Myopic Markets

Benjamin Graham has always emphasized on normalized earnings since there are many one time expenses/income reported by companies which needs to be adjusted to know the true earning power of the company. But markets may remain myopic and look at only the reported numbers. I will provide two examples of this situation:

The first example is that of a pharmaceutical company, Unichem Laboratories. The company has always been a very well managed company. Due to improvement in employee productivity, many companies allowed employees to opt for VRS during 1995-1997. This added some one time expense for companies. Unichem also allowed some employees to opt for VRS and incurred an expense of INR 9.08 Crore in 1997 and INR 11.13 Crore in 1998. The EPS of the company was thus INR 8.16 instead of INR 20.93 for 1997 and INR 9.41 instead of INR 22.21 for 1998. The facts were clearly mentioned in the annual report and annual results of the company. EPS for 1996 was INR 15.31 thus EPS declined by almost 40%. The company's share price declined from INR 270 to INR 84.75 between March 1996 and February 1998. This made a P/E of 9 on reported earnings but a P/E of only 4 on actual normalized earnings. What happened next when the market realized this mistake? When the company reported EPS of INR 23.65 and INR 36 for years 1999 and 2000 respectively, the investors became overly optimistic and share price went up to INR 780 in February 2000, a P/E of 21.67, nine times the original price in two years.

The second example is that of an FMCG company, Britannia Industries. The company reported a one time income of INR 120.2 Crore in FY2000 so the total profits came in at INR 203.2 Crore, with EPS of INR 72.5. The share price went up to INR 1809 in September 1999 while the actual profits were only INR 83 Crore with an EPS of INR 29.65. Thus, even though P/E looked like 25, the P/E on normalized earnings was more like 61. Even today after ten years, the share price is below 1999 high.

Conclusion? Wear specs!!!!