Weak EPS growth and strong GDP growth can coexist

OVERVIEW

Published on: 28 Nov, 2018

There is needless angst in India about EPS growth staying weak even as the economy grows at 7%. Such a phenomenon is actually a good thing for the Indian economy – it highlights a shift to a more competitive, pro-consumer paradigm which sets the stage for efficiency improvements in the economy.

“…the relationship between earnings per share growth and GDP growth is quite different in the shorter term. If you could accurately predict the next three years of GDP growth, this would be decently helpful for investment purposes as the fastest 20% of growers in the developed world outperform by 2.6% annualized over that three-year period… Why does it work in the short term, but not the long term?…In the shorter term, strong GDP growth is associated with cyclical widening of profit margins, whereas long-term growth does not have a similar impact. Where all this gets a bit more confusing is that it almost certainly isn’t GDP growth per se that is most correlated with EPS growth…”– Ben Inker of GMO in ‘Ditch the Good, Buy the Bad & the Ugly’ (2014) [underlining is ours]
A decade of weak EPS growth and strong GDP growth

The 12th November 2018 edition of the Business Standard contained an article which said that over the past decade the annual earnings growth of listed Indian companies has been a mere 4.1% whilst nominal GDP growth has been around 12.9% over this period. The Business Standard report alongside a similar article from a foreign brokerage prompted plenty of hand wringing about what has gone wrong in India

Competitive Advantage 101 can explain what is going on

Using a relatively simple model of competition, it is possible to understand what has happened in India. In a competitive economy only two types of firms are able to generate healthy profits (defined as ROCE in excess of cost of capital):

Companies who have sustainable competitive advantages either on the demand side (i.e. they have access to market demand – thanks to product differentiation or branding or customers’ switching cost – that their competitors cannot match) and/or on the supply side (i.e. cost advantages that allow a company to produce and deliver its products or services more cheaply than its competitors). These cost advantages could be due to proprietary technology or due to privileged access to raw materials or due to experience or some combination of these. [Source: “Competition Demystified” by Bruce Greenwald and Judd Kahn] Sustainable competitive advantages of this sort are evident in India in sectors FMCG, Banking, Pharma and light electrical manufacturing.
Companies who do not have sustainable competitive advantages but have made themselves highly efficient by squeezing costs relentlessly over a long period of time. You can see this paradigm at work in India in sectors like Cement and Steel where there is very little to distinguish one company’s product from the next

It follows therefore that if a firm does not fall into either of these buckets, it is in trouble. Examples abound in India eg. Idea in Telco, Jet Airways in airlines, several NBFCs, several private sector banks who don’t have CASA franchises, lots of construction companies, several cement companies, etc.

Until a decade ago these weaker players would keep chugging along due to: (a) soft loans from PSU banks; and (b) implicit gentlemen’s agreements in their sector which would put a floor on prices and therefore on profits. Whilst this would keep the weaker players alive, the Indian consumer/taxpayer was worse off as she would pay higher prices/taxes (which effectively were subsidies to keep the inefficient players alive).

For reasons which we don’t fully understand, this paradigm was disrupted around a decade ago and we entered a more competitive era in Indian business wherein weaker firms were either bankrupted or forced to sell out. What we have seen over the past decade is not just weak EPS growth but also a steady decline in the Nifty’s pre-tax ROCE (from 20.5% a decade ago to around 15.5% now). This has happened alongside better products and more competitive pricing for the consumer who has flocked to buy these products thus boosting consumption growth even as capex growth stays muted. The most vivid illustrations of these are:

The domestic airline sector where the planes are full, the airports are heaving but no airline makes any money due to to intense competition
The domestic taxi market where the streets are full of Ubers and Olas and
consumers are getting a good deal but neither Uber nor Ola nor their taxi
drivers make money (defined, again, as ROCE > WACC).

Thanks to greater competition, we have transferred the profits of weaker companies into the pockets of the consumers (primarily, middle class consumers; workers at the bottom of the pyramid face a challenge which is discussed further on in this piece).

Other than consumer, who are the winners in this uber-competitive paradigm?

As EPS growth becomes a permanent challenge in a more competitive economy, efficient firms who have built strong moats will continue to trade at high premiums to their peers. We continue to believe that firms who consistently generate double digit revenue growth whilst delivering ROCE>WACC will continue to be attractive stocks to buy and hold.
Well managed moated sector leaders like Dr Lal Path Labs and Asian Paints realise that if they hike prices, whilst their profits grow faster, life also becomes easier for their less able rivals. Hence price hikes from market leading companies has become increasingly rare. Similarly, in banking the leading private sector banks are not increasing their lending rates materially even though the cost of 3-month money market paper is up almost 200bps this year. These banks realise that by not hiking their lending rates, they can squeeze the less able lenders out of the game. As this dynamic becomes widespread in India, it becomes easier for the RBI to control CPI inflation and give a positive real rate of return on bank fixed deposits. That in turn should encourage the ongoing “financialisation” of the economy
With economic growth being faster than growth in corporate profits, the
funding for growth initiatives has to – by definition – come from bank loans, private equity and from the capital markets [for the overwhelming majority of companies, retained profits won’t be sufficient to fund capex]. This dynamic should interplay with the previous bullet and bring to the stock and bond
market a broader range of Indian companies
As weaker companies are driven into the NCLT process, stronger, more
efficient rivals will be able to acquire their capacities at attractive valuations. This will (and is producing) a concentration of economic power hitherto
unseen in India. Whilst many fear that this would ultimately lead to an
oligarchy wherein politicians and promoters collude to screw the consumer, as
yet there is no evidence of the same largely because any attempt to gouge
the consumer is likely to trigger new entry

All of this being said, there are three big negatives associated with the new paradigm of competition in India:

As firms seek efficiency, in almost every industry one is seeing a replacement of people with machines/automation. Eg. Maruti’s EPS growth has risen by 15% per annum over the past decade but its headcount has only risen by 10%. HDFC Bank’s EPS growth has risen by 23% per annum over the past decade but its headcount has only risen by 9%. For Indians – blue or white collar- who don’t have jobs, this development spells trouble.
Less able firms – many of who are SMEs – are being squeezed relentlessly in a more competitive economy. Increasingly, their response is to either shut shop or to sell out to more efficient rivals who then get rid of the labour and hold on to the revenues.
Indian stocks have seen an EPIC re-rating over the past decade as market cap has compounded at 15% whilst EPS has grown at only 4%. During this period, the cost of capital was falling globally courtesy QE. Now that the US 10-year bond yield has doubled from 1.6% in September 2016 (a 50-year low), the P/E multiple of the Indian stockmarket looks increasingly unsustainable.

Note: the above material is neither investment research, nor investment advice. Marcellus does not seek payment for or business from this email in any shape or form. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services.

Saurabh Mukherjea is the author of “The Unusual Billionaires” and “Coffee Can Investing: the Low Risk Route to Stupendous Wealth”