Devangshu Datta: Dropping PE ratios

BEATING THE STREET

For the past two years, steel prices have climbed steadily. This is in part due to strong Chinese demand and the US war efforts and the massive spending related to that have certainly helped matters along. So, despite an anaemic global economy, all metals (not just ferrous metals) have done well.

As a result of the boom in steel demand, efficient producers like Tisco have seen soaring profits. Even inefficient producers like Sail have seen turnarounds going from massive losses to profits. Iron-ore producers like Sesa Goa have also done well.

The market's response to the boom illustrates the classic boom-bust cycle. In July 2002, Tisco was trading at 125, a price""earnings (PE) discount of 22 on the basis of its 2001-02 earning per share (EPS) of Rs 5.5.

Incidentally, 2001-02 was the bottom of the steel industry cycle. Tisco's earnings, sales and profits all contracted during that financial year. In 2001-02, Tisco registered net profits of Rs 205 crore on sales of around Rs 7,700 crore. The industrial recovery started in 2002-03.

In January 2004, the Tisco share price hit a high of Rs 490. On the trailing 2002-03 EPS of Rs 27.4, Tisco had a PE of about 18. The stock price has since fallen to around Rs 400 level. On the basis of 2003-04 results when the EPS hit Rs 47.3, the stock now has a trailing PE of about 8.5.

The financial results show an interesting pattern. Profits rose from Rs 205 crore in 2001-02, to Rs 1,012 crore on a turnover of Rs 9,844 crore in 2002-03 and then in 2003-04, profits rose to Rs 1,746 crore on a turnover of Rs 12,070 crore.

Notice the trend of rising profits, rising sales, rising EPS, rising share prices "" and dropping PE ratios. Admittedly, Tisco is a market leader. It's an extremely efficient producer "" perhaps the most efficient in the world. It's been aggressive in cost-cutting and in matching its product-mix to maximise returns. So the growth ratios have been better than with less-efficient companies.

But the pattern of dropping PEs versus rising shareprices is often replicated in highly cyclical industries. There's a point in the boom cycle where profits rise faster than prices and so, PE ratios drop. Conversely in the bust phase of the cycle, profits drop quicker than the prices leading to rising PEs.

This pattern undoubtedly has something to do with mass psychology. Investors never have the collective nerves to bet heavily on a cyclical stock at the bottom of the cycle or in the early stages of a turnaround.

Some smart money will enter a cyclical business when it's at the nadir but most of the money will wait for something like six profitable quarters before they take a shot at the stock. Investors are also reluctant to exit a cyclical when the early warning signs of a bust become apparent. They tend to wait perhaps two or three quarters longer than they should.

Perhaps the conventional wisdom about buying at low PE ratios and selling at high ratios makes the best course of action counter-intuitive. In a cyclical industry, we could actually make a case for investing at high PE ratios!