Earnings growth to remain muted in FY16 and FY17 though the economy’s prospects are good over the long term
After a decade of ossification, the landscape is changing at a rapid rate for India Inc as: (i) An unconventional PM calls time on the traditional model of subsidy funded consumption growth and crony capitalism driven capex growth in India; (ii) A gutsy RBI Governor brings about multiple policy changes to radically increase competition in the financial services sector; and (iii) Technology lowers the barriers to entry into sectors such as lending, consumer goods and auto. The impact of these resets are manifold and include: (i) Weak earnings growth in FY16 and FY17; (ii) A big step-up in Sensex churn; and (iii) Single digit returns from the Sensex over the next sixteen months.
The disconnect in corporate earnings growth versus GDP growth
Whilst India has witnessed healthy GDP growth averaging 10% in nominal terms over the last six quarters, the earnings and revenue growth for Nifty companies have remained unusually weak. What has caused this disconnect between the GDP growth versus EPS and revenue growth? The answer lies in three profound structural changes which are reshaping the economy and exerting unprecedented pressure on the profitability of at least two-thirds of the Sensex companies.
Macroeconomic Implications: A more competitive economy
An interplay of these three resets is likely to decrease the costs of factors of production i.e. land, labour and capital. Whilst in the long run, this is likely to result in higher economic growth, as more businesses are set up due to lower barriers to entry, in the short run, the incumbents that have thus far enjoyed high earnings growth on the back of corruption and artificial suppression of competition will face increasing pressure on their revenues and earnings.
Investment Implications: Weak earnings growth=>single digit returns
With: (i) The Sensex PE (price-to-earnings ratio) multiple likely to remain unchanged due to the offsetting effects of cost of equity and RoE; and (ii) EPS growth in FY16 and FY17 likely to remain in single digits, we expect the Sensex to generate single digit returns in FY16 and FY17. We cut our FY16-end Sensex target to 26,500 (from 28,000) and we set our FY17-end Sensex target as 29,000, implying that over the next five quarters the Sensex will generate annualised returns of around 11%.
Our highest conviction SELLs are L&T, ICCI, Hero Motocorp and Hindalco. Our highest conviction BUYs are Bank of Baroda, Trent, Sadbhav Engineering and Ashoka Buildcon.
All change in India
Over the last six quarters, whilst nominal GDP growth has averaged around 10%, EPS growth for the Nifty has been non-existent. Now even revenue growth for Nifty companies has conked off. Understanding this disconnect is central to coming to terms with how the country is changing under a Prime Minister and a central bank Governor who are radical departures from their predecessors.
In one exhibit we plot the disconnect between GDP growth and Nifty EPS growth between the December 2012 and September 2015 period.
This correlation breakdown between GDP growth and earnings for the Nifty 50 companies, in our view, is a reflection that a significant portion of the economic growth pick-up is no longer being exploited by listed large cap companies. Our hypothesis is that this is because India is being fundamentally changed by an inter-play of the three dominant forces at work in the country today.
The reset engineered by PM Modi
PM Modi has engineered three resets: (i) to shift India’s savings landscape away from physical assets towards the formal financial system, (ii) to disrupt the model of crony capitalism, and to (iii) redefine India’s subsidy mechanism. These resets in turn are likely to structurally lower inflation while reducing the cost of the factors of production i.e. land, labour and capital. While a structural decline in inflation, corruption and the cost of factors of production are likely to make several businesses viable and even flourish, at the same time these are also likely to reduce barriers to entry in most sectors thus challenging the supernormal profitability of several of the larger incumbents.
Rajan’s anti-inflationary policies
The RBI governor Raghuram Rajan has, in our view, succeeded in achieving the following: (i) bringing down inflation, (ii) keeping real interest rates positive, (iii) reducing currency volatility, d) changing the rules of the game for creditors through the Strategic Debt Restructuring (SDR) regime and the draft Bankruptcy Code; and (iv) rapidly creating new payment banks and small finance banks. Whilst these steps are likely to bring down the cost of capital for borrowers on a sustainable basis, they have also resulted in greater foreign appetite for Indian corporate debt. While this is positive for borrowers in general, it is likely to pose a serious threat to competition and hence profitability of Indian lenders. Second, while SDR and the new Bankruptcy Code will simplify matters for creditors, in the short term, it could pressurise SME borrowers. Finally, the entry of 25 new banks is likely to squeeze the RoEs of existing banks.
The technological revolution
The disruption created by advances in technology coupled with easy access to low cost funding has resulted in the competitive moats around incumbent duopolists/monopolists shrinking. These disruptions may range from the relatively obvious ones (like Flipkart for brick and mortar retail and Paytm for financial intermediaries) to more complex ones like e-commerce players with access to vendors’ credit history also stepping in to provide financing to these SMEs (such as Ant Financial appears to be doing in China).