Mar 2013 : Earnings trailing revenue growth

Equity markets were mostly weak during the month, with the Nifty down 0.2%, on the back of weak market conditions in key emerging markets, and fresh concerns about the potential slowdown in government policy due to political instability. Our portfolios broadly tracked the Nifty. For the financial year ending March 2013, the Nifty was up 7.3%. Our portfolios on the whole were close to the market. Over the past 5 years, the Nifty has seen an annual performance of 3.7% per annum, whereas our portfolios have seen an annual rate of return close to 12.7% per annum. With nil tax on dividends and long term capital gains, the post tax returns on the portfolios is not too different from 12.7%, as most of the gains we have been booking have been long term in nature, unlike debt instruments.
The last 5 years have been one of the tougher periods for equity markets – this period is somewhat comparable to the phase between 1998 – 2002, when the aggregate Sensex company earnings grew 0% over the period. As the markets turned, earnings were up 34% in 2003. This time around, earnings have grown a better 8.6% over the last 5 years, and the Sensex earnings growth between Dec 2011 and Dec 2012 is actually a pretty decent 18%. Even the 8.6% growth trails the long term average of 14%, thus setting us up for some potential regression to the mean over the next 5 years. It is a matter of time before corporate India’s earnings growth catches up with long term averages.
For our portfolio companies, we try and select companies which have a consistent track record of having done well through different market conditions. The top 10 portfolio companies grew their revenues, on the average, at 19.2% per annum over the past 5 years, whereas their earnings growth on the average was only about 12.7%. Note that the earnings growth has been much better than market averages, but even these companies saw their earnings growth trail revenue growth, as margins got compressed below historical levels. Regression to the mean for revenue growth and margins can potentially accelerate earnings growth for these companies, going forward. Five years after an economic slowdown starts, it is often difficult to imagine the catalyst which will drive growth going forward, but history tells us that this usually does happen eventually.
Revenue growth and earnings growth quality alone does not define the attractiveness of the portfolio. Finally, it is all about what price one pays for these stocks. Markets over the past 5 years have become cheaper. The average market PE has come down from a 28x PE, in 2008, to current levels of close to 15x, which is close to median values at the bottom historically. Valuation of companies is an imprecise science and it is difficult to reach definitive conclusions. Based on our best judgement, our portfolio companies are trading, on the average, well below their intrinsic values. The weakness over the past few weeks has expanded the discount to intrinsic value. We have also deployed all our personal investments in exactly the same strategy as our portfolios, and we feel very comfortable with our holdings at this point of time.