Where are the earnings?

06th Apr 2013 ARCHIVES | EQUITYMASTER HOMEPAGE

The share price of a typical Indian company, I have often noted, will e set y foreign flows !t the val!e of an
Indian company will e determined y their aility to create economic val!e and grow earnings"
As of now, there has een a lot of visiility on foreign flows # and no visiility on earnings"
Aided y the !nprecedented printing y their central an$s, foreign investors are investing in stoc$ mar$ets
aro!nd the world" %ne of those mar$ets to enefit is India &Tale 1' which in (alendar )ear 2012 saw over *+,
2- illion of foreign flows even as the local investors &as meas!red y the redemptions in the m!t!al f!nds' have
sold *+, 3 illion"
The first three months of () 2013 saw a contin!ed s!rge of flows with foreign investors !ying *+, 10 illion in
the Indian stoc$ mar$et" .etail investors, fed !p with a m!t!al f!nd and */I0 ind!stry that contin!es to pretend
they never resorted to any 1!estionale selling practices, contin!ed to sell"
Table 1: Foreigners b!" lo#als sell
Perio$
%e& Foreign
A#&i'i&! (US) *+
%e& ,o#al Fn$
A#&i'i&! (US) *+
To&al (US)
*+
C-ange in S.P /SE012 TRI in
&-a& Perio$ (3 US4+
() 2003 6,622 22 6,316 426"56
() 200- 2,667 #253 2,-16 420"56
() 2005 10,303 3,0-7 13,356 4-0"26
() 2006 2,106 3,-13 11,517 451"66
() 2003 13,655 3,222 20,233 463"06
() 2002 #11,73- 2,501 #7,-33 #60"26#
() 2007 13,-52 #1,132 16,326 70"36
() 2010 27,362 #6,0-7 23,313 42-"16
() 2011 #352 1,3-3 725 #35"26
() 2012 2-,332 #3,25- 20,512 42-"56
(!m!lative 110,625 2,322 112,753 4-70"56
8ar#13 1,635 #276 1,337 #1"16
)T, 2013 10,310 #1,-1- 2,276 #2"26
+o!rce 9www"+ei"gov"in
The Indian economy, meanwhile, contin!ed to show s!#66 growth in :,0 # etter than the gloal averages of
s!#36, !t lower than what India is !sed to seeing in recent years"
The !dget was another !seless e;ercise aimed to d!ll the imagination, tho!gh m!ch of (orporate India &or
sho!ld we call them (hic$en India' contin!ed to rate it as a 3<10 or 2<10"
:loally, the economic environment is e;tremely !ncertain" The *+ economy is recovering in some sectors !t
anyone elieving that this is a strong and even#$eeled recovery is del!sional" The middle class in the *+
contin!es to see a decimation of its ann!al income and its cons!mption power while the lower income class has
little hope of moving into the middle class rac$et" %ver 5 million =os have een lost in the *+ over the past
decade and the median ho!sehold income has risen y less than 16 # far lower than the cost of living" >on!ses
for the financial firms are pretty m!ch ac$ to what they were pre#/ehman s!ggesting that the 16 got thro!gh
this gloal crisis with a minor scratch" The ta; pay ers were not so l!c$y and govern ment alance sheets &which
many of the 776 will rely on for their f!t!re pensions' have een severely ma!led" With pension oligations far
more than assets, retirees in the *+ will either have to accept a lower f!t!re inflow # or dig in for a long fight with
governments to ma$e good their promises"
Gra5- 6: In$ia -i&s a lo7 on G4P gro7&-
+o!rce9 >loomerg
?!rope is still torn etween the :erman prescription of ta$ing it on the chin and read=!sting to the new reality of
lower growth and the l!re of the American charm of printing and getting o!t of the mess" The :erman scepticism
of printing money lies in their own e;perience prior to World War II # they elieve the *+ will end !p in a igger
mess at an !n$nown, f!t!re date" The comical an$r!ptcy of (ypr!s and it@s even more h!mo!ro!s resc!e
pac$age efforts show the diffic!lties of $nitting together very different c!lt!res !nder one c!rrency !mrella, the
?!ro"
Aapan, a case st!dy for Bederal .eserve (hairman >en >ernan$e of how to r!in an economy, has ac1!ired the
Cest to print" It wishes to e etter than Delicopter >en # so named eca!se >ernan$e once remar$ed that he
wo!ld e willing to throw *+ ,ollar ills from a helicopter to $ic$#start an economy" /!c$ily for *ncle >en, the
printing presses of the Bed are wor$ing well and he does not need to get on a helicopter to do what he promised
to do" Tho!gh the Aapanese are the last $id to =oin the printing race, the Aapanese government is now ready to
print at a rate e1!al to what the *+ Bed is printing9 appro;imately *+, 32 illion per month"
We are all Americans9 we eat 8c,onald@sE we drin$ (o$eE we !y American dollar illsE and we print"
Flo7s 7ill be s&rong" b& 7-a& abo& earnings8
With all this gloal printing activity, money flows to India are li$ely to remain in the *+, 20 illion per ann!m
range even in if foreign investors are nervo!s ao!t India" If there is an estimated *+, 2 trillion of new money
created in the develop world and 16 of that gets allocated to India, that is *+, 20 illion in flows"
If India was Fli$edF y foreigners, we may end !p getting 26 of that *+, 2 trillion # or *+, -0 illion" That wo!ld
send the stoc$ mar$ets soaring to new highs"
>!t India is not Fli$edF at this point in time largely d!e to the ovio!s reasons of9
1" 0olitical !ncertainty and elections &y +eptemer<%ctoer 2013, in my view',
2" (orr!ption and lac$ of transparency in how companies win government contracts or win control over
government assets,
3" A (!rrent Acco!nt ,eficit that is rising and needs to e financed y foreign inflows # and contin!es to
leave India v!lnerale to shoc$s in the gloal financial mar$ets, s!ch as a /ehman#li$e event which wo!ld
rattle the Indian c!rrency"
>!t there is a more tro!ling side of the story that has not really een e;plored9 corporate earnings"
8ost analysts do not e;pect India, Inc" to see m!ch growth in profitaility for the res!lts for the year#ended 8arch
31, 2013" These will e $nown y A!ne 2013" +toc$ mar$ets in general # and individ!al shares in partic!lar # may
o!nce aro!nd a lot ased on whether companies FeatF, FmeetF, or Ffail to meetF these e;pectations of the
8arch 2013 earnings season" >!t, for the mar$et as a whole, e;pect nothing spectac!lar"
Dowever, m!ch of the mar$et@s foc!s will e on f!t!re earnings9 will companies significantly add to their
profitaility in 8arch 201-?
And this is where the research comm!nity may get it terrily wrong"
%r, if they have fig!red it o!t # they are not tal$ing ao!t it" And this co!ld e d!e to the classic conflict of interest
and sense of d!ty that pervades the financial services ind!stry # in India and gloally" The over#riding 1!estion9
sho!ld we wor$ for o!r clients, or sho!ld we wor$ for o!r commissions?
Imagine yo! are a ro$er ao!t to e;ec!te an order for a large BII which will ring in a lot of commissions and
prevent yo! from eing fired in an already shrin$ing ind!stry" A!st efore placing the !y order, the BII as$s9 FTell
me, what is the ho!se view on earnings for 8arch 201-?F
)o! can answer the 1!ery in m!ltiple ways9
1" )o! can tell yo!r research analyst, the person who writes the Fho!se viewF to give a rosy pict!re or else
yo! will fire him, or
2" )o! can tell the BII that the Indian mar$et is trading at its long term average 0? of 16; historical earnings
so it is not FcheapF and neither is it Fe;pensiveF # yo! sort of evade the 1!estion of f!t!re earnings, or
3" )o! can loo$ gl!m and tell yo!r BII client9 Fthere is little hope of any ma=or growth in earnings for 8arch
201-F"
.esponses 1 or 2 will proaly still generate the F!yF order from the BII" The commissions from that will $eep
yo!r =o intact and, if yo! are l!c$y, yo! may see a on!s at the end of the 1!arter"
The client interest has een !ried and yo!r interest is intact9 yo! are a tr!e hero and deserve to e employed in
the financial services ind!stry"
%r yo! may e a maveric$ and give F.esponse 3F, which may not go down well with the BII"
The BII may still !y eca!se all the other BII fol$s are !ying"
%r the BII may red!ce the siCe of the !y order # or, worse, not !y at all"
&Statutory Warning: Please do not ascribe any genius to these FII folks - you hear them on TV and they babble
and guess like everyone else. Their suits and accents are a little more refined than the stars that come on TV at
am and tell you !hich stock is likely to rise or fall in the ne"t #$ minutes of trading% but they are all e&ually
dangerous to your !ealth.'
With a :,0 of less than 66, interest rates that are !nli$ely to decline a lot f!rther from here, and interest rates
for small#cap and mid#cap companies that may act!ally increase &given their inherent !siness and management
ris$' # I don@t see a great s!rge in earnings"
Mone! in'es&e$" 7ill no& genera&e *#- earnings
>etween 2006 and 2002, Indian companies raised a lot of money &det and e1!ity' to finance a massive capital
e;pendit!re &cape;' inge" India, if yo! recall, was +hining and every Indian company wanted some of that shine
to r! off on it"
(arried away with visions of their own s!perior powers and their aility to t!rn a political friendship into a private
$haCana, (orporate India invested as if money was free # and it was"
At least for a while"
Gow that cape; inge is ready to start prod!ction"
>!t the economy is slow, so sales may not e as great as (orporate India e;pected when they first set those
plants !p" (apacity !tilisation will e lower than e;pected for most !sinesses"
And Finterest e;penseF and Fdepreciation e;penseF will increase"
This will res!lt in s!ppressed Freported profitsF"
B%. TD%+? WD% WI+D T% HG%W TD? A((%*GTIG:, .?A, TDI+, %TD?.WI+? +HI0 ,%WG"""
When a (lant is ready% the interest that is (aid on the creation of the (lant no longer ends u( as )ca(italised
interest)% it has to start flo!ing through the (rofit and loss as an )interest e"(ense). * bit of accounting here:
When a (lant is being built% the interest on the loans taken to build that (lant are (aid by the com(any to the
bank +so it sho!s u( in cash flo!' but it does not get deducted through the (rofit and loss statement, it gets
added to the value of the ca(ital asset being built and sho!s u( as a Fi"ed *sset or Work In Progress. *nd once
the ca(ital asset is ready% then it is amortised or de(reciated over a -% .$% or ./ year (eriod: this de(reciation
sho!s u( in the (rofit and loss statement.
%nce the plant is ready and commissioned, it needs to e depreciated over the estimated !sef!l life of the
plant"This adds to the )de(reciation) e"(enses and reduces the re(orted (rofitability. 0ut it makes no difference
to the )cash flo!) of the com(any% since this is only an accounting entry - no (erson is actually (aid this
)de(reciation e"(ense) amount every year. The (lant !as already (aid for !hen it !as built and ended u( as an
asset in the balance sheet. Since it has a limited life% the de(reciation charge !ill bring that asset value do!n to
1ero over time.
*sing data so!rced from the ?1!itymaster F)earoo$sF which analysed the financial statements of 133 to 137
companies etween 2005 and 2012 &the a!dited, f!ll year n!mers for 8arch 2013 are not yet reported', one
gets an idea of how profitaility has changed over time and what co!ld have ca!sed these changes in
profitaility" Go an$s and financial firms were incl!ded in this list"
Table 6: Gro7" gro7 0 an$ borro7 &o bil$ ne7 5lan&s
+o!rce9 >loomerg
.ecognising that there is no a!dited data for B)2013, and ma$ing certain ass!mptions on how m!ch of the
overall cape; completed this year was done y this sample of companies, the interest cost of their det, how
they will !tilise their e;panded capacity &and many other variales', I ended !p with the following9
If 206 of the new capacity coming to fr!ition in India was implemented y this sample of companies !sing
B)2012 as a ase, then9
1" ,epreciation and interest will red!ce reported 0rofit >efore Ta; y #-"76E
2" .even!es from higher capacity will increase 0rofit >efore Ta; y 46"-6E
3" Get effect will e an increase in 0rofit >efore Ta; y 41"56"
.ecognising that this e;ercise is done !sing B) 2012 data as a ase year and recognising the vario!s
ass!mptions made on so many fronts, there is room to add some growth for the B) 2013 earnings"
>!t, if yo! told an BII short#term investor &and most of them are short#term' that they were p!mping illions of
dollars every month into a stoc$ mar$et where there is a marginal 1"56 improvement in profits, they wo!ld not
e a partic!larly happy lot"
Gote that this is a macro calc!lation for a large n!mer of companies # there will still e companies that may not
have this large cape; cycle and are ale to generate a healthy clip of 156 to 206 growth in their earnings"
0lease don@t ta$e me wrong9 I am a long term !yer of Indian stoc$s" 8y advice to investors is to invest 506 to
356 of their intended investment into Indian e1!ity at these levels of the Inde;" >!t a long term !yer &with cash
on the side to ta$e advantage of a decline' is not loo$ing at B)201- earnings"
The money eing p!mped into India as a y#prod!ct of all the gloal printing is not necessarily long term money"
In fact, my g!ess is that 706 of it has a 1#day to 70#day view on any mar$et, incl!ding India"
They get disappointed very easily" They get e;cited very easily"
.ecall the small#cap and mid#cap mayhem"
.ecall what they did even to large companies li$e Infosys when they had disappointed earnings"
+o, the mar$ets are at a dangero!s place for tr!sting investors"
?asy money and a fast#tal$ing Binance 8inister with many 1!ic$#fi;es has ca!sed a s!rge since A!ly 2012" >!t,
event!ally, we need earnings to s!stain any mar$et rise"
I wo!ld rather e a !yer of stoc$s in a mar$et where there is strong earnings and wea$ flows" >eca!se then I
am !ying into a company which is growing its intrinsic val!e # and others have not yet come forward to !y its
share" That is fine with me"
This mar$et is the reverse9 the money flows are there for s!re !t, on a mar$et level, I don@t see the earnings in
the near term"