There has been a flurry of new articles in the recent past addressing the issue of distress in the Indian economy. Several respectable organizations including the World Bank, IMF, or multi-national research houses have painted a grim picture on India’s growth, giving a low single digit estimate for 2020. Understandably investors are worried and we’re getting a lot of queries on the correct course of action. Surely it doesn’t make sense to add or maybe even hold onto money in equity given the morbid outlook on India’s growth?

In times like these it makes sense to go back to the basics and objectively analyze what we know before we let our emotions take over our decision making. It is generally believed that strong economic growth is good for stock returns and vice versa. If you ask most individuals, they will say that a poor growth outlook almost certainly means poor equity returns. Intuitively this also makes sense. However, practically, this is simply not true. The relationship between GDP and equity returns is actually a complex one and multiple studies have shown that there is no correlation (relationship) between the two. A study conducted by UTI MF compares the GDP growth vs. broader market returns for several countries for the ten year period CY 2008 to 2017 (see chart below). The most striking difference is that of China’s; despite registering a real GDP growth of 8.2% (graph shows nominal GDP growth), the Shanghai Shenzhen CSI 300 Index was down 24.50% (absolute). The study also calculates the correlation between the Sensex and Indian GDP for the period 1991 to 2018, concluding that the correlation between the two is 0.2 (a number close to 1 indicates a strong relationship, and a number closer to 0 indicates a weak relationship).

*Source: “GDP and its Relationship with Broader Markets”, UTI Mutual Fund

So what explains this divergence? Well, the underlying drivers of equity returns and economic growth are fundamentally different.

1. Equity returns in the long term are solely determined by the earnings (profit) growth of the business. To understand this phenomenon better, let’s take the example of ONGC. The Indian multinational crude and oil and gas corporation is a part of the fortune 500 and even ranked 7th among the top global energy companies. It has over 35,000 employees and has seen a consistent growth in revenue from 90,000 crores in 2008 to 432,000 crores in FY ended 2020. There is no denying that an organization of this scale makes significant contribution to the economy’s GDP. Isn’t it surprising then, that its investors have made no real wealth over the long term? In fact a faithful shareholder holding ONGC stock from 1st April, 2005 to 1st April, 2020 (15 years) would have barely made a return of 3-4% (capital gains plus dividend). Hardly a satisfactory result!

In our example above, the reason investors haven’t made any money is simply because there has been no consistent earnings (profit) growth. In fact, its EPS has grown from Rs. 14.55 in 2008 to a mere Rs. 16.85 in 2020 (with many fluctuations in between). There are several industries like telecom, aviation, PSUs, commodities, etc who grow in volume every year (more revenue, more employees, bigger balance sheets) but have not created any wealth for shareholders simply because they are unable to generate profit growth. Of course in the short term, investor expectation drives the stock price up or down (and you may even earn money from these stock’s movements provided you get the timing right). The following quote from the legendary investor Charlie Munger sheds some light on our discussion.

“Over the long term it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earn 6% on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with one hell of a result” – Charlie Munger

2. GDP on the other hand is a measure of a country’s output (it is a revenue number) determined by the formula C + I + G + (X-M), where;

a. C is Consumer spending: sum total of all private consumption or consumer spending (goods and services).

b. I is Business Investment: purchases that companies make to produce consumer goods (capital expenditures).

c. G is Government Spending: the government spending on goods and services.

d. NX is Net Exports: It shows the difference between domestic spending on foreign goods (i.e., imports) and foreign spending on domestic goods (i.e., exports). If there is a trade deficit which is the case for India, this figure would be negative.

Let’s take another example, of Tata Motors. Over 70% of its revenue comes from Jaguar Land Rover (JLR), operations of which are run from the United Kingdom. Evidently, earnings from JLR will form a large part of Tata Motor’s profits. Therefore, although JLR’s operations will not add to the Indian economy (as evident from the formula above), its profit contribution would greatly impact its share price and return. In fact investors will know that poor performance of the brand since acquisition has been one of the reasons Tata Motor’s stock returns have been subdued.

As you can see equity returns and GDP are dependent on fundamentally different drivers. GDP is a revenue figure whereas equity returns are dependent on the company’s profit growth. While one may argue that a strong economic environment is conducive for higher earnings, it is clearly not a sufficient condition. This is why despite a roaring economy, weak businesses almost certainly give investors disappointing results whereas great companies remain resilient even in the worst of times. As far as the corona virus is concerned, rationality suggests that plateauing infections, extensive global lockdowns, and controlled mortality rates may cause earnings disruption for a negligible period of time when comparing to the time horizon of an average equity investor. Therefore, since economic forecasts like the ones we’ve been reading have seemingly limited bearing on our returns in the long term, all our time is better spent on focusing on two questions.

1. How can I find identify great companies (ones that are able to grow their earnings consistently)?

2. How can I ensure they will continue to do so?

Although apparently simple questions, they are definitely not easy to answer. One may go on to the BSE website, filter for companies that have grown their earnings at an impressive rate for the last 10-15 years and invest in those (an approach that’ll still make you more money than most people). However, there are two problems associated with that;

1. Relying on accounts of Indian companies – Unfortunately even the largest listed companies in India are notorious for misreporting their numbers. In fact, the recent past will give you several examples of “respected large” companies who have been prosecuted for accounting fraud. It takes specific technical knowledge, skill, and experience to detect illegitimacy in accounting.

2. Past trends do not continue – We live in a capitalist economy and capitalism invites competition. Years of strong earnings growth in the past does not guarantee that such performance will continue. In fact history has given us several examples of great companies washed ashore by newer, more efficient competitors (50% of companies in the Nifty today will exit within the next decade). Ensuring that dominant performance due to competitive advantage will continue requires a combination of elements such as access to management, expertise in business valuation, timely information, etc.

This is why at BlueFort Financial we insist that equity exposure is taken only and only through professional management (mutual funds and PMS). Creating a resilient high performing portfolio is both a science and an art. And expecting to beat fund managers with access to vast resources is often wishful thinking. We have identified 7 such fund managers through an extensive combination of quantitative and qualitative processes. These fund managers have proven to be wizards in their stock selecting capability and rewarded their investors with consistent benchmark beating returns. Our advice would be that you ignore the noise and focus on what really drives your portfolio’s return (clearly not the GDP or corona virus). Macro economic forecasts are subjective, often fickle and subject to frequent change. While others panic and let emotions take over, I would urge that you sit down and analyze in a rational and data backed manner. There are a multitude of opportunities in equity even in what seems like a very morbid time. I will conclude with an overused yet relevant quote.

“Be fearful when others are greedy. Be greedy when others are fearful” – Warren Buffett

Siddhanth Jain | Partner

BlueFort Financial