Deep N Mukherjee is currently Chief Product Officer, handling product design and analytics in a Indian credit bureau. He has over 14 years of experience in Risk Management and Credit Assessment. Prior to his current role, within Fitch he was in structured finance team. Prior to his organization he was with American Express where he was heading the Institutional Risk Management Team focusing on quantitative risk management. He is also a visiting faculty in finance with IIM Calcutta. He has done his graduation in engineering from IIT, Kharagpur (BTech, 1999) and has obtained his management degree from IIM Lucknow (PGDM 2002).

At least for the last two years several analysts have been predicting a strong revival in earnings growth of Indian corporates. However the earnings growth in FY16 has been anaemic and elusive. The aggregated EBITDA earnings of BSE500 (Excluding Banks and financial Services) and also BSE200 have shown a marginal uptick in FY16 over FY15 levels. However it is not close to the fantastic growth rate of 12%-15% that has been doing the rounds for last couple of years. However most analysts usually focus on PAT. The aggregated growth rate of PAT is lower than that of EBITDA.

The more popular reasons for this uptick in earnings, in the recent past, are fall in commodity prices benefitting input costs of corporates as well as low base of previous years. However one reason that is often missed is that the market index of corporates usually have positive selection bias. To elaborate, companies which have significantly lost their market capitalisation were periodically removed from the index and their place was taken by companies with better performance. Thus if one is tracking the earnings growth(y-o-y) of any stock market index by considering the earnings of the corporates which are part of the index at that point of time, it is possible that the earnings growth may appear better. Ideally to track the earnings trend one may have to consider the same set of companies over time. One possible way may be that if one is tracking aggregated earnings growth for a five year period one may consider taking the corporate in index three years back and monitor their earnings performance. This may control for the positive selection bias in market index. It may be noted that considering the latest constituents of market index and tracking the earnings for the same companies for the past five years may not fully eliminate the positive selection bias.

A common approach, at least , in Indian markets is to take a set of companies and perform a bottom up analysis ie; expected earnings growth of each of the companies are first predicted and then rolled up to predict the aggregate earnings growth of a group of companies. Nothing per se wrong with this approach. Even in bleak economic scenarios it is possible to find a handful companies whose earnings growth will be much higher than other companies. However, the criticism of this approach of aggregate earnings growth prediction is that such approaches do not, explicitly and methodologically, consider macro-economic factors. Neglecting these macro factors while modelling the future aggregate earnings growth may be one of the reasons, why the aggregate earnings prediction has been way off the mark in most instances.

Macro-Economic Framework for Aggregate Earnings Predictions:

The anaemic earnings growth of Indian corporates may be better explained by a framework known as Kalecki Levy Profit Equation (KLPE). This possibly is the only equation, discovered way back in early 1900, which explicitly connects and explains aggregate corporate profit in terms of macro-economic variables. Unfortunately and surprisingly, most macro-economic text books as well as books on investment management do not even make passing reference to KLPE. This equation is more on the lines of an identity and has been found to have a high success rate in predicting corporate earnings across a wide variety of economies and at various points in the business cycle.

The relationship between aggregate corporate earnings and macroeconomic variables were first recognised by Jerome Levy. Levy, as the story goes, sold his stock holdings in 1929 just before the US stock market tanked. The analytical basis for his decision was provided by the above referred equation. However, credit goes to polish economist Michal Kalecki, who in 1930s, independently rediscovered the relationship. Further his explanation and derivation of the identity contributed significantly to broaden the appeal and usage of the equation.

 KLPE is expressed as follows:

Aggregate Corporate Profits (in an economy) equals(=) Investment less Foreign Savings less Household Savings less Government Savings add Dividends add Corporate profit tax. So as per KLPE the aggregate Corporate Profits will increase as economy-wise Investment (in real assets) increases; similarly if more Foreign Savings come into the economy in the form of spend (export income) or foreign investment it increases corporate profits. If households start saving more, which is consume less, it will drag corporate profits. Less intuitive may be the aspect that increase in government savings (i.e.; reduction of government’s fiscal deficit) adversely affects corporate profits, which is to say what is good for government balance sheet may not be good for private corporate’s balance sheets. Likewise dividend and corporate taxes of the equation may appear counter-intuitive at first glance. So let’s take a look at KLPE in more details.

The Ground Rules:

Let’s start with a simplistic economy with just two sectors, businesses and households. Businesses supply goods and services which are purchased by households and other businesses. Households provide labour to business and earn wages. Households are also consumers and help businesses generate revenues and earn profit. In this hypothetical closed economy, the total income of the business (corporate profit) and the household (wage) is equal to the total expense of the business (investment) and the expenses of household (consumption). So, Corporate Profit + household wage = Corporate Investment + Household Consumption. Acknowledging that for the household sector, wage net of consumption is household savings, the above equation becomes: Corporate Profit = Corporate Investment + Household Consumption – Household Wage. So Corporate Profit = Corporate Investment – Household Savings. If the economy-wide, businesses do not invest in physical asset creation, the investment’s contribution to aggregate corporate profit is zero. In such a situation, even if households spend their entire wages on consumption, there is zero household saving and, thus, incremental profit still remains zero.

How Investment gives ‘Birth’ to Profit:

Investment leads to creation of physical assets which did not exist previously. When a firm buys an asset, in the year of purchase there is hardly any revenue expense for the buyer. In the process of buying, one form of asset (cash) gets converted to another (plant and machinery). Subsequent to purchase, expense arises as depreciation attributable to the economic aspect of the asset’s value erosion, owing to wear and tear. For the firm selling the asset the selling price includes the profit for the seller firm. The investment transaction between the buyer firm and the seller firm not only created investment but also ‘gave birth to’ profit in the economy, which otherwise would not have been there during that period. The bumper profits enjoyed by the Indian corporate sector during the period FY05 to H1FY09 were driven mostly by investments created in the economy.

Currently the investment growth in India is quite discouraging on the private corporate side and most investment in the economy is driven by government. However, historically private investment has been the bulk of the investment in India. Given this, the current investment level is unlikely to give a boost to aggregate corporate profit.

The Karma of Corporate Short-Term Decisions:

Corporate actions that may be driving short­term profitability of one firm, if adopted by all firms in the economy may be detrimental to the overall profitability of the corporate sector. For example a firm may decide to boost its profits by reducing wage outflow and/or raw material consumption. This very ‘reasonable decision’ if replicated by all firms in the economy, would start restricting profitability possibly more and for a longer period of time than the short term benefit of cost savings. This is because as overall wages in the economy is constrained, consumption will fall, corporate revenue growth will be muted, systemic capacity utilisation starts signalling overcapacity, thereby slowing capital investment in the economy. Similarly, raw material suppliers are themselves firms. If their users reduce raw material purchase, then the revenue of raw material suppliers will fall. Thus a vicious downward cycle of overall low corporate revenue growth and constrained profitability arises because of an otherwise ‘sensible’ (from a micro perspective) decision of cutting cost at a firm level.

For the business sector, the aggregate profit net of corporate profit tax and dividend of all corporates is a measure of corporate savings. Given that savings are the accumulation of wealth, corporate savings represent the corporate sector’s ownership on incremental wealth created in the economy during that period. Thus at a firm level, distributing dividend or paying taxes tends to reduce the wealth of the firm.

But if one broadens the argument to an economy-wide level, then the aggregate dividend paid by all firms in the economy will provide more spending power to their shareholders. These shareholders would then be able to spend more on goods and services. This will add to the revenue of the business segment within the economy.

Similarly, higher corporate tax outflow may be detrimental to a specific firm in that time period, but it will provide more spending power to the government, which may then be used for capital expenditure and other consumption related spending. Of course a government can always create money to spend in the economy. If the government does spend, then this would benefit the overall revenue and profitability of the business sector.

The Household Decision and Corporate Profit:

In the current scenario in India where corporate, particularly private corporate investment is somewhat muted, what may possibly boost corporate profit? One of the drivers of corporate profitability can be household dissaving’s. Which is if households start spending their past savings or taking a step further if households borrow to pay for their consumption. Thus if abundant and cheap credit is made available to households who then spend it, it would give a boost to corporate profitability. Moderation of consumer inflation may also provide higher consumer surplus. Thus households may be better placed to drive corporate profitability. However since the size of that spend is much limited compared to investment size (as has been the case in the past) it may not push up the corporate profit growth by a large extent.

Lowering Fiscal Deficit limits Corporate Profits:

Government spending in the economy — be it for the creation of public utilities or even direct transfers to the households — ultimately creates revenues and aids profitability. However, at a time when the other big driver of corporate profit, i.e., investment is struggling, the check in fiscal deficit may further aggravate the corporate earnings pressure. The boost in aggregate corporate profitability during FY10­FY11 owes a lot to the spike in government spending in H2FY09 in response to the global financial crisis. Of course the government’s fiscal deficit rose sharply around that time but what were the other choices post the Lehman Shock?

Current Account Surplus Boosts Profits:

Current Account Deficit (CAD) is technically foreign dis-savings. When payments to foreign participants in a domestic economy exceed the receipts from them, then there is a net outward transfer of wealth from domestic economy. This transfer of wealth drags down economy wide profitability. In case of Current Account Surplus just the opposite happens. It may be noted that reduction of CAD as is the case currently in India creates a base for revival of corporate profit growth.

What Does KLPE Tells About Future Corporate Profitability of India:

If savings/surpluses of sectors such as household, government, foreign investors/trade partners are not circulated back to the economy for consumption or real assets creation, the aggregate corporate profitability will be dragged lower. Economic uncertainty may discourage household from spending and persuade them to put money in savings deposit. Likewise banks struggling with corporate NPA may adopt a very conservative approach to lending. One will limit consumption the other will limit investment and creation of real asset. Both these feed into systemic low capacity utilisation which reduces corporate appetite for investment. The vicious cycle in private sector has potential to limit profitability/ growth for next two-three years. Government spending may have saved the situation in the medium term that would have caused government’s fiscal deficit to rise. While fiscal discipline has long term benefits it does not help the corporate profitability in the short to medium term. What may significantly save the day is heavy duty transfer of foreign savings in India in the form of Investment. But that may not be easy, given the global uncertainty and the ensuing reduced risk appetite for emerging market investments such as India.

Thus unless government spends heavily on the economy and households too spend, the aggregate corporate profit growth of India may continue to remain lukewarm. The profit growth is less likely to fall to FY13 and FY14 levels given some spending by government on Seventh Pay Commission, but believing that alone and an improving CAD situation will boost corporate profit in next two years is possibly a bit optimistic.

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