Where are the earnings? - The Honest Truth By Ajit Dayal
Investing in India - Honest Truth by Ajit Dayal
Where are the earnings? A  A  A
6 APRIL 2013

The share price of a typical Indian company, I have often noted, will be set by foreign flows but the value of an Indian company will be determined by their ability to create economic value and grow earnings.

As of now, there has been a lot of visibility on foreign flows - and no visibility on earnings.

Aided by the unprecedented printing by their central banks, foreign investors are investing in stock markets around the world. One of those markets to benefit is India (Table 1) which in Calendar Year 2012 saw over USD 24 billion of foreign flows even as the local investors (as measured by the redemptions in the mutual funds) have sold USD 3 billion.

The first three months of CY 2013 saw a continued surge of flows with foreign investors buying USD 10 billion in the Indian stock market. Retail investors, fed up with a mutual fund and ULIP industry that continues to pretend they never resorted to any questionable selling practices, continued to sell.

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Table 1: Foreigners buy, locals sell
Period Net Foreign Activity (US$ m) Net Local Fund Activity (US$ m) Total (US$ m) Change in S&P BSE-30 TRI in that Period (% USD)
CY 2003 6,628 88 6,716 +86.5%
CY 2004 8,669 -253 8,416 +20.5%
CY 2005 10,707 3,049 13,756 +40.2%
CY 2006 8,106 3,413 11,519 +51.6%
CY 2007 17,655 3,222 20,877 +67.0%
CY 2008 -11,974 2,501 -9,473 -60.8%-
CY 2009 17,458 -1,132 16,326 90.3%
CY 2010 29,362 -6,049 23,313 +24.1%
CY 2011 -358 1,343 985 -35.8%
CY 2012 24,372 -3,854 20,518 +24.5%
Cumulative 110,625 2,328 112,953 +490.5%
Mar-13 1,675 -296 1,379 -1.1%
YTD 2013 10,310 -1,414 8,896 -2.2%
Source :www.Sebi.gov.in

The Indian economy, meanwhile, continued to show sub-6% growth in GDP - better than the global averages of sub-3%, but lower than what India is used to seeing in recent years.

Graph 2: India hits a low on GDP growth
Source: Bloomberg

The budget was another useless exercise aimed to dull the imagination, though much of Corporate India (or should we call them Chicken India) continued to rate it as a 7/10 or 8/10.

Globally, the economic environment is extremely uncertain. The US economy is recovering in some sectors but anyone believing that this is a strong and even-keeled recovery is delusional. The middle class in the US continues to see a decimation of its annual income and its consumption power while the lower income class has little hope of moving into the middle class bracket. Over 5 million jobs have been lost in the US over the past decade and the median household income has risen by less than 1% - far lower than the cost of living. Bonuses for the financial firms are pretty much back to what they were pre-Lehman suggesting that the 1% got through this global crisis with a minor scratch. The tax payers were not so lucky and government balance sheets (which many of the 99% will rely on for their future pensions) have been severely mauled. With pension obligations far more than assets, retirees in the US will either have to accept a lower future inflow - or dig in for a long fight with governments to make good their promises.

Europe is still torn between the German prescription of taking it on the chin and readjusting to the new reality of lower growth and the lure of the American charm of printing and getting out of the mess. The German scepticism of printing money lies in their own experience prior to World War II - they believe the US will end up in a bigger mess at an unknown, future date. The comical bankruptcy of Cyprus and it's even more humourous rescue package efforts show the difficulties of knitting together very different cultures under one currency umbrella, the Euro.

Japan, a case study for Federal Reserve Chairman Ben Bernanke of how to ruin an economy, has acquired the zest to print. It wishes to be better than Helicopter Ben - so named because Bernanke once remarked that he would be willing to throw US Dollar bills from a helicopter to kick-start an economy. Luckily for Uncle Ben, the printing presses of the Fed are working well and he does not need to get on a helicopter to do what he promised to do. Though the Japanese are the last kid to join the printing race, the Japanese government is now ready to print at a rate equal to what the US Fed is printing: approximately USD 78 billion per month.

We are all Americans: we eat McDonald's; we drink Coke; we buy American dollar bills; and we print.

Flows will be strong, but what about earnings?

With all this global printing activity, money flows to India are likely to remain in the USD 20 billion per annum range even in if foreign investors are nervous about India. If there is an estimated USD 2 trillion of new money created in the develop world and 1% of that gets allocated to India, that is USD 20 billion in flows.

If India was "liked" by foreigners, we may end up getting 2% of that USD 2 trillion - or USD 40 billion. That would send the stock markets soaring to new highs.

But India is not "liked" at this point in time largely due to the obvious reasons of:
  • Political uncertainty and elections (by September/October 2013, in my view),
  • Corruption and lack of transparency in how companies win government contracts or win control over government assets,
  • A Current Account Deficit that is rising and needs to be financed by foreign inflows - and continues to leave India vulnerable to shocks in the global financial markets, such as a Lehman-like event which would rattle the Indian currency.
But there is a more troubling side of the story that has not really been explored: corporate earnings.

Most analysts do not expect India, Inc. to see much growth in profitability for the results for the year-ended March 31, 2013. These will be known by June 2013. Stock markets in general - and individual shares in particular - may bounce around a lot based on whether companies "beat", "meet", or "fail to meet" these expectations of the March 2013 earnings season. But, for the market as a whole, expect nothing spectacular.

However, much of the market's focus will be on future earnings: will companies significantly add to their profitability in March 2014?

And this is where the research community may get it terribly wrong.

Or, if they have figured it out - they are not talking about it. And this could be due to the classic conflict of interest and sense of duty that pervades the financial services industry - in India and globally. The over-riding question: should we work for our clients, or should we work for our commissions?

Imagine you are a broker about to execute an order for a large FII which will bring in a lot of commissions and prevent you from being fired in an already shrinking industry. Just before placing the buy order, the FII asks: "Tell me, what is the house view on earnings for March 2014?"

You can answer the query in multiple ways:
  • You can tell your research analyst, the person who writes the "house view" to give a rosy picture or else you will fire him, or
  • You can tell the FII that the Indian market is trading at its long term average PE of 16x historical earnings so it is not "cheap" and neither is it "expensive" - you sort of evade the question of future earnings, or
  • You can look glum and tell your FII client: "there is little hope of any major growth in earnings for March 2014".
Responses 1 or 2 will probably still generate the "buy" order from the FII. The commissions from that will keep your job intact and, if you are lucky, you may see a bonus at the end of the quarter.

The client interest has been buried and your interest is intact: you are a true hero and deserve to be employed in the financial services industry.

Or you may be a maverick and give "Response 3", which may not go down well with the FII.

The FII may still buy because all the other FII folks are buying.

Or the FII may reduce the size of the buy order - or, worse, not buy at all.

(Statutory Warning: Please do not ascribe any genius to these FII folks - you hear them on TV and they babble and guess like everyone else. Their suits and accents are a little more refined than the stars that come on TV at 9 am and tell you which stock is likely to rise or fall in the next 390 minutes of trading, but they are all equally dangerous to your wealth.)

With a GDP of less than 6%, interest rates that are unlikely to decline a lot further from here, and interest rates for small-cap and mid-cap companies that may actually increase (given their inherent business and management risk) - I don't see a great surge in earnings.

Money invested, will not generate much earnings

Between 2006 and 2008, Indian companies raised a lot of money (debt and equity) to finance a massive capital expenditure (capex) binge. India, if you recall, was Shining and every Indian company wanted some of that shine to rub off on it.

Carried away with visions of their own superior powers and their ability to turn a political friendship into a private khazana, Corporate India invested as if money was free - and it was.

At least for a while.

Now that capex binge is ready to start production.

But the economy is slow, so sales may not be as great as Corporate India expected when they first set those plants up. Capacity utilisation will be lower than expected for most businesses.

And "interest expense" and "depreciation expense" will increase.

This will result in suppressed "reported profits".

When a plant is ready, the interest that is paid on the creation of the plant no longer ends up as "capitalised interest", it has to start flowing through the profit and loss as an "interest expense". A bit of accounting here: When a plant is being built, the interest on the loans taken to build that plant are paid by the company to the bank (so it shows up in cash flow) but it does not get deducted through the profit and loss statement; it gets added to the value of the capital asset being built and shows up as a Fixed Asset or Work In Progress. And once the capital asset is ready, then it is amortised or depreciated over a 7, 10, or 15 year period: this depreciation shows up in the profit and loss statement.

Once the plant is ready and commissioned, it needs to be depreciated over the estimated useful life of the plant. This adds to the "depreciation" expenses and reduces the reported profitability. But it makes no difference to the "cash flow" of the company, since this is only an accounting entry - no person is actually paid this "depreciation expense" amount every year. The plant was already paid for when it was built and ended up as an asset in the balance sheet. Since it has a limited life, the depreciation charge will bring that asset value down to zero over time.

Using data sourced from the Equitymaster "Yearbooks" which analysed the financial statements of 173 to 179 companies between 2005 and 2012 (the audited, full year numbers for March 2013 are not yet reported), one gets an idea of how profitability has changed over time and what could have caused these changes in profitability. No banks and financial firms were included in this list.

Table 2: Grow, grow - and borrow to build new plants
Source: Equitymaster

Recognising that there is no audited data for FY2013, and making certain assumptions on how much of the overall capex completed this year was done by this sample of companies, the interest cost of their debt, how they will utilise their expanded capacity (and many other variables), I ended up with the following:

If 20% of the new capacity coming to fruition in India was implemented by this sample of companies using FY2012 as a base, then:
  • Depreciation and interest will reduce reported Profit Before Tax by -4.9%;
  • Revenues from higher capacity will increase Profit Before Tax by +6.4%;
  • Net effect will be an increase in Profit Before Tax by +1.5%.
Recognising that this exercise is done using FY 2012 data as a base year and recognising the various assumptions made on so many fronts, there is room to add some growth for the FY 2013 earnings.

But, if you told an FII short-term investor (and most of them are short-term) that they were pumping billions of dollars every month into a stock market where there is a marginal 1.5% improvement in profits, they would not be a particularly happy lot.

Note that this is a macro calculation for a large number of companies - there will still be companies that may not have this large capex cycle and are able to generate a healthy clip of 15% to 20% growth in their earnings.

Please don't take me wrong: I am a long term buyer of Indian stocks. My advice to investors is to invest 50% to 75% of their intended investment into Indian equity at these levels of the Index. But a long term buyer (with cash on the side to take advantage of a decline) is not looking at FY2014 earnings.

The money being pumped into India as a by-product of all the global printing is not necessarily long term money. In fact, my guess is that 90% of it has a 1-day to 90-day view on any market, including India.

They get disappointed very easily. They get excited very easily.

Recall the small-cap and mid-cap mayhem.

Recall what they did even to large companies like Infosys when they had disappointed earnings.

So, the markets are at a dangerous place for trusting investors.

Easy money and a fast-talking Finance Minister with many quick-fixes has caused a surge since July 2012. But, eventually, we need earnings to sustain any market rise.

I would rather be a buyer of stocks in a market where there is strong earnings and weak flows. Because then I am buying into a company which is growing its intrinsic value - and others have not yet come forward to buy its share. That is fine with me.

This market is the reverse: the money flows are there for sure but, on a market level, I don't see the earnings in the near term.

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Disclaimer: The Honest Truth is authored by Ajit Dayal. Ajit is a Director at Quantum Advisors Pvt. Ltd and Quantum Asset Management Company Pvt. Ltd. The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and has not been authenticated by any statutory authority. The author, Equitymaster, Quantum AMC and Quantum Advisors do not claim it to be accurate nor accept any responsibility for the same. Please read the detailed Terms of Use of the web site. To write to Ajit, please click here.

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3 Responses to "Where are the earnings?"


Apr 23, 2013

I do not agree particulary your argument that the money coming in only have a 1 day to 90 days view with no long term view. Your argument that inflows are risks do not have a strong basis and is completly contradicted by your own data on sustaining strong net foreign inflows since 2005. Please please do not atleast misguide.
Everyone knows that we are nearing an elections, so I don't think any level of guessing is required about what is in store.



Apr 8, 2013

Good question. Earnings are slowing down but the index is holding up..Do you expect the index to slip from here? I understand the top message.. keep investing and wait for the longer term..but want to know your opinion on the index



Vijay chugh

Apr 6, 2013

Mr Dayal, you write with such flair, wit and financial wizardry.

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