On the occasion of the release of the 24th Wealth Creation study, which places Reliance Industries, HDFC Bank and TCS amongst top three wealth creators during 2014-2019, Raamdeo Agrawal, chairman, Motilal Oswal Financial Services says that it may take at least six months for the economy to recover. In an interview with Vishal Chhabria, he says that the recent rise in inflation is temporary and believes that it is a matter of time that consumption will pick up. Edited excerpts:
What is the key takeaway from your latest wealth creation study?
In equity investing, management is 90 per cent, industry 9 per cent and rest is 1 per cent. So, this time the subject is ‘integrity of management’ and the creative accounting they do. Books are nothing but a management’s communication to the people at large. If their integrity is in doubt, then the doubt is visible in the communication– through profit & loss and balance sheet. There's only one way of writing correct accounts, and a million ways of manipulating them. Trying to figure out all the tricks of manipulation is impossible, but trying to figure out the right way is possible. In this study, we have attempted to look at the interplay of cash and accrual.
Company managements have the power to accrue sales even as payment has not been received for 60 days, but in case of cash the same is not possible. Such transactions can be spotted by looking at cash flow statement.
There are four types of accounting—conservative, neutral, aggressive and fraudulent. There are a lot of companies that do conservative accounting, Indian as well as multinational, but there are many more that follow aggressive practises. Markets probably know to some extent, but it is not easy for investors to gauge management integrity. They need to see the details in P&L, balance sheet and cash flow statements to gauge the accounting a company follows.
Companies tend to inflate profits as it helps boost market value manifolds, leading to better ranking, higher promoter networth, possibility of issuing shares at higher value, etc. But, when they do so to sustain higher growth, they have to do it every year to keep the number going higher. In the process, it becomes difficult to get off the tigers back, as you cannot keep fudging the accounts forever. And a time comes when they collapse. That’s why many companies fall from being Hero to Zero; this year has been a record, and lot of them have manipulated accounts.
In investing, it is important to get a management with integrity and competence. Talking to its customers, employees, suppliers, competitors, etc will give an indication.
In the study, all the top 10 wealth creators have seen a faster growth in market value than in earnings?
This is the character of the market and economy right now. There are very few companies with true earnings growth, and there's so much money chasing the same companies, which is why re-rating is a bigger portion of wealth creation than earnings growth.
What is your view on markets, have they peaked out?
Indications suggest that markets have peaked out. Four times in the Indian history, in 1992, 2000, 2007 and now, markets are at 25 times price-earnings. The only flip side argument is that markets are expecting corporates to deliver the expected earnings over the next 6-12 months. But, this hope rally is going on for some time. I think, significant rise from here is not going to happen till earnings come.
Do you expect the rally to spread to the mid-caps?
Looks very unlikely till the economy turns around. In tough times only good and large companies do well; they have ready customers, high bargaining power, etc. Top customers stay with large companies during bad times. Smaller, mid-sized companies in the same field struggle a lot more than large companies. The reverse is also true when the economy turns around. The question is, how far is the economic recovery? My sense is another six months.
With macro indicators weakening and now that we have inflation rising, how will this reflect on corporate earnings?
Higher inflation is somewhat temporary, and not structural in nature. Once the winter crops come, it will lead to lower inflation, unless some other events occur -- like a spike in commodity or oil prices or if the US and China settle their trade issues, it can lead to a sentiment driven rally.
Otherwise, the reforms or changes the RBI and government are doing, that should start reflecting. Also, how far can you delay buying your car or changing house furniture or clothes, etc. It is a matter of time that people will open up their purse, which usually takes one to 1.5 years. Unless there are more major blow-ups or events as we have seen in recent past, things should start looking up.
Any particular themes, sectors or stocks you expect to play out in 2020?
If the economy recovers very vigorously, there will be sector churn. The cyclicals and commodities and nearly dead sectors like real estate, PSU banks and telecom, can surprise us. If the economy doesn’t turn around as expected, the ones which are doing well will continue to do so. In fact, the weak or ones not doing well will see further selling pressure.
Any downside risks to markets?
If earnings disappoint for one or two quarters, then markets can correct very sharply, which doesn’t seem to be the case as of now. Currently, things look to be in place. However, valuations are the top, and a correction isn’t ruled out.
Any other interesting aspect you would like to mention about the wealth creation study?
The best guys to help minority shareholders to get good accounts are auditors. Auditors should be made accountable to minority shareholders. For instance, there can be a question & answer session before or after the AGM, before the accounts are passed, to address the minority shareholders. Auditor is the entity scrutinising the books, and giving a certificate that the accounts are true and fair. I'll be very surprised that the auditor would not know the condition of the company’s books.
Since auditors check the accounts, they are in know of things. So, when you make them responsible for answering those qualifications or badly drafted accounts, shareholders will benefit. In good times, things are usually good. But, auditors should become useful in bad times at least. They are the inspectors for the shareholders.
We haven’t seen many auditors saying that the books are clean and hence, they are resigning. Even if they might be resigning, they never say that books are bad. It is only after many months that one comes to know that the books are cooked. I think the cosy co-relation between the majority owner and auditor must be broken, by making auditors accountable to minority shareholders to avoid sharp practices by the management.
Secondly, the reconciliation of profit & loss and cash flow must be explained by the management. And there is no extra cost to this.
As there is a saying, “There is only one way of writing honest accounts and infinite ways of manipulating them.” So, the auditors must help.