Sustaining rapid growth

Our analysis of the performance of a large sample of 1,700 Indian companies, representing about 75 per cent of the market capitalisation of the Bombay Stock Exchange, reinforces the very positive macro-economic news from 2006-07. Incomes (sales revenue and other) grew by over 27 per cent for the sample as a whole, the highest rate of growth in the five-year period 2002-07 and significantly higher than the previous year's growth rate of about 20 per cent. Operating profits (EBDITA) grew by almost 40 per cent, compared with 11 per cent in the previous year. This was despite material and manpower costs increasing by over 27 per cent. And net profits grew by 47 per cent, compared with a measly 14 per cent growth in the previous year and second only to the 53 per cent achieved in 2003-04. The one dark spot on this very impressive performance is the relative decline during the fourth quarter of the year, but that was not enough to offset the achievements of the previous three quarters.

There are some fundamental issues arising from this performance, which relate to sustainability over the longer term. One set of issues pertains to the sources of this growth. Clearly, productivity is a significant contributor, reflected in the wide gap between income growth and profit growth; but it is not the only driver. The corporate sector has been making huge investments in capacity over the past four years, a process that is reflecting in major macro-economic indicators, such as the capital goods segment in the Index of Industrial Production (where the capital goods sub-set has been outpacing others) and the Gross Fixed Capital Formation numbers in the National Accounts (growth now comes more from investment than consumption). Such investment upswings are typically thought to last about three years, but nothing seems to be typical in the Indian economy today. Assuming this capacity expansion goes on for some more time, many companies will very likely find themselves in a situation in which their capacity exceeds their ability to sell domestically. At that point, they will either have to look more aggressively for markets abroad, or, failing this, curb investment plans until demand catches up with capacity. The high profit levels of the 1,700 companies (9.1 per cent of sales, on average) would suggest that they have the cushion to get into export markets despite the rise of the rupee. If they fail to do that, then declining investment can precipitate a fairly sustained slowdown in growth, as India saw between 1997 and 2003. The essential point is that higher penetration of global markets is critical to sustaining the kind of performance seen in recent years.

Another issue that arises is the way in which the stock market values the large mass of companies in this sample. A simple analysis of ratios suggests that the price-earnings ratio of this sample is higher than that of the 30 companies comprising the Sensex. Since all 30 are part of the sample, this means that the ratio for the non-Sensex companies is higher than for the sample as a whole. Evidently, a lot of companies in the lower ranges of market capitalisation are being valued rather aggressively by investors. The large number of new fund offers for mid-caps, small-caps and now even micro-caps is testimony to this. It is quite conceivable, though, that any significant correction in prices will hit smaller companies hardest, particularly those which have not been able to hedge their bets by diversifying outside the country. In short, while it is entirely appropriate to celebrate last year's successes, it is also time to tread cautiously and focus on companies that are doing what is necessary to sustain their performance.