February 2019: Stock prices are slaves of earnings

The Nifty, which is roughly composed of the 50 largest companies in India, is a closely followed market index and its performance is considered by some as a fair representation of the overall stock market performance. Since inception, in 1995, the Nifty has delivered a return of close to 14% p.a. This correlates fairly with nominal GDP growth of roughly 14% p.a., which is a combination of 7-8% real GDP growth and 6-7% inflation. As inflation has trended down over the last 4-5 years, the observed nominal GDP growth as well as stock market performance has also tended towards the 12% growth number which has a similar real GDP growth number as the past but the lower inflation has dragged the overall number also down. This can be a fair guesstimate of what is likely to happen in the future as well. This also assumes the leading companies in India would grow in line with nominal GDP of the country. Of course, things can change if GDP growth or inflation changes significantly from these levels.

Unfortunately, unlike a fixed deposit, this expected return from the equity market is not going to come in an orderly fashion. There will be negative, moderate and very strong years. We have typically seen in the Indian case that a third of the years are negative, a third are moderate and the remaining third are very strong years. Also it is fair to say that even the best of experts find it difficult to forecast these years.

Over long periods of time, stock prices are slaves of earnings per share changes. In between there are many changes – governments come and go, poor monsoons are interspaced with good ones and interest rates change in one direction or another but at the end, the stock prices of the stocks in our portfolio 10-20 years from now, will be driven by the earnings per share they report in that time period in the distant horizon.

Over a shorter time frame like 3-5 years, stock prices are driven by 2 factors – the underlying earnings growth and the valuation change, which could be upwards or downwards. The median PE Ratio (Price-to-Earnings) of the Nifty has historically ranged between 15 and 23. At present the Nifty’s PE is close to 23, which suggests that further growth in the Nifty needs to be driven more by earnings increases as there is less room on the valuations side. This comes with the caveat that margins for the Nifty are compressed compared to historical levels and this may be dragging down earnings (e.g. banks which have taken a lot of provisions).

However, as portfolio managers what matters to us are individual stocks and how their earnings are shaping up over the long term because this can vary significantly from the Nifty. As such, we spend a fair bit of time thinking about the long term earnings growth of our companies over as long a horizon as one can, with some certainty. Earnings in turn are dependent on the core profitability of the business as represented by the return on equity (RoE) and the underlying growth for the products and services of the company in question. Over years of experience, we have found that we like consistency in earnings and favour that in our investment mix. If we add to that, our maxim of trying to buy companies at a reasonable price, it adds to the probability of making a reasonable return over the long term.