 per cent in FY16 and 17.6 per cent in FY17.

Goldman Sachs says earnings will accelerate to 16 per cent in 2015 and 18 per cent in 2016. The potential for earnings upgrades is high in consumer discretionary, financials and industrials. If the rupee continues to depreciate further, the information technology sector could also see earnings upgrades.