The winning numbers

The third quarter results are optimistic. To begin with, there has been a surge in corporate sales and earnings growth—both these aggregates have posted a sharp rebound to double-digit levels for the first time since end-2008. Almost all the sectors have witnessed an increase in margins compared to that for the fourth quarter of 2007-8, led primarily by the lower raw material cost and interest cost and buoyed by volume growth. The favourable base is also leading to much better annual growth figures for EBITDA as well as operating profit parameters. The good news is that the improvement is fairly broad-based. If we consider a universe of 750 largest companies by market capitalisation, the year-on-year net profit has grown by 34 per cent, the highest in almost seven years. Excluding oil companies, EBITDA margins are at the levels last seen in 2004-7.

The sectoral break-up shows positive trends in growth and margins across the board, except for the telecom sector, which has been impacted by a cut-throat pricing war. All the domestic consumptiondependent sectors have delivered spectacular results, led by FMCG, auto, retail and media. The sectors that have disappointed include engineering and infrastructure. To some extent, this signifies that the private sector capital expenditure has not picked up meaningfully, but this is expected to change. A pick-up in the private capital expenditure is crucial for a sustained economic and corporate growth in the coming quarters. Another key conclusion from these results is the strong resilience of domestic demand. Compared with flat sales growth over the past two quarters, sales not only rebounded over the third quarter but also drove profitability.

After a year of re-rating, earnings expansion will remain the key driver for equities in 2010. Going forward, a conducive interest rate, pick-up in private capital expenditure led by a strong economic growth and a recovery in the developed economies will drive demand and, hence, investment in the economy. So, the corporate profits are expected to grow strongly in the coming quarters. But gross margins could remain range-bound as the positive impact of low commodity costs wears off.

There are two critical factors to watch out for— domestic interest rate scenario and a roll-back of stimulus measures. Given the concerns over inflation, there is a need for interest rates to tread towards normalisation, which is likely to happen over the next year. India will continue to remain an attractive investment destination and the resultant foreign inflow could make interest rate management all the more challenging. Also, given the resilience shown by the Indian economy, the fear of a negative impact of stimulus roll-back is over-emphasised. In an economy that is witnessing a strong recovery, perhaps less fiscal stimulus— not more—is required for it to flourish. Note that the quantum of the stimulus was much lower in India—around 2 per cent of GDP compared with 13.3 per cent for China.

Overall, domestic consumption continues to gain traction. With the government's focus on inclusive growth, rural consumption will act as a strong catalyst in spurring demand. This translates to higher capital formations and, in turn, higher growth. The EPS may grow by 20-25 per cent in the next financial year. However, given the focus on domestic consumption and infrastructure development, the earnings growth in 2010-11 can be a positive surprise. Here's some more hope—a more convincing, revenue-driven EPS upgrade moments.

Vikram Kotak is Chief Investment Officer, Birla Sun Life Insurance