Challenge the equity-return assumption

Whenever financial markets are roiled by events such as Brexit, market experts use just one argument to reassure investors: 'Don't worry. If you hold on patiently for the long term, equities will deliver a 15-20 per cent annual return'. A 15-20 per cent return from equities is also the assumption that most financial planners use when working out the monthly investment required to get to your financial goals. But where does this number come from? The most common explanation goes as follows: India's long-term GDP growth rate has been in the range of 8 to 9 per cent. Add to that an inflation rate of 5 per cent and you get a nominal growth rate of 13 to 14 per cent. Now given that the listed companies represent the best and the brightest of Indian business, they would grow at a multiplier to GDP of, say, 1.4 times in good times. That leads us to sales growth of 18-20 per cent. Assuming profit margins remain constant, the profit growth of Sensex companies would thus get to this magic number of 18-20 per cent. Missing the target But while this calculation sounds neat and simple, the problem is that Sensex companies have had an extremely tough time delivering this growth in recent times. In the just-concluded results season for FY16, for instance, Sensex companies reported a 2 per cent fall in their per share earnings (₹1,330 per share), when compared to their FY15 numbers. At about 1 per cent, FY15 growth numbers were not much better either. While slow growth in corporate profits over one or two years should not be a worry, the problem is that earnings disappointments have become quite a regular feature with corporate India in the last five years. In fact, if you take stock of the actual CAGR in Sensex earnings for the last five years, it stands at a modest 5.3 per cent (per share earnings onl

This article was originally published on July 28, 2016.