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Anoop Bhaskar, head of equities at IDFC Mutual Fund, expects robust growth in corporate profits as nominal GDP accelerates and continued strength in cyclical stocks and sectors. But he also worries about valuations standing two standard deviations above normal. Edited excerpts from his interview with Mint:

You have a very interesting chart on how profit after tax (PAT) as a percentage of gross domestic product (GDP) dropped from 4.9% in March 2008 to just 2.3% in March 2020, before bouncing back a little to 3.1% in March 2021. The chart goes on to say that even with this bounce, PAT to GDP won’t be significantly more than the historical average, in effect leaving room for growth. Could you elaborate?

Corporate profits to GDP shot up in FY21 because GDP growth contracted. We won’t see that kind of jump going forward, but you will see steady growth. Whenever nominal GDP growth is increasing and it crosses 10%, corporate earnings growth is faster. It’s not that nominal GDP has to be double digit. Rather, the GDP growth graph has to be turning upwards. In the next three-four years, we think that we will see a repeat of 2002-10 when you had a nominal GDP graph rising and hence profit growth rising faster. Over the next two-three years, if we have 5-6% inflation and 6-7% real GDP growth, we will have nominal GDP growth of 13-15%; this should boost earnings growth after a tepid growth rate between 2011 and 2020.

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According to your report, profit recovery over the past year has been driven largely by corporate banks, commodity (metals), and oil and gas companies. But with some factors propelling this, such as low rates or oil prices going into reverse, will this recovery sustain?

In terms of corporate banks, banks in the PSU segment have around 50% of their pre-provisioning operating profit going into provisioning, which leaves a lot less money for shareholders. Even for banks such as ICICI, it was higher at over 35%. Their own internal guideline says that provisioning should not cross 25% of operating profit. But consider this, even if operating profit stays the same and provisioning falls from 40% to 25%, you would still get net profit growth, plus corporate tax rates have reduced from 33+% to 25%. The hypothesis is that most PSU banks from 2018 to 2021 have not lent much money to corporates. They have not gone out to get new corporate customers. Plus, the capex cycle was not visible in the last three-four years. This time, they have got more than 3 trillion as additional capital from the government to write off bad loans incurred in 2015-19. The credit cost of corporate banks has gone down in FY21 and we don’t expect it jumping up in the FY21-23 phase as well. Even if there is marginal loan growth, lower provisioning will drive profitability. We are not forecasting a number for loan growth that goes to 10-12% or 14-15%.

Now, turn to oil and gas. If crude oil stays in the $60-80 per barrel range, profitability will not swing greatly as it did in FY20 and FY21. In the case of metals, due to the deleveraging in FY21 and the first half of FY22, interest cost has gone down massively. More than 50% of Ebitda (earnings before interest, tax, depreciation and amortization) was going towards interest cost, which should drop to 25%. So, even if sales don’t grow spectacularly, the overall profit pool of the metal sector will be positive and higher compared with losses between FY11 and FY20, when these companies failed to make profits consistently.

The two-year forward price-to-earnings (PE) ratio of the Nifty is two standard deviations above normal. It is the same for small-caps. As per your presentation, historically Nifty returns from these levels over the next 12 months have been -3.2%. Isn’t that a reason to exit the market?

That is the single biggest risk to the equity markets in India as well as globally. You can justify it by saying we are at a historical low in terms of bond yields. While this can justify some bit of today’s valuation levels, these valuations overall are a recipe for underperformance because they will go back to normal. You can have earnings growth, but you can also have a derating in PE, which can neutralize earnings growth. This is something that has not happened in the last 10 years, so people believe it will never happen. That’s why high-quality growth companies continue to trade at high valuations. They keep showing 12-13% earnings growth, but never get derated. But this is the biggest risk factor in the market.

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