Debt Ratings And Equity Performance

 Though equity analysts justify stock price movements by citing stellar corporate performance, debt raters are still on the side of caution

 Stocks have been rising like there is no tomorrow. This has been the fastest rally seen over the last decade. A little over four months and the market is up nearly 1300 points (42 per cent).

 Unlike in the past few bull markets when the rise was confined to a few sectors or stocks, this time the surge has been across the board.

 All stocks - large and small - have participated in the rally and so have most of the sectors. Why? Market players say that this rally is built on sound fundamentals propelled by good corporate performance.

 Just to cross-check the credibility of this argument, The Smart Investor looked at companies from a different angle - corporate debt ratings.

 Debt ratings are better reflective of the financial position of a company because the primary concern for a lender is whether or not a company will be able repay its debt.

 So, a company's ability to generate enough cash flows to meet debt obligations is of paramount importance to the lender.

 Debt rating agencies, thus, base their ratings purely on a company's financials which determine its ability to honour its commitments.

 So, a look at the debt rating of a company can be useful to get a clearer picture of its financial stability.

 And your chances of going wrong may be far less if you buy into financially sound companies operating in good businesses.

 Domestic companies haven't seen any serious rating upgrades for the past the few months (since late-April when the stock market rally began), though there have been some over the last one year.

 The country's top credit-rating agencies like Crisil and Icra say that there has been a definite improvement in the credit ratio - the ratio of credit upgrades to downgrades.

 Over the last one year Crisil upgraded about 12 manufacturing companies while downgrades were 10 (See table: Gainers and losers).

 Says Arun Agrawal, general manager, corporate rating, at Icra, "There have been no rating upgrades in this rally. However, since May 2003 the ratio of upgrades to downgrades has been favourable and we have seen less downgrades in the past few months. We are optimistic about the economy."

 However, the number of upgrades pales when one looks at the way stocks have been surging ahead. The Sensex has gained 42 per cent while stocks in the S&P 500 have gained 44.25 per cent on an average.

 However, these companies have hardly seen an upgrade. Most companies with doubtful financials continue to have low ratings. (See table: Dashing ahead even with defaults)

 For instance, look at Jindal Iron and Steel. It gained 72.50 per cent during the rally. However, its debt ratings are still D or default category - that is, it is already defaulting on interest payments or is expected to default on maturity.

 In fact, rating agencies, too, look at pointers from stock prices for reviewing prospects of companies, but only to a limited extent.

 "Stock price movement is definitely one of the inputs for debt ratings. Changes in prices are analysed to see whether they were because of any fundamental change in the stock. But if the cause of the surge is market sentiment or liquidity then it is equally possible for stock prices to dip due to the same factors. It is at these times that stock prices are not considered for ratings," says Pawan Agrawal, head, corporate rating, at Crisil.

 Besides, debt raters have other reasons for not upgrading as quickly. Debt raters normally do not take a short-term view.

 Rating for long-term papers are generally reviewed on a half-yearly basis, at best on a quarterly basis. On the other hand, stock markets tend to discount any news and views almost instantly.

 "Debt ratings are made keeping in mind a three to five-year horizon and it cannot be changed based on short-term news and views," adds Arun Agrawal.

 Also, while equity researchers often have a buy side bias, debt raters are at most times less exuberant.

 "Rating agencies as a practice are quicker in downgrading a company. For an upgrade we continue to monitor the company's performance to test its sustainability. It's only after the company has proven its track record we consider an upgradation," says Arun Agrawal.

 So, how should investors read into these stock performance numbers? Is it just by fluke that stocks are rising? Or is it just a money game - too much money in the system trying to chase stocks since the debt markets seem to have bottomed out?

 Market experts say that stock markets have a knack of sniffing the future. So economic recovery, if it happens, will first get reflected in the stock prices and then in the financial statements.

 However, debt ratings are seldom predictive in nature. Often debt raters are criticised for effecting downgrades too late.

 For instance, look at SAIL. The scrip is the second highest gainer in the S&P CNX 500. It has gained around 320 per cent since August 2002 and is currently trading at 320 per cent.

 The company's net loss has reduced to Rs 304 crore in fiscal 2002-03 from Rs 1706 crore in fiscal 2001-02. And the company's ratings got upgraded for its financials and the global positive outlook on steel prices only a week ago.

 There are several such companies like Dabur India (net profit Rs 85.10 crore in fiscal 2003, up 32.06 per cent), Gujarat Ambuja Cements (net profit Rs 221.7 crore, up 19 per cent) and M&M (net profit Rs 145.5 crore, up 41.7 per cent), which have seen an improvement in financials in the last couple of quarters but are yet to be upgraded.

 So even though debt raters may not have effected too many upgrades, not all stock price rises are without valid reasons.

 But the less informed retail investors can definitely keep a watch on debt ratings to gauge the financial health of companies. Beware of the D category ones, particularly! There might just be defaults on the equity side, too.