Depending on how you account for extraordinary items, Sensex profits for 2014-15 were either flat or up about two per cent. This is the second lowest earnings growth delivered by the Sensex in the past 15 years, beaten only by the marginal earnings decline the Sensex suffered in 2008-09, due to the global financial crisis.
The ultimate outcome of no earnings growth delivered by corporate India in 2015 (as proxied by the Sensex) obviously caught most investors by surprise. As late as November 2014, investors were still expecting the Sensex to deliver 14 per cent earnings growth for 2014-15. These earnings expectations got crushed in the past two quarters as the Sensex companies delivered two consecutive quarters of negative earnings growth. While we are using data for the Sensex, as it is widely tracked and there is history, the conclusions are very similar if not, in fact, worse for corporate India as a whole. The broader the universe of companies considered, the worse are the data.
It is important to focus on corporate earnings and the reasons for the decline as the next stage of the India bull market needs robust earnings growth. We have passed the stage of multiple expansion and with rates unlikely to decline significantly from here (at least in the short term), markets cannot advance without earnings acceleration.
The bull case for a strong earnings recovery is quite clear. Corporate profits as a percentage of gross domestic product (GDP) are significantly below trend. After peaking at 7.1 per cent of GDP in 2007-08, profits are today only 4.3 per cent of GDP. The last time they were this low was in 2003. As the economy accelerated between 2003 and 2008, earnings exploded, rising from 4.3 per cent of GDP to 7.1 per cent. In this five-year period, the Sensex earnings tripled. Most market bulls now expect something similar to happen over the coming few years. GDP growth is poised to accelerate as the economy recovers, and as margins normalise, the bulls expect another period of very strong earnings growth for corporate India. Most of the bulls have factored in near 20 per cent earnings growth for our equity markets over the coming few years. If this earnings trajectory can be delivered, with its corollary effects of rising return on equity (ROE) and free cash flow, then current valuations of 16 times earnings for India can sustain and be justified. It is this bull case of accelerating earnings,rising ROE and falling inflation that has caused foreign institutional investors (FIIs) to so dramatically overweight Indian equities.
But first, why have earnings been so disappointing?
There are two or three main issues, in my mind. First of all, one has to look at nominal GDP to assess the true scale of the economic slowdown, and not the reported real numbers. Corporate earnings track nominal GDP, not real GDP. The nominal GDP numbers have almost halved from 13.7 per cent year-on-year in the third quarter of calendar 2014 to 7.7 per cent in the first quarter of calendar 2015. The drop has been very sharp in the last six months, as inflation has come off sharply, coinciding with the steep earnings decline.
Linked to this point is the argument on real interest rates and tight liquidity. With inflation having come off sharply and the Wholesale Price Index (WPI) in the negative territory, has the Reserve Bank of India (RBI) been too conservative in cutting rates? The bulls will argue that even after the last cut of 25 basis points in the repo rate to 7.25 per cent, real rates are still 2.3 per cent, if deflated by the Consumer Price Index (CPI) or 10.2 per cent if deflated by the WPI; and this, too, at the short end of the yield curve. WPI may arguably be the more relevant basis to look at real rates for corporate India, as companies deal more with wholesale prices in business transactions.
Such high real rates will obviously have some impact on private corporate capital expenditure (capex). Weak capital spending is the other obvious reason for such poor corporate profits. Gross fixed capital formation in India has fallen from 33.6 per cent of GDP in 2011-12 to 28.7 per cent today. This decline has been almost entirely driven by a collapse in private sector capital spending. Investors forget that any strong profit cycle needs high growth in capex. A strong capex cycle front-loads profits, as the seller of the capital equipment or services books profits upfront, while the buyer depreciates the cost over the life of the asset. The last profit cycle for India, in 2003-08, was also marked by a surge in capital spending.
I also suspect that we have seen many instances of significant inventory losses, as corporate India has tried to adjust to the bust in the commodity supercycle. Again, the inventory loses happen immediately, while the benefits of lower input prices take time to materialise either in higher gross margins or increased marketing spending and, thus, higher volumes.
The other factor has been the relative strength of the rupee, especially in relation to currencies other than the dollar. This has put serious pressure on the profitability of any company that sells into or competes against non-dollar competitors.
The cutback in government spending in the first quarter 2014-15, as the government scrambled to keep the fiscal deficit on target, has also obviously had an impact on the corporate sector.
I also suspect that there has been some element of throwing in the towel among companies. Many promoters were trying to hold on in the hope that they could raise equity, use an economic recovery to sell assets or maybe convince the banks to continue to support them. As the recovery has not really kicked in and equity markets remain shut to most, maybe these entrepreneurs are no longer able to sustain and, thus, are effectively cleaning up their books and showing the true picture.
Be that as it may, will earnings come back?
My own sense is that we are still probably a couple of quarters away from seeing the beginnings of the earnings upcycle. Earnings estimates for 2016 will probably have one last set of downgrades, as the consensus of near 20 per cent earnings growth is unlikely to be met. After this cut, we will have to track government spending, and not just from the Budget but also what is being spent at the central public sector undertakings. Unless we see a pickup in public spending, the capex cycle will not revive, and without an acceleration in investment spending, earnings will not accelerate. With the slowdown in rural India and the RBI seemingly unwilling to cut rates sharply, consumer demand will be unlikely to drive the recovery. The external-facing businesses such as pharma and technology are already sitting on very high margin structures, thus, they will not see breakout earnings growth. The delta in earnings will, thus, have to come from sectors with strong linkages to the broader economy, such as banks.
While we may despair about our earnings, the picture for the broader emerging markets universe is even worse. The cuts in earnings expectations for emerging markets are even greater than what we have seen in India.
Markets seem to be in a holding pattern till we get greater evidence of a recovery on the ground. I still believe this recovery will come and it is only a matter of time. Once the evidence is clearer-cut, investors will regain confidence on the earnings outlook and markets should move higher.
The writer is at Amansa Capital. These views are his own