December 2016: Regression to the mean to lead to long term earnings growth

The Nifty has been subdued for the second consecutive calendar year, up 3.0% in 2016, after recording a negative 4.1% in 2015. In effect, the total return on the Nifty has been zero over 2 years. Over the past decade, since 31 Dec 2006, the Nifty is up from 3966 to the current level of 8186, a CAGR of 7.5% pa (8.8% pa including dividends). This is way below the historical norm of 14-15% recorded over a longer history. Market returns tend to be lumpy. Over the last decade, the Nifty was negative for 3 years and had sub-par returns for 2 years. Returns in the remaining 5 years were exceptionally good.

Over the last decade, nominal GDP has grown at 14.3% pa. This is a combination of real GDP growth of 7.5% pa and the balance is due to price increases. On the other hand, earnings growth for the Nifty companies has averaged only 7.1% pa over the last decade. This can be partially explained by the fact that Nifty companies witnessed very strong earnings growth in the 2003 – 2006 period, when margins expanded well beyond historical average margins – margins have compressed since then. The Return on equity (RoE) for the Nifty was 24.6% in 2006 – this is down to 14.6% in the current year. The last two years have also been difficult for several large companies due to falling commodity prices as also the PSU banks who have seen earnings declines. Regression to the mean is a strong force in financial markets whereby aberrations from long term averages usually get corrected over time. We therefore expect the Nifty average RoE to trend upwards over the next decade and this should translate to higher earnings growth for the Nifty over the next decade.

Though the Nifty has averaged about 7.5% pa over the last decade, our portfolio returns have been higher at about 16% pa. We believe that this maybe because of a better selection of stable companies and the fact that our discipline allowed us to buy these companies at sensible prices. Though earnings growth for some of these companies may have been slower in the recent past, partly due to lower pricing power, the long run growth potential looks attractive.

In 2000, India was the 13th largest economy in the world, at $ 476 billion, – since then GDP has steadily grown to $ 2.1 trillion in 2016. Over this period India’s GDP has become larger than several countries like South Korea, Spain, Brazil, Russia, Italy, Mexico, Canada and more recently UK (though there is a large currency impact in this, due to the fall in value of GBP, post the Brexit referendum). Prospects for the Indian economy over the next decade look good with the economy expected to reach $ 4.7 trillion by 2025 as per a McKinsey study. This implies a dollar GDP growth of 9.2% which is about 1% higher than the 8.1% dollar GDP growth witnessed over the last decade. Events like demonetization may cause some delays, but long term prospects continue to look good. At the crux of the potential for growth is a favourable demographic profile, high savings rate and the under penetrated nature of the economy vis-à-vis comparable Asian economies like Indonesia, Malaysia and Thailand. While it is difficult to predict when the economic growth momentum will pick up, regression to the mean suggests that it is more a question of when rather than if. Our portfolio companies should also benefit in line with historical trends. Given the current market uncertainty the next few quarters should be a good period to build out a portfolio of companies which can benefit as the economy grows.