Nifty PE crosses 24|A statistically informed entry-exit model!

Investing Strategies
1681

Not so easy. Profits will be 15% higher every year than what they would be with old tax rates. But growth rate will not be higher, it will be the same. Therefore, there is no reason for P/E expansion, assuming we are not considering second order effects. Thus, valuations get better by 15% only, not 35%.

However, he has clarified further this works for BFSI, which I agree. Because, here Retained Earnings itself is the Raw Material which can be leveraged and so, growth rate will be automatically higher. So P/E expansion can also be considered.

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1682

Fully Agree on this. However, large part of the slowdown was a result of liquidity problem arising as a result of huge NPA’s. If this benefits BSFI more, that means BFSI will take less time to repair their balance sheet (Which is almost complete with provisioning already around 75-80% for most PSU banks). This inturn should increase credit offtake and help other sectors.

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1683

Why only BFSI? Consider Dmart for example. It retains all the profits and reinvests it into business expansion. Now it will have 15% more profits, and therefore higher reinvestments, which should lead to higher growth trajectory than before.

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1686

Can you please explain how PAT jumps by 15.12 % when tax is slashed by 10%. sorry newbie question!

1687

It is very simple. Assume pbt of 100 rupees. So at 35% tax, Pat is 65 rupees. If tax rate is 25%, Pat becomes 75. So company gets additional Rs. 10. 10/65 is 15%.

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1688

Does that mean on approximate basis, sensex which was at 36000 will move to 41000 and then this whole tax cut gets completely priced in. Nothing much has changed in Macros, so further upside is limited. Is this a correct line of thought?

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1689

Another point from the same thread: the valuation may have moved even higher, like ~44% if the ROE is 25%, as the company is able to deploy the retained profit at even higher rates.

1690

The tax cut is not for 1 year. It could be for more than a year and some even expect it to be perpetual. So you may have to calculate that based on the tenure of this savings. Second order and third order events may add up over the longer term if this is not reversed too soon.

1691

No it does not. The tax cut will lead to an immediate gain in earnings by 10-15%, depending upon the earlier tax rate. Now if you assume earlier P/E ratio is maintained, therefore price should go up by 15% (that takes sensex from 36000 to 41000), that is a simple way to explain the rally.

Alas valuation is not such a simple matter. Valuation of the stock reflects sum of all future discounted cash flows. It won’t rise by 15% just because the current year cash flow has increased by 15%. That increased in profitability also holds for the competition, and gives the incentive to the sector to expand supply. If the business does not have a strong moat, that 15% gains will eventually be squandered to consumers, and the cash flow will return to earlier profitability levels. So in this case the valuation will rise by less than 15%, depending upon how much demand is stimulated.

On the other hand, if the business does have a strong moat, it may be able to protect a significant fraction of 15% gain in future as well. Furthermore, if the said business retains all the profits and reinvests it at high rates, then the gain in future cash flows can be even higher than 15%.

So you need to be business specific, analyse how much of the increased profitability will be retained, what fraction will be reinvested and what will be future rate of returns for this additional investments.

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1692

What about good but cyclical businesses that are reeling under pressure. Their profitability is low or even negative, interest coverage ratio is getting worse by the quarter. What positive effect will this policy have for them?

Auto and ancillaries, Tyres, Pharma, Reality, Energy, Consumer stocks, to name a few sectors that are facing a down cycle.

1693

If they are making profits and paying taxes in higher bracket they will benefit.
This will help many companies deleverage quicker than anticipated.

They can get better deal from their suppliers (in they benefit from tax cut).

So tax cut benefits everyone to some extent.

1694

Okay, let me clarify why only BFSI.

What is the business model of a finance company? You have Net Worth X. On the basis of that, you can leverage a maximum of say, 8X. So you have 9X to lend. You lend these 9X and generate your income. You cannot lend beyond 9X with Net Worth X because if you borrow more than 8X, your capital adequacy will fall below the regulatory minimum. Now assume next year, your Net Worth becomes 1.1X with the addition of Retained Earnings. So now you can leverage upto 8.8X. Your asset base can be maximum 9.9X. On this, you earn interest. You cannot go beyond 9.9X asset base for the same reason that you couldn’t go beyond 9X last year. This is the base scenario without tax cuts.

But now due to tax cuts, you have higher Retained Earnings. So assume your Net Worth becomes not 1.1X but 1.15X. With this you can borrow upto 1.15X multiplied by 8 which is 9.20X. So your total asset base can go up to 1.15X + 9.20X = 10.35X. You earn income on 10.35X (due to tax cut) instead of 9.9X (without tax cut), which in turn leads to higher Retained Earnings in the year after that. This cycle repeats, compounding itself. Citerus paribus , your equity base (i.e. book value) is the only constraint to your growth rate because it limits your asset size. Tax cuts leads to higher Retained Earnings, leading to higher leverage leading to bigger asset base, leading to higher interest income leading to higher profits leading to higher retained earnings - and the cycle repeats. Thus, the intrinsic growth rate itself improves, and so a higher P/E can be assigned. This is the point Basant Maheshwari is making.

Why this will not happen in case of other businesses?

Taking D’Mart as a hypothetical example - let us say, D’Mart added 30 stores last year. Funds were not a constraint for opening 31. Thirty was the number operationally arrived at, based on their assessment of market opportunity, availability of premises, competition, management & manpower availability etc. Higher Retained Earnings would not have led to more store openings. Also, each existing store is already optimally stocked, it can accommodate only this much inventory and this many customers. Store sales or new store openings will not go up just because your tax rate came down . Hence, the intrinsic growth rate will not change – and so the P/E shall also remain the same.

BFSI companies present the purest form of intrinsic growth that comes from Retained Earnings in any business. You can almost arithmetically arrive at the improvement in growth rate due to higher Retained Earnings. For other business, growth rate remains the same, and so P/E will remain the same. Among non-BFSI businesses, one can say that companies having debt will experience faster growth than companies with zero debt, since improvement in debt repayment capacity and lower interest cost will add to the bottomline.

Of course, we are not considering second order effects in all of this but only the direct effects.

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1695

The answer will vary with stock in question. A business can operate in cyclical industry and yet have competitive advantages.

If you are wondering if the demand in industry will pick up, as supplier can now reduce prices, then that depends upon how the government funds this tax reduction. If it does that by printing more money, then we are only replacing corporate tax with inflation tax and that doesn’t leave us any better.

https://www.bloomberg.com/amp/opinion/articles/2019-09-23/india-s-helicopter-money-tax-cut-is-a-fiscal-gamble

If on the other hand, government funds it through divestment, then the boost could be real. Whether it will be enough remains to be seen, but it will take time to take effect.

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1696

I agree. If the company cannot find any opportunities to invest additional capital then there will be no additional growth. In the case of BFSI, in a capital starved country like India, that doesn’t seem to be a issue.

Perhaps you are also right about Dmart restricting itself to 30 stores due to operational constraints and not funding constraints this year. But that need not be the case in future, and that need not be the case with all non financial businesses (unless you claim that lack of cheap capital is never a growth constraint in India). Besides Dmart does seem to need additional capital, other than profits retained, which it is filling with debt, which is now replaced by internal cash flows. If cheap additional capital ever becomes a constraint to growth in future, then having this extra retained profit will certainly help.

1697

Warren Buffett in his 1986 letter wrote about tax cut which is very relevant for equity investors in India. https://twitter.com/SmartSyncServ/status/1175628542165405696/photo/1

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1698

Neatly expressed for even a layman to understand complex economics. Conclusive lines were, to paraphrase, do you expect a surgeon or a lawyer to reduce his fees because the government reduced taxes? It ended with saying that eventually the inflation and taxes both increase.

So, it wasn’t wise of the FM to change the taxes.

1699

Disagree. If you want to encourage businesses to open in India, you need to cut taxes to globally competitive levels. But to do that, you also need to cut down government bureaucracy and state expenditure which is sucking all the taxpayers money and more. Now that is the real challenge. Slashing tax rate was the easy part, everyone loves government largesse as long as they don’t have to pay. But to get rid of loss making, non essential PSU, like BSNL, Air India will cost some votes. It remains to be seen whether the government will make that sacrifice.

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1700

This thread is discovering that the bonanza offered by the FM will best apply to BFSI in the immediate term, and not to most other companies in Nifty; tks @Chandragupta

In another thread, our friend @sujay85 has posted an article which suggests that some FMCG companies may not take up these benefits because they are already paying lower taxes due to exemptions.

EDIT: In Conclusion, since BFSI stands to benefit most from the new tax reforms, and BFSI constitutes around 40% of Nifty, the effect of the new policy on Nifty PE will be only in proportion, and not in the full force that it was earlier made out to be.

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1701

One of the underappreciated levers of re-rating is dividend per share. In cos with strong dividend payout policies , the tax cut will directly result in a good increase in dividend per share. It had happened in Maruti when they changed the dividend policy and it got instantly rerated (check out Maruti payout from 2014 onwards and correlate with its share price movement). Several cos in India have extremely attractive dividend policies and share dividends liberally. It could prove fruitful if one looks for these setups.

Maruti comes to mind because it made a public announcement about change in the dividend policy in 2014. Relaxo also increased payouts in 2017 which led to a breakout in its share price. One stock to lookout for is MRF which has maintained payouts at 2% for an extremely long period of time, any change here would be interesting. However, the most convincing example is Accelya Kale which in 2012 increased its payouts dramatically and the rest ofc is history

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1703

Instead of looking forward, can we look backward. What I mean is , lets us consider HDFC bank (for example). If we look at the last 10 years data, there was a gorwth of 20% YOY + corporate tax of 35%, if we replace 35% by 25% for last 10 years, what would be the retruns today ? ( atleast 15+% addtional CAGR ? )

Now, Considering HDFC bank will have same growth next 10 years ( from 2020 ), with 25% corporate tax wont there be a wind fall of gains ? Correct me if my thinking is wrong.

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