Economic growth has long-term trends. In the 1950s, 60s and 70s the average annual economic growth in India was a paltry 3.5 percent a year- the so-called ‘Hindu Growth Rate.’ In the 80s, the growth rate improved to 5.6 percent. After the liberalization initiated in 1991, growth rate moved to a higher trajectory. During the 26-year period 1992-93 to 2017-18 India’s GDP grew at a rate of 6.7 percent a year on average, making India the second fastest growing economy in the world during that period.
Normally, corporate profit growth follows the nominal GDP growth trends. If GDP growth rate is 7 percent and inflation is 5 percent, nominal GDP growth rate would be 12 percent. The trend of corporate earnings normally tracks nominal GDP growth. Of course, there are periods when corporate profitability ebbs and flows; but the long-term trend is in tune with the nominal GDP growth. But the last decade, 2008-2018, tells a different story.
2008-2018: The GDP growth – Earnings growth disconnect
Research by BS shows revealing data on the GDP growth – Earnings growth disconnect. During the decade 2008-2018, nominal GDP grew at a rate of 12.9 percent. But, surprisingly, corporate earnings (net profit of listed companies) grew only by a low 4.1 percent. In absolute terms, nominal GDP grew 236 percent from Rs 50 trillion to Rs 167 trillion. But corporate earnings grew only 50 percent from Rs 2.6 trillion to Rs 3.9 trillion. Since the market cap of listed companies grew by 11 percent CAGR during this period of low of corporate earnings, the valuations expanded.
Revenue growth also lagged nominal GDP growth with a growth rate of 10.8 percent. In absolute terms, the combined net sales grew by 179 percent from 25.2 trillion in 2008 to 70.1 trillion in 2018. Corporate revenue as a percentage of GDP fell from 50.4 to 41.8 during this period. Clearly, corporate sector growth had lost its momentum.
This mismatch between GDP growth and corporate earnings has led to a sharp fall in corporate profits to GDP ratio, which fell from the historical average of 5.6 percent to 2.3 percent presently. This is a steep fall, indeed. The 5.6 percent corporate profit to GDP is the post 1991 average, which peaked at 6 percent in 2007-08 when revenue growth was 25 percent and profit growth was 30 percent.
Why are corporate earnings tepid?
The huge loss accumulated by PSU banks is an important factor. In FY 2018 alone PSU banks accumulated losses of Rs 82000 crores. When financials are excluded, the growth rate of corporate earnings improves from 4.1 to 5.98 percent. But even this figure indicates a huge under performance in comparison with the nominal GDP growth of 12.9 percent. It is important to note that corporate’s revenue growth trailed nominal GDP growth in six out of the 10 years and profit growth trailed nominal GDP growth in eight out of the 10 years. How do we explain this disconnect?
Unprofitable mega investments
During the boom years of 2003-08 some sectors emerged as engines of growth churning out huge profits. IT, telecom, pharma and financial services grew fast and generated impressive profits during this period. Though some pockets of the financial sector are still churning out good profits, there are no such sectors pulling up the economy now. The mega investments that went into sectors like e-commerce, aviation and telecom are not generating profits. Most e-commerce companies are not profitable. The aviation industry, growing at a scorching pace (double digit passenger growth in the last four years), is accumulating losses. The telecom sector, which saw huge investment, is in the red due to high debt, expensive spectrum and price war. The massive investments that went into the steel and power sector have become NPAs crippling the banking system.
Private capex constrained
Private capex is a function of profitability. If profits are attractive, capex happens. Tepid profits on one side, and mounting losses on infra projects like steel and power on the other, turned the investment scenario unprofitable. In India, reinvested profits have been a major contributor to Gross Domestic Capital Formation. Poor profitability impacted capital formation. Also, excess capacity in many industries constrained investment.
Poor private investment is an important factor constraining economic growth. There are four pillars to growth explained by the simple macro equation GDP = C+I+G+(x-m) where, C is Consumption, I is Investment (private), G is Government expenditure and x-m is net exports. Of these four drivers of growth, private investment has been the weakest. Government has been doing most of the heavy lifting through public investment. If GDP growth is to pick up smartly, private capex has to resume in a big way. This needs improvement in capacity utilization and corporate profitability.
If winter comes can spring be far behind?
The long 10-year period of low profitability, coupled with financialization of savings and increasing flow of funds into equity, pushed stock valuations high. There is no room for further expansion of the PE multiple. In brief, earnings will have to drive up market, going forward. Fortunately, there are signs of that trend. Capacity utilization in manufacturing has improved and this can lead to pick up in private capex. The Q2 results of capital goods majors like L&T, Siemens, ABB and Cummins indicate smart pick up in order inflows indicating revival of capex. The huge losses of the PSU Banks are likely to turn to profits for the FY 2019-20 making a big difference to profit growth and Nifty earnings growth in FY20. By May 2019 we will have a new government at the Centre, which hopefully, will accelerate the much-needed reforms. Business Standard described the long period of tepid profits for the corporate sector as “India Inc’s long winter.” It might take a few months more, but there are signs that this winter is going to end. As poet Shelly famously wrote, “If winter comes, can spring be far behind?”