Nothing can be too taxing


Director, Banyan Tree Advisors

December 20, 2011

HAVING TAKEN up investing as a career, I often meet great investors so that I may pick up some nuggets of wisdom to make me a better investor. Why reinvent the wheel?

I met one such investing guru some five years ago. You could call him an investor or a market operator, and you would get a big yes from numerous individuals from two completely different quarters. When I finally managed to meet him, I asked him the standard question, ‘How do you choose companies to invest?’. Which I presume is reasonable – after all, the biggest part of investing is choosing the right companies to buy. His answer surprised me: “The company should be paying taxes’. I have to admit I was a bit disappointed, a bit like the guy who climbs the Himalayas to ask a rishi the secret of happiness, only to hear something like ‘Sleep well’. (I was later told that this investor was one of the highest individual taxpayers in India.)

The best performers pay taxes…As with all great truths, it was only later that this one’s import sunk in. Some of the best investments of the past decade — Hindustan Lever, Hero Honda, Castrol — all pay taxes at higher rates than their respective sector’s average. Look at lists of the best-performing stocks over any 5-year period, and you will find them packed with companies that have a high tax outgo. (Infosys and Wipro are of course exceptions to the rule, as their export incomes do not attract tax — but that advantage is to go away over the next five years.)This criterion for great stock picks is quite simple in essence: as long as a company is paying taxes, you can be certain it is making profits. (Though there are exceptions — we have all heard of companies that doctor their numbers to show profits on their books, usually just before they want to raise money through public issues. With all due regards to auditors, this seems common.)

…skimping on taxes hits valuations

One corollary of that principle is that relative valuations of companies are directly proportional to their tax outgo. For instance, take the PER (price to earnings ratio), a simple and at the same time a reasonably good measure of valuation. One qualification: the PER criterion is useful only when a company is operating at its optimal level of profitability. The best way to ascertain this is to check if the return on equity (RoE) is consistent with its historic levels.

As a general rule, companies paying high taxes consistently get high valuations on the bourses. On the other hand, companies that have a low rate of taxation get a low PER. Take Zodiac Clothing – the stock has a great record of RoE and profit growth, but its tax outgo has always been below 6 per cent of pre-tax profits. Investor are evidently rather  skeptical of such companies; why else is the company’s PER stuck between 4 and 6?

The right PERStock prices are a reflection of the market’s perception of their companies’ earning potential. Many companies can at times delay paying taxes by either setting up new capacities or making use of tax sops. But ultimately, taxes are inevitable. Moreover, companies that pay taxes seem to command similar valuations to companies that make higher profits but pay no taxes. Some examples of such companies are Marico, Dabur and Nirma, which pay taxes of less than 20 per cent of pre-tax profits, despite being consumer product companies. Their MNC counterparts (such as Colgate and HLL), on the other hand, pay considerably higher taxes.

This may well be a result of some smart tax-planning, but the market does not seem impressed – take a look at their valuations. Evidently, the markets value them on a peer-to-peer basis at the pre-tax levels. Still not convinced? Check out the tax rates of the dogs in your portfolio.