Can better than anticipated earnings growth surprise markets?

Mar 19, 2015

In this issue:
» Fed maintains its dovish stance and delays rate hike
» What does S&P think of India's NPA malice?
» A round up on markets
» ...and more!

  Chart of the day
As was discussed in last week's weekend edition of The 5 Minute Wrap Up, we continue our discussion on the financial performance of India Inc over the past few years. For today's discussion, we have decided to go back fifteen years in history.

We went about the process by taking all of the listed companies' data with the help of our database tool. Then, we excluded companies from the finance and energy spaces. With this, the count came down to about 4,875. Further, to make the comparison more meaningful, we only included those companies for which data is available for this entire 15 year period. This brought the list further down to about 2,400 companies; which we believe is a good enough number to use for this study.

We came across an interesting article in the Business Standard recently, through which we have taken inspiration for this study. We thought this would be an interesting one to do considering that the financial performance of India Inc has not met market expectations of late; with a significant cut back in earnings estimates being done in recent times.

So let's take a look at how India Inc has performed over the past decade and half.

The chart below pretty much summarizes the same.

India Inc's financial performance in past decade and half
* Equitymaster Research

As you can see, sales growth has remained strong over this long period - over 16% annually. In the past decade, sales of this group have grown by 18% on an annual basis. However, when it came to operating profits, the same grew by 15.4% and 16.3% respectively over these two periods.

Margins over this period however have been very volatile, with the same being at their lowest in recent years. As such, if things were to normalize in the future, it would not be wrong in saying that a large part of the spike in earnings could be due to the base effect. And what makes it interesting is that broader favourable factors such as low commodity prices could play a strong role. Not to mention the lowering of interest rates (although not captured in the data above) will only go on to provide a fillip to the profits.

Another point that validates the same is the lower asset turnover ratio (fixed asset; shown in the chart below) along with the return on capital employed (RoCE) of this lot.

India Inc.: Good scope of improvement going ahead?
Data source: ACE Equity; Equitymaster Research

Asset turnover, while not at its worst levels over the past fifteen years, was at the lowest levels in recent years in FY14; a good enough indicator of there being a good scope of improvement in utilisation levels going ahead. And considering all of the combined parameters discussed above, it has all taken a toll on the companies' overall return ratios which were at their lowest over this period.

So, to sum it all up, while earnings growth has been dull in the past one year, the data points above do indicate that there is a good amount of scope for improvement simply by such metrics going back to long term averages - which would not necessarily be a difficult thing to achieve as and when the economy picks up.

Essentially, all it boils down to is when the same will happen. However, with valuations of Indian stocks hovering around in the frothy zone, is the market pricing in a better than anticipated recovery in earnings? Our guess would be as good as yours.

We would nevertheless like to get your views on the same.

Do you think markets are pricing in a stronger than anticipated growth in earnings? Let us know your comments or share your views in the Equitymaster Club.

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The Fed, on Wednesday, did what it has been doing for the last 9 years i.e. keep the benchmark rates unchanged or reduce it. However, this time there were expectations that Fed may break the 9 year jinx and raise the rates. But to the surprise of many it chose to remain dovish citing growth concerns. Its commentary, however, was hawkish and it did not rule out an increase in rates in the coming months.

So, how will an increase in interest rate affect emerging markets (EMs)? And is India well prepared to counter any rate hike by the US?

Well, a rate hike will end the easy money that made its way into asset classes especially equities across the world. Since the time Fed has been maintaining a near zero interest regime, liquidity has moved to riskier asset classes like equities. A rate hike will increase the borrowing cost and thus discourage/hurt investors. In fact, if the Fed increases interest rate there are chances that liquidity will move out of EMs as there will be a capital flight. Any rational investor would prefer investing his money into a risk free treasury bond of the US by withdrawing his capital from EM equities if rates rise. Also, increasing rates is a signal that US economy is recovering making US equities attractive, furthering his case to cash out from his EM portfolio.

Now, if the Fed indeed increases interest rates, as guided by Janet Yellen, how well is India prepared to deal with it?

No doubt, a rate hike will cause volatility in Indian markets. However, as per RBI governor Dr Rajan, normalcy will be restored soon and India is already taking steps to deal with it. For one, India has healthy forex reserves (US$ 280 bn odd; though it has declined recently) that shall help in supporting Rupee. Further, the current account deficit has also declined thereby lowering the downward pressure on Rupee in case there is a capital flight.

While India may be well prepared to deal with volatility in case the US raises interest rates, Indian banks are not as well prepared when it comes to clearing their NPA menace as per global rating agency S&P. While the pace of stressed asset growth may fall due to an improving macro environment, material recovery is far off. We kind of agree with the assessment of the rating agency here.

While private sector banks are relatively better placed when it comes to dealing with NPA problem, the same has been a thorn in the flesh for public sector banks. However, they are the only ones to be blamed for it. For one, the lending practices at PSU banks are not that transparent. We all know about the bribe for loan scam that came to light some time back. Not that all PSU banks are opaque but one cannot ignore that there is a dire need to strengthen their vigilance department.

Asset quality has been an issue with PSU banks for long. Adequate capitalization has also been a cause of worry. Hence, time and again we have seen government extending support to them for re-capitalization. If steps are not taken to improve the current situation, PSU banks could subject themselves to endemic risks which might put the entire banking system in disarray.

The Indian stock markets are trading flat today. At the time of writing the BSE-Sensex was trading down by around 49 points, while the NSE-Nifty was down by 16 points. Losses were largely seen in banking and realty stocks. Most Asian markets closed today's trading session in the green. European stock markets, however, opened mixed today.

 Today's investing mantra
"I insist on a lot of time being spent, almost every day, to just sit and think. That is very uncommon in American business. I read and think. So I do more reading and thinking, and make less impulse decisions than most people in business. I do it because I like this kind of life". - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Jinesh Joshi and Devanshu Sampat.

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Equitymaster requests your view! Post a comment on "Can better than anticipated earnings growth surprise markets?". Click here!

2 Responses to "Can better than anticipated earnings growth surprise markets?"

Akshay HIre

Mar 19, 2015

This 5 minute wrap up is very innovative & informative style of keeping people in touch with financial world. I personally like it a lot & wait for this to drop in to my e-mail box.

Like (1)


Mar 19, 2015

This is an excellent analysis, however conclusions are simply attempting to make the point that low earnings, low returns, etc are indicators that from such low level these can only go up. It would have been more meaningful if underlying causes are analysed to understand why after peak in 07-08 why all key indicators are going down. If ROE is just around 11-12%, if capital turnover is declining, if margins are declining, why?

Only when we understand cyclical reasons and broad economic aspects then only we can reach and conclusion. Improving utilization also impact capital spending in current situation as indicated by lower growth in capital goods industry. Recent study in bank financing also indicates lower growth for project financing.

One can take a very optimistic view that anything improving from low level is an upside. This is obvious but not necessarily is an indication that economy will improve.

Like (1)
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