The Hindu Business Line : Profit growth: FM hopes for encore

The striking aspect of the 2006-07 Budget is the assumption of a muted growth in nominal GDP. Gross Domestic Product is the measure of economic activity that is equal to the value of annual output in goods and services. The Finance Minister, however, is hoping that buoyancy in corporate tax collections will continue. That means he expects India Inc to do well yet again.

Stock prices, too, have factored in such growth. Even as the outlook appears rosy, the need for caution cannot be over-emphasised. Rising depreciation and interest costs will pull down profit growth in the next few years. We also need to consider the consistency factor. Few companies have exhibited consistent profit growth even over the past four years.

GDP and corporate profits

At the aggregate level, growth in profits of profit-making companies have been significantly higher than GDP growth over the past four years. For instance, aggregate profit growth in 2003-04 and 2004-05 was more than twice the growth in GDP of industry. Besides, a number of small and medium sized companies grew even faster. For instance, aggregate profit growth in 2004-05 was about 20 per cent. Many small and medium companies, though, reported over 25 per cent growth. For FY 2006-07, growth in nominal GDP is modest, mainly because nobody expects agriculture to keep doing well. Growth in industry and services, however, is expected to be in double digits. So, a 10 per cent growth in value added by industry and services might translate into a 20 per cent growth in profits of listed companies in FY07, or so many market analysts expect. Again, they expect small and medium sized companies to outperform.

It may, however, be unreasonable to expect profit growth to exceed GDP growth significantly every year. After three years of rapid profit growth, companies may only keep pace with GDP as rising depreciation and interest costs will exert pressure.

Lacking consistency

In addition, corporate profit performance lacks consistency. There are 1,261 listed companies that have made profits in all the four preceding financial years. There are, however, only 111 companies that delivered profit growth of 10 per cent or more in each of the past four financial years.

There are also not many companies with a consistently high profitability. Only a third of the top 500 companies consistently generated returns on net worth of over 10 per cent in the past five years. Besides, even at the GDP level, growth in the various components of industry — manufacturing, mining and energy — have been relatively volatile. Construction has been the only bright spot. Services growth, especially financial services, too has been consistent.

Large companies that recorded steady growth in profits include Reliance Industries, Infosys Technologies, Bharat Electronics, ABB and HDFC. Medium sized companies that recorded consistent profit growth are Voltas, Goodlass Nerolac, Nagarjuna Construction, Glenmark Pharma and Subros. Similarly, among the companies that enjoyed consistently high profitability are Nestle, Automotive Axles, Swaraj Mazda, Abbott India and Marico Industries.

Low returns

The problem with companies that were consistent in terms of either profitability or profit growth is that the valuations already reflect this phenomenon. This is especially true of large-cap stocks. Most of them are trading at a PE of 25 or higher. If valuations appear reasonable, then the performance in terms of consistency in profit growth is not inspiring.

It can be argued that in the swelling tide of profits, all boats, including the leaky ones, will rise, and that investors are now paying more, not for consistency, but for the higher degree of visibility in profit growth. However, they need to suitably temper their expectations.

Analysts will tell you that the returns are bound to be low and investors will need to have a considerably long-term investment horizon even to generate such low returns. Investors should stay invested in equities and avoid shifting from debt to equity now. The right way to build exposure to equity would be to invest a small sum every month over the next few years.

Suresh Krishnamurthy

More Stories on : Insight | Stock Markets | Budget | Taking count

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page