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Challenge the equity-return assumption

Why you can no longer rely on 15-20 per cent returns from Indian equity markets


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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'.

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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 (R1,330 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 only grew from R1,024 to R1,330 per share).

This is of real worry to investors. After all, if profit growth for Sensex companies is at just one-third the returns that financial planners assume, how can investors be assured their goals will be met? For stock prices to really deliver a 15-20 per cent CAGR, corporate profits have to grow at a similar pace.

What's hurting profit growth?
To understand, let's go back to the GDP. As we know, India's real GDP growth (real GDP measures actual output without inflation) has been picking up gradually from its slump in FY12. As per data from the Central Statistics Office (new series), GDP growth recovered from 5.6 per cent in FY13 to 6.6 per cent in FY14 and 7.2 per cent in FY15. India's GDP growth for FY16 is estimated at 7.6 per cent.

By the theoretical explanation, therefore, Sensex companies should have seen their sales growth improve from 10.6 per cent in FY13 to 11.6 per cent in FY14, 12.2 per cent in FY15 and 12.6 per cent in FY16. That's assuming a 5 per cent inflation rate on the real GDP growth mentioned above.

But, in reality, the sales growth for corporate India has been trending down, especially in the last two years. After growing their sales at over 12 per cent in FY13 and FY14, Sensex firms saw their aggregate sales decline by 0.9 per cent in FY15 and 1.2 per cent in FY16.

So what's cooking? Understanding the reasons for the divergence between GDP growth and Sensex profits is essential to evaluate if equity returns will really make it to that 15-20 per cent target.

Deflation hurts
One explanation for the poor Sensex growth clearly lies in inflation rates far undershooting the 5 per cent that planners assume. According to official data, while India's CPI (consumer-price) inflation dipped from over 6 per cent to 4.8 per cent in the last three years, WPI (producer-price) inflation slid from over 7 per cent in FY14 to a negative 0.8 per cent in FY16.

Now, as it is the WPI which reflects the selling prices charged by producers of goods and services, it is clear that dipping producer prices are hurting corporate sales growth. Even if the volume of products and services that companies are selling continues to grow due to an improving economy, the deflation in selling prices is leading to lower value of sales, accounting for a poor top line. Clearly, therefore, for India Inc to get back to better sales growth, higher inflation, especially in the WPI, is a must. That's the first earnings trigger equity investors must watch out for.

Commodity revival
Two, even within India Inc, it is not as if all firms are equally hurt by this lack of pricing power. In fact, delving deeper into the sales growth of Sensex companies for FY16, a good number of them managed strong double-digit sales growth - auto majors (Maruti, M&M), pharma firms (Cipla), private banks (HDFC Bank, Axis Bank), large infra players (L&T, Power Grid, Adani Ports) and technology firms (Infosys, TCS). But this growth was more than offset by anaemic growth from public-sector banks (SBI) and contraction in the sales of energy majors (Reliance, ONGC, GAIL) and metal firms (Tata Steel). This suggests that for Sensex sales and thus profits to get back on track, consumer demand should hold up. But a moderate revival in commodity prices is critical, too.

This is a delicate balancing act though. If commodities jump too much, that can hurt the profits of the users of commodities, such as consumer goods, infra, auto and pharma.

Global factors
Three, apart from deflation hurting sales growth for some firms, aggregate Sensex profits have been hit hard by the sharp profit declines at banks like SBI and ICICI (profits down 28 per cent and 17 per cent, respectively, in FY16), setbacks to global operations of firms like Tata Motors (profits down 21 per cent), apart from oil and gas majors facing a margin squeeze (22 and 28 per cent dip in the profits of ONGC and GAIL). Now, bank profits will recover if credit growth picks up and the provisioning for bad loans falls. An improvement in the global economy is essential for better profits at firms like Tata Motors and Tata Steel, and inventory losses need to fade for oil majors to report a profit.

Overall, therefore, for the Sensex to really get back anywhere near that 15-20 per cent growth that everyone is factoring in for the long term, investors need to hope and pray for four things to happen. One, inflation, especially in wholesale prices needs to get back to 5-6 per cent levels. Two, oil and metal prices need to show a modest recovery (but not too much!). Three, there should be no new slippages on bad loans of domestic banks. And four, the global economy has to recover from the doldrums.

If one of the above four or just two of the above factors are supportive, Sensex earnings will stage only a partial recovery, maybe to high single-digit growth. As investors, we obviously cannot control what happens to the commodity cycle or global economy. But we can make conservative assumptions. So if you're a conservative investor making your financial plans, it would be safer in the current context to stick to a 12-15 per cent return assumption for equities. For now, let's forget about 20 per cent. After all, if earnings and returns overshoot our targets, that's a good problem to have!

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