Were Indian Corporates faking earnings?

Banks, Real Estate, Engineering, Capital Goods and Commodity producers seem to have faked up their earnings through fx and ipo punting & some creative accounting of hedging transactions. The last budget of Chidambaram confirms that, "The capital markets seem to have fallen off the government's agenda. "

The Indian equity markets have just completed their worst quarter since 1992, with the broad indices down about 28% in dollar terms and selected mid-caps down between 35 and 40%. Shell-shocked investors are obviously wondering what happened. Wasn't the credit crisis centred in the US? Isn't India supposed to be isolated from the financial system woes of the West? Why is India among the worst-performing markets year-to-date (YTD), and why are we dramatically underperforming other emerging markets?

Investor sentiment in India has turned extremely cautious, and outstanding open interest in the F&O markets is down about 65%. FIIs have sold about $3 billion YTD, and even local flows into mutual funds and insurance ULIPs have slowed down. There is a general sense of unease and nervousness and I know of very few people who are willing to commit fresh capital. The market, once seen as expensive, trading at over 20 times forward earnings, is now 15 times March '09 earnings, and, if you make a couple of adjustments for embedded value, about 12.5 times. At 12.5 times, the market is pretty much at its long-term average valuation multiple, and for a near 20% RoE, not outlandish. Yet nobody has the confidence to buy today.

Just three months back we were invincible, growing at 8-9%, insulated from the US and full of confidence. But all this confidence has now evaporated.

To understand the markets' poor performance, one can point to the obvious factors of global risk aversion and de-leveraging across all markets and asset classes. India had also had a dream run over the past few years and was thus seen as expensive, over-owned and a good source of profit. We also have an economy which is clearly slowing, though still likely to grow at between 7 and 7.5% in 2008-09, and in tune with most other emerging economies we have a growing inflation problem. The above issues are well-known and pretty much common across most large emerging markets.

I think India has lost out in two areas -- first, the transparency and predictability of corporate earnings, and, second, government action.

One has to accept that the Indian corporate sector has hardly covered itself with glory in terms of disclosures and transparency over the past few months. We now have evidence of banks punting the IPO markets and showing it as normal earnings, numerous companies punting FX markets and now trying to pretend they were mis-sold these exotic derivative structures as the trades go bad, respected companies booking commodity losses, etc. There is a general sense of mistrust around company earnings, especially for the banks, and the more aggressive mid-caps and most investors are braced for March 31, 2008, balance sheets and whatever surprises may be in store there.

We have also seen many of the investor favourites (in the capital goods and power sectors, particularly) disappoint on execution and margins. Despite having solid order backlogs and supposed earnings visibility, these companies have not been able to deliver on very high investor expectations. In every sector, investors can now find reasons as to why earnings will disappoint. For consumer-facing sectors, the high and expected rising interest rate environment will dampen demand.   For manufacturers, rising input prices will crush margins, for exporters the rupee is a huge problem. For commodity producers, the government seems determined to kill their pricing power and anyone with capital markets exposure is toast.   Anyone in need of raising fresh capital like the real estate boys is perceived to have little chance of either raising the money or making their numbers. Banks are faced with slowing loan growth and rising NPAs. Investors also now fret about negative operating leverage as growth slows.

I have never seen analysts or investors more uncertain on earnings than they are today. It is also an amazing turnaround, for just a few months ago conventional wisdom was confidently discounting 15-20% earnings growth as certain. Today suddenly all earnings numbers are in doubt, either due to margin or execution challenges. Investors are not used to downgrading earnings in India, and the past high valuations have been justified on the sustainability of earnings.

An expensive market where earnings come into question is bound to derate, and that has been India's fate as well. Expectations were too high and are now coming in. We are not seeing new buying at seemingly attractive levels as investors are still not clear as to the likely earnings trajectory in 2008-09. Investors hate uncertainty, and till we get more visibility on earnings, don't expect strong inflows.

A second issue in India has been the response of the government. Starting from the farm loan waiver to perceived government interference in all types of pricing, investors are worried about an increased penchant of the government to resort to price caps, export bans and moral suasion to control prices or compromise industry economics. How can you give full value to a company that is unable to maximise returns for its shareholders in good times, but has to bear the losses of the bad times?   The government has also shown a willingness to use PSUs to support its social agenda, a case in point being the refining and marketing companies. Nobody questions the necessity of having petroleum subsidies, only as to why publicly listed companies should bear the burden and not the government budget. To many, the government has lurched back into a command economy mindset, when dealing with the recent inflation spike and government action has increased earnings uncertainty.

Even in the Budget, instead of recognising the critical role the capital markets need to play to fund India's aggressive infrastructure and capacity build, we had a hike in the capital gains tax and changes in the securities transaction tax, which have seriously damaged trading volumes and sentiment. The capital markets seem to have fallen off the government's agenda.

Combine all of the above with an election year, public comments of a willingness to sacrifice growth to control inflation and one can see why investors currently lack confidence in India.

I don't think all is lost, the current earnings woes are temporary and visibility will improve. Pressure on the government to show action is also at its most intense today, and hopefully economics will once again take centre stage. Investors will return, but we need some more time to consolidate.