Indian equities not as expensive as reported, says Valens Research CEO

As-reported financial information cannot be trusted and have blinded investors from seeing the true earning power, valuation, says Joel Litman

The price to earnings multiples of Corporate India as measured by Uniform Earnings is at a 10-year low, signaling markets have room to run, says Joel Litman, president and CEO of Valens Research and Chief Investment Strategist of Altimetry, who was in India earlier this month to speak at the CFA Society India’s 10th India Investment Conference. In an interview with Ashley Coutinho, he says that the as-reported financial information given under current accounting standards cannot be trusted. Edited excerpts: 

Could you tell us more about your "Uniform Accounting" system, and the flaws with the prevalent reporting and accounting standards around the world?

The as-reported financial information cannot be trusted and have blinded investors from seeing the true earning power, valuation, and credit health of companies. The goal of Uniform Accounting (UAFRS) is to create more reliable and comparable reports of financial activity. With the UAFRS Advisory Council of more than 50 financial experts around the world, we’ve identified over 130 inconsistencies in both GAAP and IFRS. 

Take research and development as an example. The R&D a company invests in any given year is likely to generate revenue for future periods as well. Facebook is still generating revenue from the R&D it spent developing their newsfeed and ad-embedding capabilities years ago. If a company earns revenue from an investment, it should be expensed at the same time the revenue is recognized. Despite the matching principle being a core of any reliable accounting system, current GAAP and IFRS accounting standards require firms to expense R&D, which violates the matching principle.

Indian ratings agencies were late in spotting trouble in Infrastructure Leasing and Financial Services that defaulted on payments to banks in September 2018. We have had cases in the past with a Satyam or a Lehman or an Enron where auditors or rating agencies have failed to raise an alarm on the financial position of the firms. Where do you think the problem lies, and what is the way around it?

It can be very difficult for ratings agencies such as Moody’s, S&P, and Fitch to issue negative credit ratings. Often, the companies they are rating are their clients. That bias has been well-documented.

In other cases, however, the agencies simply don’t have the best tools and resources for assessing corporate credit risk. Being dependent on as-reported GAAP and IFRS (Indian Accounting Standards which are very similar to IFRS), it’s no wonder they miss the early signals or problems that the best investors see far ahead of time.

Cash flow is a key component to assigning proper credit ratings, and it is impossible to accurately measure cash flow without adjusting GAAP and IFRS data. The as-reported statement for cash flows is notorious for including non-cash items like pensions and stock options in the cash flow calculation. It’s also highly susceptible to mis-categorizations like not placing interest expense or leasing under financing activities.

Investors need to remove their dependency on the rating agencies and utilize more reliable analysis.

What are the 2-3 signs that may indicate that a company may be about to go bust? What are the red flags that investors should watch out for?

If you want to understand the equity markets, you have to listen to what the credit markets are saying. Mitch Julis, one of the great investors of the last 40 years, taught me early in my career that one must be a solid credit analyst to be a great equity investor. 

What many investors don’t realize is that credit is a leading indicator for equity securities, and the equity market as a whole for that matter. In order to properly evaluate a company’s credit health, investors need to get as close as possible to real cash earnings and obligations. 

If a company’s true cash earnings fall below the ability to service debt maturities or interest repayments, the company could obviously be in trouble. As-reported numbers might not reflect that. Investors also need to think about the refinancing environment. If interest rates are kept low and the company has the ability to “kick the can down the road”, the said company may be able to stay afloat despite having obligations greater than projected cash flows. 

You have said that an active credit default swap market could help Indian companies and banks address the country's corporate debt problem, which has arisen due to rising bad debt and risk-aversion of lenders. Could you explain...

An active CDS market, similar to what we have in the US, allows institutional investors to better assess and price in corporate credit risk. Investors can use the CDS spread - approximately the amount of money it costs to “insure” a company’s credit - as a barometer for a company’s perceived credit risk. Lower spreads mean less credit risk, and higher spreads imply higher credit risk. Because many emerging markets do not have an actively traded CDS market, investors lack this source of information. 

When investors and lenders have more reliable information on credit risk through an active CDS market, they are more confident in their capacity to take on additional risk. It creates liquidity in the debt markets and ultimately, more capital formation for companies.

A number of corporate governance issues have come to the fore in India in the past few years. A number of independent directors and auditors have quit as the government has tightened rules for the Board and increased accountability. Independent directors and auditors are now thinking twice before signing up on boards of companies. Could you list out a few ways corporate governance standards in India could be improved without putting the fear of God among auditors and independent directors?

As financial markets mature, additional scrutiny from sophisticated investors will inevitably prompt institutions to tighten the reins on governance issues. This is what we’ve seen with the revisions in India’s corporate governance standards. 

Directors and auditors making more informed decisions will hopefully improve the stability of these positions going forward. Tightening the rules set by the Indian government can be seen as preparation for steps that will bring in more international investors and help India’s investment climate. Higher standards of corporate governance may also help deter manipulation of accounting data and strengthen compliance practices. 

Unfortunately, around the world, too much stress is placed on structural aspects of governance, like splitting the chairman and CEO roles, setting age limits for board members, and insisting on majority or super-majority independent directors. The evidence supporting structural aspects of governance like these is highly suspect. In fact, research shows that the opposite might even be true. Our research shows quantitatively that the ideal board is made up of smaller number of directors who are incredibly experienced, are paid little in fees, and hold high amounts of company stock relative to their own net worth. Whether or not they are old or independent is inconsequential if these other factors exist.

In fact, there is even strong evidence to show that if the Chairman and CEO is the same person, one sees higher average valuations at those companies versus peers, particularly if they have a low salary and high stock ownership.  

Valuations of Indian shares relative to Asia ex Japan peers remain at a premium both on price to earnings multiples and price to book value, and the current premium is slightly higher than the long-term average. What’s more, there was a sharp polarization in valuations between “high-quality” stocks and the rest and we have seen selective rally in select large caps in the past few months. How bullish or bearish are you on Indian stocks and what is your take on valuations?

We need to reduce our reliance and ongoing commentary on antiquated measures of as-reported P/E and P/B multiples. On a Uniform Accounting basis, India’s equity market is trading at the upper end of regional valuations compared to some other Asian countries. India is more expensive than its peers, trading at 23x Uniform P/E, but not as expensive as its as-reported P/E of 26x would suggest at this time. 

With an ROA that has increased from 5 per cent to 7 per cent for corporate India, as measured by Uniform Accounting, that’s a major jump in corporate earnings power. We calculated the aggregate Uniform ROA by measuring across most of the largest of 412 publicly listed Indian corporations.

Meanwhile, the P/E of Corporate India as measured by Uniform Earnings is currently at a ten-year low, signaling markets have room to run before valuations get out of hand. These are very bullish signals for the Indian stock market and longer term, suggesting more upside than downside when the right trends are in place.

What about growth?
 

Market indicators show mixed signals on India’s current market conditions. An increasing inflation rate, weak currency performance, declining GDP growth, trade deficits, and increasing non-performing loans might cause volatility in the near term. However, declining interest rates and unemployment rate, strong corporate cash holdings, favorable corporate cash flows relative to credit obligations, and treasury yield spreads are potential tailwinds to India’s growth.

US equities have enjoyed more than a decade-long bull run. Is the rally sustainable? 

As of right now, Uniform-based valuation ratios are at reasonable levels in corporate US, contrary to what as-reported metrics may be showing investors. 

Yes, we’re in the middle of a decade-long bull run, but bull markets don’t die of old age. In fact, the “Market Phase Cycle” monitor shows that longer-term equity market upside may be warranted. 

Again, I want to reiterate the importance of credit. If major corporations experience a credit crunch, smaller firms will most definitely experience one as well. If financial institutions commit to extreme credit tightening, companies will suffer. 

Investors ought to watch the credit markets actively. When you do, you see that there are still no signals of a near-term credit crisis with low-to-no credit risk moving through 2020.

How do you view the FAAMG stocks? 

Some of the FAAMG stocks, and large cap tech and services in general, still look really interesting. Allow me to focus on just one for now.

Under as-reported earnings and financial statements, Facebook has generated near average ROA since it went public and has traded above corporate average valuations with a 20x-40x P/E. In reality, Facebook has been generating at least 45 per cent ROA under Uniform metrics and has never traded at a Uniform P/E above the mid-20s. 

Our analysis shows that the market may be overly negative about Facebook given its strong Uniform fundamentals, excellent execution, and growing management optimism.