We are about to enter the earnings season for the third quarter of 2006-07. Expectations are that this should be a very strong quarter once again for earnings, with 40-45% year-on-year earnings growth predicted.
If, as everyone expects, these forecasts do come to pass, it will mark the 15th quarter in a row wherein earnings have been higher than or matched expectations. The financial year 2006-07 should be the fourth in a row where earnings growth has been higher than 20-25%.
The inevitable question is: How long can this continue? For, haven't we all been taught that over the long term earnings cannot grow faster than nominal GDP (otherwise, they will eventually become an impossibly large share of GDP)?
Haven't we all been warned that you should never extrapolate strong earnings growth into the future as the nominal GDP constraint is unavoidable?
This is one of the basic tenets of understanding long-term market performance and behaviour. Thus how can the market bulls expect earnings to keep compounding at 20% for the foreseeable future?
How is it that with nominal GDP growing at best around 13%, earnings have been able to compound at 25% and that too for years on end?
I think there are three or four explanations for this phenomenon.
First, prior to this earnings surge, corporate India was coming off a period of lacklustre earnings performance from the mid-1990s till 2003, as the economy had weakened and companies were engaged in cost cutting and rationalisation.
Thus prior to this earnings surge the profit share of GDP was probably below its long-term average. We could simply be seeing a mean reversion as corporate earnings regain their rightful share of GDP.
Secondly, I think that as capital expenditure has accelerated among Indian companies, this has also been a boost to earnings. Whenever you have a strong capex cycle, it inevitably boosts earnings. For the company selling the capital equipment or recording the sale books the profit upfront on the sale, whereas the company buying the equipment capitalises the cost and amortises it over multiple years through depreciation. Thus, a strong capex cycle inevitably frontloads profits, and to the extent the capex cycle in India is still accelerating and the investment share in GDP rising, this will be a powerful boost to profits over the coming years.
Thirdly, I think what we are seeing also is the fact that while nominal GDP is growing at 13%, ex-agriculture it is actually growing at 15-16%, and within this the private listed corporate sector is growing still faster. With the economy also being gradually liberalised, the role of the private sector is expanding across various fields of activity.
For example, insurance, aviation, banking and telecom are huge sectors that come to mind straightaway, wherein the private sector has entered, gained share from the government, and will eventually make huge profits. There are other huge sectors where for the first time, major players are getting listed. Real estate is an area where everyone is now getting listed and thus boosting earnings growth of the listed sector, though not of the economy.
To the extent that the listed private sector gains share across the economy, one can argue that its profit share of GDP should also be in a secular uptrend. Either the profit share of GDP of the whole economy will rise as we become more capitalistic or the private sector's share will rise at the cost of the public and unlisted sectors. Take the case of aviation, where till recently the private sector made money at the expense of Indian Airlines.
As the listed private sector becomes a larger part of the economy, which is to my mind an inexorable trend, it can grow at a multiple of nominal GDP to account for its share gain.
The fourth point would be that Indian companies are clearly going global and increasing the international share of their business. The share of international trade to GDP is on a structural rise for the economy.
To the extent that Indian companies are able to open up markets and address global customers, there is no reason that their profit growth should be constrained by domestic factors alone. As they gain share globally, it opens up a new profit stream for them and they can break out of the profit constraints of only being dependent on the local economy.
In India we also have entire sectors like software that are totally focused on global markets and have very little to do with the Indian economy. In the more advanced and mature countries of the west, the share of international trade to GDP tends to be quite stable and thus the above dynamic does not really play out the way it does in India.
We are also experiencing very strong productivity growth in India, and this normally is highly beneficial to corporate profits as labour's share of profits tends to structurally decline in such an environment.
The final explanation can be that in fact we are growing much faster than the government statistics show, or that as we reform and improve tax compliance, the underground economy is shrinking and this is not fully captured in government statistics, but shows up in profit numbers.
Corporate earnings have had a dream run over the last four years, and all signs seem to indicate that the dream run will continue. Sceptics point to deteriorating earnings quality and the lack of free cash flows, but I think that is noise, which cannot detract from the very strong corporate performance.
They also point to the strong commodity cycle as an explanation, but again there is more to the strong earnings performance than simply commodity prices. A worrying trend is the inevitable increase in competition as all the capex plans of companies fructify, and global players gain entry, but hopefully strong growth will absorb this.
As to how long this performance can continue is difficult to say, but if you believe that the Indian economy is on an 8%
long-term trend growth rate, 20% may be the trend for corporate earnings, at least for the foreseeable future. This ultimately is the attraction of India, for in no other market can you reasonably expect the listed corporate sector to compound earnings at 20%, with a reasonable level of transparency and capital efficiency.