Earnings upgrades can touch 25% if cos retain tax savings: John Praveen, QMA

Considering increasing allocations to India in the fund’s global equity portfolios

India's move to cut corporate tax rate is likely to give a boost to sentiment and earnings expectations, and help the Indian stock market post further gains over the rest of the year, said John Praveen, portfolio manager at QMA, part of US-based PGIM. With the likely improvement in sentiment and earnings expectations, Praveen is also considering increasing allocations to India in his fund’s global equity portfolios. Unlike in the US, the current tax cuts in India are unlikely to result in a big increase in stock buybacks, said Praveen in an interview with Sanam Mirchandani. Edited exerpts:

Will Indian government's move to cut corporate tax rate lead to any material change in outlook for Indian equity market?

Indian stocks have been under downward pressure in 2019 year to date due to a combination of domestic and global factors. Domestically, growth has been slowing down well below 6% and reached 5% in Q2 which is the slowest in more than five years. Globally, stock markets have been hit by the sharp increase in US-China trade tensions which has depressed business confidence, especially manufacturing confidence and raised growth risks.Year-to-date, the Sensex has lagged both developed markets and emerging markets, which suggests there is room for further market gains to catch up with other markets.

The tax cut announcements is likely to result in upward revisions to corporate earnings expectations. Previously, expectations for FY2019-20 earnings growth were around 15%. The earnings expectations could be revised sharply higher to as much as 25% if companies retain the bulk of the tax cuts.


Thus, the extent of positive earnings revisions will depend on how much the companies pass on their tax windfall to consumers. The Indian corporate tax cut is a fiscal stimulus which should complement the RBI’s monetary easing. This is in line with developments globally. With policy rates already at or near zero in many countries and negative interest rates having adverse unintended consequences for bank balances sheets, there have been calls for fiscal stimulus to boost growth, especially in Europe. The Indian tax cut announcement is a welcome move and likely to give a boost to sentiment and earnings expectations, and help the Indian stock market post further gains over the rest of the year, and catch up with the developed markets and other emerging markets.

India's fiscal deficit target is likely to be breached due to the tax cut. Are you concerned about the fiscal impact?
The tax cut is likely to provide a fiscal boost to investment spending and thereby to GDP growth at a time when RBI rate cuts have not been successful in preventing the Indian growth deceleration with GDP to a low of 5%. So while the tax cut is likely to increase the fiscal deficit in the short-run, it is a good policy move for the economy and markets given the depressed business and consumer sentiment in an environment of slower global growth.

The finance minister has noted that that the revenue loss to the exchequer will be ?1.45 trillion in FY20. While the government had slashed its fiscal deficit to 3.3% of GDP in its July budget, the current set of tax cuts are expected to push back the fiscal deficit back to around 4%.
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Policymakers face the dilemma of slowing growth while keeping fiscal deficits under control. The OECD recently released its latest forecast update and they revised down India’s GDP growth estimate for FY2019 to 5.9% from 7.2% and for FY 2020 to 6.3% from 7.4%. While there is a risk that deficit targets could be breached in the near term, the risk of not implementing significant fiscal measures along with the monetary easing measures is that the economy could further decelerate to under 5%.

Will the move lead to foreign investors' flows into India reviving? Would you look at increasing allocation?
These are positives for the Indian market and likely to improve foreign investor sentiment towards India and result in increased inflows. With the likely improvement in sentiment and earnings expectations, we are also considering increasing the allocations to India in our global equity portfolios.

In the US when tax rates were cut, companies resorted to buybacks. Is the same likely in India?
There are some similarities in the situation in the US and India. However, the business environment and the state of corporates are different between the US and India. The US is a mature economy and market and India is an emerging economy where the need for business investment spending is significantly higher in the case of India whereas the US already has a high level of capital stock given it is a developed economy.
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Further, the private sector still has some slack with capacity utilisation around 78% compared with a historical average of around 80%. There has been pressure on corporates from activists to return capital to shareholders rather than indulge in expensive M&A or other wasteful activities. Hence, the bulk of the tax cuts in the US were used to return capital in form of buybacks and dividends.

In India, business investment spending has averaged 6.2% in the past ten years and comprise just around 32% of the economy. In comparison, the business spending in China accounts for around 42% of GDP and has averaged 12% growth annually over the past 10 years.
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There is a dearth of infrastructure investment in India and with the economy posting solid growth despite slowing in past several quarters, companies are still likely to find several opportunities to invest to reap the benefits of faster economic growth.

Indian companies are still trading at a premium to their own historical averages and not at a discount which would make them attractive for buybacks. There is no valuation case for buybacks despite the modest gains posted by Indian stocks yearto-date. There is no significant need for companies to goose up their earnings. Earnings expectations are in the double digits now and the tax cuts will push earnings even higher.

A significant factor in case of Indian companies compared to US companies is the predominance of owner operated companies in India. Companies with significant family control usually opt for buybacks when their stock valuations are very cheap which is not the case is now. Unlike in the US, the current tax cuts in India are unlikely to result in an big increase in stock buy-backs.
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