The Indian profit cycle

Indian companies have learnt their lessons from the gut-wrenching boom and bust cycle of the mid-1990s

Cafe Economics | Niranjan Rajadhyaksha

Indian companies have usually done better than the overall economy in the past 10 years. Will they continue to do so in the future as well?

The answer to this question matters a lot in these times of rising inflation and slowing growth. And it could also offer useful clues to equity investors who have been battered and bruised in the crash of 2008.
The record so far seems impressive: Every year since 1998, on average, the largest listed Indian companies have managed to increase their net profits around 11 percentage points faster than the nominal economic growth, which is measured as the gross domestic product, or GDP, at current prices. This result is based on profit data from 359 of the companies that comprise the BSE 500 stock index and for whom data going back to 1998-1999 is readily available.

What does this tell us?

To use a more contemporary word to describe the situation, it seems that companies have decoupled from the overall economy in the past decade or so. They managed to run ahead of the rest of the pack. But this is a mildly misleading conclusion, as I shall try to show later in this column, because the averages hide more than they reveal.

The stellar show by Indian companies in itself is not surprising. Indian companies have learnt their lessons from the gut-wrenching boom and bust cycle of the mid-1990s. The investment surge in the middle of the last decade of the 20th century led many companies to make expensive mistakes that were exposed when the global economy fell into trouble in 1998. New projects were launched based on overly optimistic demand forecasts, were funded with heavy doses of borrowing and were backed at a time when India was still a heavily protected economy. The subsequent pain was severe.

Since then, Indian companies have focused on getting the most of what they already have — through tighter working capital cycles, productivity drives on the shop floor and cutting debt from their balance sheets. Investments in new projects picked up again only around two years ago. This discipline paid off. So, even as sales went up and down, profit growth continued to be healthy.

That sort of explains the apparent decoupling of profits from the rest of the economy.

Going by the average difference between net profit growth and nominal GDP growth — of around 11 percentage points — it would seem that Indian companies are well placed to weather the coming slowdown. Here’s a quick back-of-the-envelope calculation. The Indian economy could grow at around 15% in nominal terms this year, with real GDP growth at 7.5% and inflation at 7.5%. If companies can outgrow this rate by the average 11 percentage points, then net profits of the largest listed companies could grow at around 26%. That would make the stock market — which trades at a forward price-earnings multiple of 13 — seem completely undervalued.

But the picture is actually far more complicated than the raw averages suggest. In fact, there is only a weak correlation (a correlation coefficient of 0.54, in case you are interested in such stuff) between net profit growth and nominal GDP growth since 1998-99. What’s more, the difference between the two fluctuates wildly. The standard deviation of the data is a hefty 11.23.

There have been years when company profits have grown several times more than nominal GDP growth; there have been years when the two have more or less marched in step with each other; and there has been one year when companies could not increase their net profits faster than the overall economy.

Here are a few random examples. In 2003-04, net profits of the 359 sample companies grew by 43.32%, while the economy grew at 12.5% at current prices. In 2002-03, profit growth of 10.62% was slightly more than nominal economic growth of 7.9%. And in 1999-2000, profits grew 1 percentage point slower than the underlying economy. What will happen over the next few years?

It is too early to say for sure. But I think that the days when companies could collectively increase their profits far faster than the growth in the economy in which they operate are over. There should usually be a far higher correlation between corporate performance and economic performance. We may even see a few years of underperformance very soon — which is not unusual — as the excesses of a boom are revealed.

There will be individual cases of exceptional companies that will beat the slowdown. But equity investors would be foolish to believe that Indian companies can keep increasing their profits at a rate that is far in excess of the country’s nominal GDP growth rate.

The past, as we all know, is not a perfect predictor of the future. The past 10 years have shown Indian companies at their productive best. But the next few years may be less impressive.