The disconnect between economic and earnings growth

Saturday, 21 Sep 2019

By Pankaj C. Kumar

THERE has been much debate about the lacklustre performance of Malaysia’s stock market vis-à-vis other regional or North Asian markets. There are many factors that determine a market’s performance and one of the reasons is due to the poor earnings in corporate Malaysia.

However, the other side of the argument is that, why aren’t our corporates doing well and showing earnings growth as we have been having relatively stable economic growth for years now?

Indeed, this is true. But to answer this perpetual question, one needs to understand how gross domestic product (GDP) is measured while at the other end, how are earnings derived. Is the comparison between GDP and earnings growth relevant and should they be correlated?

GDP can be measured on three counts namely by expenditure, output or factor income, and all three measurements provide the same sum of value. We typically explain GDP by expenditure and output or also known as aggregate demand and aggregate supply respectively.

Measurement of GDP by factor income is not a common practice in Malaysia. GDP measured by factor income takes into consideration income (i.e. wages and salaries); profits of businesses and the third component is rental income from ownership of land.

image: https://apicms.thestar.com.my/uploads/images/2019/09/21/284546.JPG

GDP measured by expenditure or aggregate demand comprises both the public and private consumption and investment, change in value of stock and net exports. GDP measured by output or aggregate supply is measured using the output of the various economic sectors and this of course includes the services sector, the manufacturing sector, mining, agriculture and the construction sector.

In essence, GDP measures the total output generated from the economy, i.e. both the value of goods and services produced and by default, it is the measure of the size of the economy. How big is a nation’s economy in terms of the value it creates every year? When we say the economy expanded by 5%, it means the output value of both goods and services grew by 5% compared with the previous year. GDP is also measured on two counts.

One is GDP in nominal terms and the other is GDP in real terms. Of course, the difference between the two is the rate of inflation and typically GDP in real terms grows slower than GDP in nominal terms which is measured based on current values. In other words, GDP in real terms only takes into account growth of the economy while GDP in nominal terms takes into consideration not only the growth factor but the price factor as well.

GDP is also measured based on a certain base year. Today, Malaysia’s economy is measured based on the 2015 base year (from 2010 base year previously), to reflect the nation’s current economic dynamics. To get a real GDP data, the nominal GDP is adjusted by a factor called “deflator”. A deflator is a measure of inflation from the current base year of 2015. Chart 1 shows Malaysia’s GDP between 2015 and 2018. From here, we could also make a summary that deflator used for the year 2016,2017 and 2018 are 1.0166,1.0552 and 1.0627 respectively.

Earnings on the other hand, is only measured based on current prices as our accounting rules do not take into consideration inflation neither is it re-based every five years. Earnings is also a measure of profit and not revenue. Typically, for GDP, the output measure is actually revenue to the provider of goods and services and not profit. Of course, one can argue that if revenue is rising, which typically does, should it not reflect in better earnings? The straight answer, yes definitely. But, bear in mind, net profit is not cashflow and earnings are also adjusted for various accounting rules as well as non-cash items like depreciation, and amortization. So to compare GDP to earnings performance is not exactly accurate either. In addition, as defined as to what GDP actually measures, it is difficult to correlate what is spent from aggregate demand of the economy to the aggregate supply as some of this demand and supply is not captured among listed companies. Hence, there is indeed a mismatch between GDP and even revenue of our corporates.

image: https://apicms.thestar.com.my/uploads/images/2019/09/21/284583.JPG

For example, the public sector accounts for almost 20% of aggregate demand while private sector accounts for 74% of the annual GDP. On the supply side, services sector is about 57% of the economy while manufacturing sector is at about 22%. Mining, agriculture and construction makes up the balance 20%. While some of this output of goods and services is carried out by listed companies, there is a significant amount that is not represented in the market. This include large MNCs which are not listed, SMEs, which are backbone of the economy, as well as smallholders in the agriculture sector while Malaysia’s No.1 corporate, Petronas, the parent company, too is not listed. Some of the output generated from these industries or by our national oil corporation is for exports and not all our exporters are listed either.

With this, we can now see that earnings are NOT correlated to the GDP and hence poor earnings growth over the last few years had little to do with economic growth. Based on Bank Negara’s statistics as per Table 1, we can deduce the market EPS at the end of each year by taking the KLCI index level divided by the market PER at the end of each period. The EPS growth can than be calculated from these figures and we can now see the correlation between Nominal GDP growth and EPS growth as shown in Chart 2.

The chart basically shows that since the re-basing of the GDP, Malaysia’s nominal GDP expanded steadily in 2016 and 2017 but fell back in 2018. Earnings on the other hand was negative in 2015, marginally positive in 2016 and 2017 but was extremely poor in 2018.

As the 1H reporting season has just ended, we have observed that based on data compiled by research houses, market earnings have contracted by 8.2% year-on-year and the current market estimate is that earnings for 2019 will be negative 1.8%. For this to materialise, corporate Malaysia’s 2H earnings has to be a strong 4.6% y-o-y growth to enable the annual earnings growth to hit the expected contraction rate of 1.8%. As inflation is probably to average about 1% this year, the 2019 nominal GDP growth too will likely mirror that of 2018 performance, i.e. at about 5.5% growth. Hence, while the economy remains on an expansionary mode, the earnings of corporate Malaysia is hardly a reflection of the strength of the economy as it is likely to remain in the doldrum, well, at least for 2019.

image: https://apicms.thestar.com.my/uploads/images/2019/09/21/284582.JPG

In addition, if we look at the composition of our 30-stock FBM KLCI, the index itself is heavily weighted towards the banking sector, which makes-up about 36% of the index, while Tenaga Nasional and the telco sector are the next heavyweights, accounting for about 21% of the index itself. Hence, with the banking sector not particularly performing well, especially with the environment where net interest margins are thinning and loan loss provisions are under pressure, the sector itself is a drag on the FBM KLCI.

The failed merger between Axiata-Digi too has now taken its toll on the index while the gaming sector (the likes of Genting and Genting Malaysia), plantation and rubber glove makers have their own issues related to governance, poor corporate results brought about by weaker commodity prices as well as stretched valuations. Hence, the poor performance of the FBM KLCI year-to-date is understandable and it is not due to the weakness or strength of the Malaysian economy but more of whether the index itself is reflective of the economy as whole or otherwise. In fact, seven companies alone represent about half the FBM KLCI weight and they are Public Bank, Tenaga Nasional, Maybank, CIMB, DiGi, Maxis and Axiata, and their market performance alone can dictate the FBM KLCI’s direction.

The views expressed here are the writer’s own.

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image: https://apicms.thestar.com.my/uploads/images/2019/09/21/284583.JPG

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Read more at https://www.thestar.com.my/business/business-news/2019/09/21/the-disconnect-between-economic-and-earnings-growth#9lGpHfbTTsxgsmQC.99




Summary:

GDP can be measured in 3 ways:  expenditure, output or factor income.

Aggregate demand:  
Public sector accounts for 20% 
Private sector accounts for 74% of the annual GDP.

Supply side: 
Service sector: 57%
Manufacturing sector 22%
Mining, agriculture and construction 20% of the annual GDP

Output of goods and services not represented in the market:
Large MNCs which are not listed
SMEs (backbone of the economy)
Smallholders in the agriculture sector
Petronas, the parent company (Malaysia's No 1 corporate)



1H reporting season (data by research houses)
Market earnings have contracted by 8.2% year-on-year
Current market estimate is earnings for 2019 will be negative 1.8%.

Earnings is a measure of profit and not revenue.  GDP, the output measure is actually revenue to the provider of goods and services and not profit.  So to compare GDP to earnings performance is not exactly accurate either.  

Some of the aggregate supply and the aggregate demand are not captured among listed companies; hence, there is indeed a mismatch between GDP and even revenue of our corporates.

The 2019 nominal GDP growth will likely be about 5.5% growth.

While the economy remains on an expansionary mode, the earnings of corporate Malaysia is hardly a reflection of the strength of the economy as it is likely to remain in the doldrum, at least for 2019.



30-stock FBM KLCI weightage

Banking sector 36% of the index
Tenaga Nasional and the telco sector  21% of the index

Banking sector not performing well especially with the environment where net interest margins are thinning and loan loss provisions are under pressure, the sector itself is a drag on the FBM KLCI.

Other issues contributing to the poor performance of the FBM KLCI:
Failed Axiata-Digi merger
Gaming sector (Genting and GENM)
Plantation & Rubber glove makers (Corporate governance issues, poor corporate results due to weaker commodity prices as well as stretched valuations).

The index is not reflective of the economy as a whole.  Seven companies alone represent about half of FBM KLCI weight and their market performance alone can dictate the FBM KLCI direction:
Public Bank
Tenaga
Maybank
CIMB
DIGI
Maxis
and Axiata

Market value, business value, Short-term & Long-term Market Returns and the effects of GDP Growth

Long-term stock market growth (by most measures of return, 10-11% annually) can be explained by adding together the following:

• GDP growth of 3 to 5%
• Productivity growth of 1 to 2%
• Long-term inflation in the 3 to 6% range

In the short-term, depending on the value of alternative investments, such as bonds, real estate, and so on, market value may actually rise faster or slower than business value. And inflation also tampers with market valuations.

So can markets grow at 20% per year? 

Not for long. It isn't impossible for the markets to rise 20% in a given year or two, but such growth year after year is hard to fathom if the economy at large is growing at only 3 to 5% annually. 

But for a particular stock? 

Sure, it's possible. If the company is building a new busines or is taking market share from existing businesses, 20% growth can be quite realistic.

But forever? 

Doubtful. Some call this "reversion to the mean" - sooner or later, gravitational forces will take hold and a company will cease to grow at above-average rates. As an investor, you must realistically appraise when this will happen. 


GDP

You can and should expect, in aggregate, that the total value of all businesses would rise roughly in line with the increase in the size of the economy, as represented by gross domestic product (GDP). This is true.

Business value grows further through increases in productivity.

The value of market traded businesses could rise still more if the businesses grew their share of the total economy - as Borders Group and Barnes and Noble have grown their share of the total book selling business in the previous decade.



Main point:  
Business value and market value of a company grow further through increases in productivity (better profit margins) and through growing its market share (higher revenues).

GDP Growth and Market Return

Economic Growth: Great for Everyone but Investors?

While it may be intuitive to presume strong economic growth translates into strong stock market performance, the evidence suggests otherwise.

By Alex Bryan | 12-19-12

By 2050 the world's population is projected to reach 9 billion, up from 7 billion today. Nearly all of that growth will come from emerging markets, where living standards are rapidly improving. Although these markets have experienced large capital inflows, they still have a long way to go to match developed countries' levels of capital and wages. Consequently, emerging markets will likely continue to grow faster than developed markets for the foreseeable future. While this growth may lift hundreds of millions out of poverty and spur investment and innovation, evidence suggests investors may be left behind.

About the Author

Alex Bryan is a fund analyst with Morningstar.

Contact Author | Meet other investing specialists

Jay Ritter, a professor at the University of Florida, documented a negative relationship between economic growth and stock market returns in his seminal research paper, "Economic Growth and Equity Returns," published in 2005. Ritter's findings are no fluke. Using real gross domestic product data from the Penn World Tables and stock market returns, as proxied by the total return version of each market's MSCI country index, I found a weak negative correlation between GDP growth and stock market returns for 41 countries from 1988 to 2010. This relationship is plotted in the chart below. However, excluding China (the outlier at the bottom right of the chart) brings the correlation close to zero.

While the strength of these relationships is sensitive to the start and end dates of the sample period, the general findings are fairly robust over long time horizons. It's clear that higher economic growth does not necessarily translate into superior stock market returns over the long run.

Reasonable Assumptions?

This result should not be surprising given the strong assumptions that would be required to make the jump from GDP growth to stock market returns. In order for this relationship to hold, corporate profits as a share of GDP and valuation ratios would need to remain stable over time. Second, current shareholders' ownership stake of total corporate profits would also need to remain constant. In other words, there should be no dilution from new share issuance, private and public companies would need to grow at the same rate, and there could be no new enterprises or initial public offerings. All existing publicly listed companies would also need to generate substantially all of their revenue and profits from the domestic economy.

The Link Between Economic Growth and Profitability

In a closed economy, it would be reasonable to expect that total corporate profits would grow at a similar rate as the economy in the long run. Although the share of corporate profits relative to GDP fluctuates over time, it tends to revert to the mean. Profits cannot persistently grow faster than the economy because they would crowd out all other economic activity and attract new competitors. Similarly, total corporate profits should not grow slower than the economy in the long run, as firms exit unprofitable businesses, allowing those remaining to preserve margins. Of course, it is inappropriate to assume that any country United States investors have access to is closed. The largest companies listed in most countries tend to be multinational firms that generate a large portion of revenue and income outside their host country. For instance, the constituents of the S&P 500 generate close to 40% of their profits outside the U.S. This international exposure means that profits can grow at a different rate than the domestic economy, even in the long run.

Even if aggregate corporate profits grow in sync with GDP, dilution can prevent shareholders from enjoying the benefits of growth. Creative destruction is essential to economic growth. In aggregate all companies that are publicly listed today will grow slower than the economy because new entrants drive much of that growth. Between the time these new companies are launched and publicly listed, their growth dilutes most investors' ownership interest in the economy. Flagrant dilution of corporate earnings through employee stock grants and seasoned offerings is also a very real risk, particularly in developing countries with a tradition of poor corporate governance. Additionally, earnings growth can only create value if it allows firms to generate returns that exceed their cost of capital. High reinvestment rates may enhance both corporate and domestic economic growth but destroy shareholders' wealth through inefficient capital allocation.

Is Growth Already Priced In?

Growth expectations influence stock market valuations. Valuations are rich when investors expect strong growth. However, as developing economies mature, their growth rates slow and valuations tend to decline. Consequently, even when countries realize their expected growth rates, their stock markets may not keep pace.

The impact of lofty growth expectations on valuations can create a treadmill effect, whereby fast-growing economies must realize high growth in order to generate a competitive rate of return. For example, in the mid-1980s the so-called Asian tigers had experienced two decades of rapid growth and investors had high expectations for future growth. In contrast, several countries in Latin America were facing severe inflation, a debt crisis, and low expectations for future growth. As a result, according to research published by Peter Blair Henry and Prakash Kannan in "Growth and Returns in Emerging Markets," in 1986 Latin American stock markets were trading at 3.5 times earnings, while the Asian markets were trading at 18.3 times earnings. Over the next two decades, Latin American stock markets posted more than twice the annualized returns as the Asian markets, despite experiencing lower GDP growth over that horizon. This was because Latin American countries implemented economic reforms that allowed them to exceed investors' low expectations. Conversely, the Asian markets performed in line with investors' high expectations, which were already priced in.

What's an Investor to Do?

In order to benefit from economic growth, investors must identify markets that have the potential to exceed expectations. Russia may fit the bill. The Russian equity market, as proxied by  Market Vectors Russia ETF (RSX), is trading at a paltry 5.6 times forward earnings, making it the cheapest of any major emerging market. Corruption and a taxing regulatory environment have stunted the country's growth and depressed valuations. However, if (and this is a big if) Russia adopts structural reforms similar to those undertaken in Latin America over the past two decades, it could offer investors rich rewards--albeit with high risk.

Even if fast-growing emerging markets do not offer superior risk-adjusted stock market returns, they can provide significant diversification benefits. Over the past 20 years, the MSCI Emerging Markets Index and S&P 500 were only 0.73 correlated. Emerging-markets equities may also offer a long-term hedge against a weakening U.S. dollar.

http://news.morningstar.com/articlenet/article.aspx?id=578607

Country P/E Ratios and GDP Growth

Jun. 23, 2010



If you take stock markets' price to earnings ratio and divide it by their expected growth, then interestingly China and Russia, two of the BRICs turn up as the cheapest stock markets based on this PEG (PE/Growth) method. Obviously growth estimates can be wrong, but this at least opens up the debate:

Bespoke:
Above are the PEG ratios for 22 countries around the world. For each country, we use the trailing 12-month P/E ratio for the index shown as well as estimated 2010 GDP growth. As shown, Russia and China have the lowest country PEG ratios at 1.86 and 1.90, respectively. Russia has a very low P/E at 8 and decent estimated GDP growth at 4.3%. China, on the other hand, has a rather high P/E ratio at 19.24, but its GDP growth is also very high at 10.10%. The US is right in the middle of the pack with a PEG of 5.07. Our neighbors to the south rank just above the US with a PEG of 3.85, while our neighbors to the north rank just below the US at 5.67.

http://www.businessinsider.com/russia-is-the-cheapest-market-based-on-growth-2010-6#ixzz0w02Qccax


----

January 28, 2010




Many investors use the PEG Ratio as a valuation tool these days because it puts a company's growth prospects into perspective along with the widely followed price to earnings ratio. The PEG ratio is the P/E Ratio over the Growth Rate, and a PEG of less than one is generally considered good.

In this regard, Bespoke created "PEG" ratios for a number of countries using the P/E ratio of each country's main equity market index along with 2010 estimated GDP growth rates. Just as with stocks, the lower the country PEG, the more attractive.

As shown, India has the best PEG out of the countries we analyzed. It has a P/E ratio of 26.19 and estimated 2010 GDP growth of 8%. While its P/E isn't as low as a lot of countries, its growth rate is very high. China ranks 2nd with a PEG of 3.66.

The U.S. ranks in the middle of the pack with a P/E of 24.53 and estimated GDP growth of 2.6%.

At the bottom of the list sits Switzerland, Italy, and the UK, while Australia, Japan, and Spain have negative PEGs due to either a negative P/E Ratio or negative estimated GDP growth.


http://protect-your-assets.blogspot.com/2010/01/country-pe-ratios-and-gdp-growth.html

Bullbear Stock Investing Notes

Economic PEG = (P/E) / (100*GDP growth)

Buffett (1992): Short-term market forecasts are poison and worthless.

Short-term market forecasts are poison and worthless. Over the long-run, share prices have to follow growth in earnings and anything more could result in a sharp correction.




Warren Buffett's 1992 letter to shareholders discussed his thoughts on issuing shares. Let us see what other nuggets he has to offer.

We have for long been a supporter of making long-term forecasts with respect to investing and we are glad that we are in extremely good company. For even the master thinks likewise and this is what he has to say on the issue.

"We've long felt that the only value of stock forecasters is to make fortunetellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children. However, it is clear that stocks cannot forever overperform their underlying businesses, as they have so dramatically done for some time, and that fact makes us quite confident of our forecast that the rewards from investing in stocks over the next decade will be significantly smaller than they were in the last. "

The above lines were most likely written by the master in the early days of 1993, a year which was bang in the middle of the best ever 17 year period in the US stock market history i.e. the years between 1981 and 1998. However, this period did not coincide with a similar growth in the US economy. Infact, the best ever stretch for the US economy was a 17-year stretch, which started around 17 year before 1981 and ended exactly in 1981. Courtesy this economic buoyancy and the subsequent lowering of interest rates, the corporate profits started looking up and they too enjoyed one of their best runs ever. Thus, a period of buoyant GDP growth was followed by a period of strong corporate profit growth, which in turn led to increase in share prices. However, share prices grew the fastest because they not only had to grow in line with the corporate profits but also had to play catch up to the economic growth that was witnessed between 1964 and 1981.

Another extremely important factor that led to a more than 10 fold jump in index levels in the period under discussion had psychological origins rather than economic. Investors have an uncanny knack of projecting the present scenario far into the future. And it is this very habit that made them believe that stock prices would continue to rise at the same pace. However, nothing could be further from the truth. Over the long-run, share prices have to follow growth in earnings and anything more could result in a sharp correction. Thus, while the share prices can play catch up to economic growth and corporate profits and hence can grow faster than the two for some amount of time, expecting the same to continue forever, could be a recipe for disaster. And even the master concurs.

We believe similar events are playing themselves out in the Indian stock markets with investors expecting every stock to turn out to be a multi bagger in no time. But as discussed above, this could turn out to be a proposition, which is full of risk of a permanent capital loss. Investors could do very well to remember that over the long-term share prices would follow earnings, which in turn would follow the macroeconomic GDP and this could be a very reasonable assumption to make.

http://www.equitymaster.com/detail.asp?date=12/13/2007&story=3

What is GDP and why is it so important?

 

What is GDP and why is it so important?

 

--------------------------------------------------------------------------------

 

 

The gross domestic product (GDP) is one the primary indicators used to gauge the health of a country's economy.

• It represents the total dollar value of all goods and services produced over a specific time period - you can think of it as the size of the economy.
• Usually, GDP is expressed as a comparison to the previous quarter or year.
• For example, if the year-to-year GDP is up 3%, this is thought to mean that the economy has grown by 3% over the last year.

 

Measuring GDP is complicated (which is why we leave it to the economists), but at its most basic, the calculation can be done in one of two ways:

• either by adding up what everyone earned in a year (income approach), or
• by adding up what everyone spent (expenditure method).

Logically, both measures should arrive at roughly the same total.

 

The income approach, which is sometimes referred to as GDP(I), is calculated by adding up total compensation to employees, gross profits for incorporated and non incorporated firms, and taxes less any subsidies.

The expenditure method is the more common approach and is calculated by adding total consumption, investment, government spending and net exports.

 

As one can imagine, economic production and growth, what GDP represents, has a large impact on nearly everyone within that economy.

• For example, when the economy is healthy, you will typically see low unemployment and wage increases as businesses demand labor to meet the growing economy.
• A significant change in GDP, whether up or down, usually has a significant effect on the stock market.
• It's not hard to understand why: a bad economy usually means lower profits for companies, which in turn means lower stock prices.
• Investors really worry about negative GDP growth, which is one of the factors economists use to determine whether an economy is in a recession.

 

http://www.investopedia.com/ask/answers/199.asp

Long-term Stock Market Growth and GDP

A stock market represents the sum total of the public's perception of the business value of the companies trading in that market.

True business value, is the sum total of productive assets and, in particular, what those assets produce in the form of current and future earnings.

As long as companies produce more, it makes sense that their values rise.

And as long as the public perception matches true value, the stock value rises in lockstep.

GDP

You can and should expect, in aggregate, that the total value of all businesses would rise roughly in line with the increase in the size of the economy, as represented by gross domestic product (GDP). This is true.

Business value grows further through increases in productivity.

The value of market traded businesses could rise still more if the businesses grew their share of the total economy - as Borders Group and Barnes and Noble have grown their share of the total bookselling business.

Long-term stock market growth (by most measures of return, 10-11% annually) can be explained by adding together the following:

GDP growth of 3 to 5%
Productivity growth of 1 to 2%
Long-term inflation in the 3 to 6% range

In the short-term, depending on the value of alternative investments, such as bonds, real estate, and so on, market value may actually rise faster or slower than business value. And inflation also tampers with market valuations.

So can markets grow at 20% per year?

Not for long. It isn't impossible for the markets to rise 20% in a given year or two, but such growth year after year is hard to fathom if the economy at large is growing at only 3 to 5% annually.

But for a particular stock?

Sure, it's possible. If the company is building a new busines or is taking market share from existing businesses, 20% growth can be quite realistic.

But forever?

Doubtful. Some call this "reversion to the mean" - sooner or later, gravitational forces will take hold and a company will cease to grow at above-average rates. As an investor, you must realistically appraise when this will happen.