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Why is sensitivity analysis of stocks so important

28 Aug 2023

Stock prices tend to be sensitive to a variety of factors. In technical parlance, sensitivity analysis is the impact on the stock price of a plethora of variables, which could be quantitative and qualitative. It is also called simulation where the impact of various variables on the stock price is simulated under test conditions. What do we understand by sensitivity analysis of stocks? What are the types of sensitivity analysis that can be conducted on stocks? Normally there are a host of independent variables that impact stock prices. Above all, what is the importance of sensitivity analysis and what is the sensitivity analysis formula? Let us first understand what sensitivity analysis is all about..


1.  Macroeconomic factors and the sensitivity of stock prices

One of the key sources of systematic risks for stocks is the macroeconomic factors. There are a plethora of factors that stock prices are sensitive to. Stock prices normally react negatively to interest rates. Why is this so? Higher interest rates result in higher financial risk for companies since they will have to raise funds at a higher cost of funds. That will negatively impact their interest coverage ratio and their ability to service their debt. Inflation is considered to be a trigger for interest rates and that is why higher inflation also has a negative relationship with stock prices. There is also the factor of present value of future accumulation that is negatively impacted by inflation. GDP growth is a positive factor as higher GDP will mean higher growth in sales and profits, especially for economically sensitive sectors like cement, steel etc. Then there are the all important oil prices. While crude oil prices are positively related to oil companies, they tend to drive up inflation and hence tend to be negative for stocks as a whole. On the other hand, lower oil prices leads to a reduction in oil inflation and helps companies to expand their operating margins. That is the kind of stock prices sensitivity that we saw post 2014.


2.  Sectoral sensitivity of stocks
Stock prices are also sensitive to shifts in the sector overall. For example, the emergence of new competition is negative for existing players as it will squeeze margins. We saw that happening in the emergence of Reliance Jio in the telecom sector. Reduction in purchasing power is also a negative factor for sectors that are dependent on consumer demand like FMCG, consumer durables, consumer non-durables, banking etc. Changes in regulation and government policy also have an impact. For example reformist policies like the New Telecom Policy or the New Exploration policy have been positive for these sectors. Similarly, when the government raises customs duties on competing products it is positive for the stocks as we saw in the case of steel and radial tyres. But higher input costs due to import duties on inputs can be negative for a variety of sectors.
3.  Sensitivity of stocks to disruption in the industry..

Disruption in any industry can happen with new products, futuristic ideas, price leadership etc. For example, Apple and Samsung were responsible for disrupting the communication industry globally. In India, Jio was the trigger for disrupting the Indian telecom industry. The rising NPAs of PSBs led to a virtual disruption benefiting private banks substantially in the last 7 years. That explains why the market cap of an HDFC Bank is more than the market cap of all the PSU banks put together. Normally, stock prices tend to be highly vulnerable and sensitive to disruption in the industry, more so if the disruption is structural and likely to have a lasting impact on the stock.


4.  Sensitivity of stocks to sentiment drivers..

We may not appreciate this factor but it plays a key role. For example, when the yields on debt went down sharply, the demand for equities in India started rising. Post demonetisation, when gold and real estate came under a cloud as asset classes, the demand for equities went up sharply. This is evident from the retail flows into equity funds and ELSS funds picked up steam in the last few years. Similarly, when the market perception is of higher growth in India, the markets are willing to give a higher P/E to the market.


5.  Sensitivity to company financials..

This is a very important set of micro factors to which stock prices tend to be extremely sensitive to. For example, companies tend to get positively re-rated when they deleverage their balance sheets. That explains why DLF has been attracting a lot of buying interest. Companies also benefit when growth and margins expand to a higher plane. That explains why FMCG companies have seen so much buying interest from investors as well as a sharp uptick in stock prices. Also when companies expand margins due to improved operating cost structures, stock prices tend to benefit. That explains why mid cap companies in India outperformed large caps over the last 3 years due to the greater benefit they derived from falling oil prices.


The crux of the story is that stock prices tend to be sensitive to a variety of factors; both quantitative and qualitative. The best one can do is to summarize all these factors in an excel sheet and simulate how the stock price will react under different scenarios for each of these factors. That is what sensitivity analysis is all about!

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