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Behind all the smoke and noise on the market’s surface, it’s important to remember that companies – small, medium, and large – make up the market’s backbone. And corporate earnings drive stock prices.” — Peter Lynch
In the long-term, profits earned, and value created by a business are directly correlated. The near-term picture is generally very noisy, however, if you zoom out and think about the longterm, it starts to clear.
Notwithstanding underlying complexities, answers to few simple questions:
1) What is the nature of the business (i.e., return on investments it can generate),
2) Its growth potential and
3) The ability of management sustain growth – helps determine profit potential for a business.
Sometimes markets start discounting the potential returns way in advance, sometimes it underestimates the likely growth. Over the longer period profits and return tend to converge. No one can see the long-term future clearly, but you start with a hypothesis and keep calibrating your convictions as things evolve.
Let’s look at a few examples to further explore this topic.
Sun Pharma
I started my career as a pharma analyst and have seen Sun Pharma evolve since early 1990’s. Over the past 27 years, the company has compounded profits at 24% and market capitalisation at 26%. Reported profit of Rs214m (US$7m) in FY95 have grown to Rs67.7b (US$900m) in FY21. Market capitalisation has grown from Rs3478m (US$111m) in FY95 to Rs1434b (US$19b) in FY21. Such a huge jump could not have been envisaged in 1995, however things kept evolving along this entire journey.
In the initial years when the profits earned are small, market is sceptical. Balance Sheet is small to absorb mistakes, management capability is untested and hence there is a risk of failure. As the company crosses a profit threshold, the market cap bucket also keeps changing. There are periods where profits stagnate, management will have to invest in new capabilities, geographies etc, to drive profits to the next level. During this period, stock returns also suffer.
Our key learning from this example is that while investing in small companies there is always higher risk till a minimum scale is achieved. As a rule of thumb, we think the threshold is profits of around Rs2bn. We can use the example of Sun Pharma and apply it to similar businesses on the profit – market cap continuum to envisage potential future returns.
Hindustan Unilever
Consumer staple companies like HUL generate high returns on capital and can sustain growth over long period. In general, our observation is that the corelation for such businesses between profits and returns broke post the Global Financial Crisis. Market Cap has grown faster than the profits since 2009. Given high degree of predictability, such businesses have behaved like bond proxies and falling cost of capital have driven returns much higher than profit growth. If the outlook on cost of capital were to change (assuming no change in future profit growth), can there be a period of stagnation or decline in market cap till profits catch up?
Does the framework described above apply to new age technology driven businesses? Such businesses have a potential to create new markets or disrupt existing businesses, implying a massive growth potential. The profits may not be visible for many years as they have to invest to acquire a minimum scale. These businesses are attracting best talent and can pivot with cost of capital advantage. During this phase the markets are mainly focused on revenue growth to evaluate such companies. However, sometime in future may be 10-12 years out, will the market capitalisation and profits converge?
The rise in Reliance Industries market capitalisation over the last 5 years is mainly due to its investment in new commerce has seen a stronger jump in market capitalisation in relation to profits.
Let’s turn our attention to the current market situation. Since GFC, central banks globally infused massive liquidity in the system to support growth. The liquidity infusion has resulted n rising asset prices. As we look forward, market is worried about withdrawal of liquidity and its impact on asset prices. This problem is further compounded with new wave of Covid 19 infections and its implication for growth? There is likely to be increased volatility going forward. Fear that liquidity will be withdrawn may cause sharp correction in prices for many speculative stocks where there is no potential for profits. Some stocks where markets have discounted to distant a future may also see correction/stagnation.
Macro picture for India still looks reasonable. Government has been conservative with its growth stimulus, fiscal situation and current account is under control. The corporate balance sheets are clean. There is expectation of revival in profit cycle. The key risks are: oil prices crossing US$90 or violent capital outflows due to global factors.
We strongly believe that genuine wealth can be created by staying focused on finding right businesses which are attractive on long term journey of profit and market cap continuum. After all profits and market cap are inseparable twins.