Anticipating a revival in earnings and demand growth is a dangerous way to plan your equity investments
Investors in the Indian equity markets have been swinging between wild optimism and quiet pessimism since 2012. Many attribute the lacklustre performance of the markets to the lack of fast-paced structural reforms or a deeper cut in interest rates. The real culprit, however, is the lack of earnings growth. Persistent single-digit earnings growth clearly indicates that corporate profits do not back early market optimism. The inordinate delay in cyclical catch-up should concern investors.
The turnaround of a bear market into a bull market is typically led by a fall in interest rates. This provides immediate relief to businesses burdened by borrowings and inventory . Then the operating margins improve, riding on lower input costs and operating leverage, as capacity utilisation increases. Soon, businesses are in a position to post a growth in revenue and expand volume and value of sales, as demand picks up. With sustained demand, businesses become con fident about making further capital investments, and the bull cycle is complete.
The main shocker in the past three years has been the failure of earnings to match up. Estimating earnings is a dangerous game, and in each of the last 12 quarters, analysts have rued that earnings have missed estimates, or the downgrade cycle of earnings has persisted.The single-digit earnings growth that we have seen for Indian equity is unprecedented and unexpected at what seemed to be a turn of the economic cycle.
A chunk of the equity markets is in structural distress. While oil and metals suffer from the downturn in commodity prices, banks are going through the pain of balance sheet restructuring. Infra and capital goods have been hit by lack of investments, and export-led businesses have been impacted by slow global economy . Auto, consumer durables and real estate face lack of demand. The absence of investment is damaging, and the low rate of growth in bank credit implies businesses are not expanding. This structural logjam is holding the markets back.
A very frequently cited explanation about the poor earnings story is that it could be a `one-time extraordinary event'. This term refers to a charge in income that is large and negatively impactful, but not expected to persist. Discussions about balance sheets of banks are rife with such comments. Is the stress in the banking system just an accounting and reporting problem, or is there a serious structural limitation to quality of earnings? It is dangerous to show bravado about a turnaround in earnings, when what is touted as `extraordinary' is only the beginning of a long rework.
There is a lot of optimism about demand revival, with the monsoon being the messiah. This time we also have the Seventh Pay Commission. The idea is that if the rainfall is normal, the purchasing power of rural masses will return. Add to this the purchasing power in the hands of government employees, who will use their higher salaries to buy stuff, and we should see a revival in demand for goods and services. Those looking at sectors such as real estate, consumer durables and automobiles are enthused by this revival. Let's consider one real estate to see how this might be an overly optimistic argument.
The real estate market in India boomed due to the runaway optimism of the early 2000s, and struggled to keep up after the global financial crisis. After a period of bravado, the reality of large unsold stocks has become stark. That's why the sector is at the forefront of lobbying for lower interest rates. However, neither a low interest rate nor a pickup in demand would help. What the sector needs is a steep drop in prices, a correction that vested interest of partly completed projects will not allow, leading to a structural logjam.
Another fallacy is that of valuation. Every time an earnings forecast goes wrong, enthusiasts point to how the markets have become cheaper. They declare that at 16 times forecast earnings, the Indian markets are so much more attractive than in the past. Price-earnings ratios have never been about the price-they are about earnings alone, and that the stubborn denominator should justify the wild gyrations of the numerator. Falling PE multiples in a market that screams turnaround should sound alarm bells about earnings not matching up.
The lack of revival in earnings points to serious structural and qualitative problems in corporate and banking balance sheets, and sector-level and company-level differences in performance. The focus for the equity investor should be on the micro-level selection of busi nesses that show relatively better quality, with sturdy models that have stood the test of time; businesses that have been conservative and consistent; and businesses that are not burdened with debt and are therefore able to capture any revival in demand.
Instead of being blindly optimistic about a revival in earnings and domestic consumption demand taking care of everything, it would be wise to acknowledge that these are times for good old-fashioned hard work around stock selection and hard-nosed fundamental analysis.