‘Rise in ROA is giving India Inc a major jump in earnings’

JOEL LITMAN President & CEO of Valens Research & Chief Investment Strategist of Altimetry

The price-to-earnings (P/E) multiple of corporate India as measured by ‘uniform earnings’ is at a 10-year low, signalling markets have room to run, says JOEL LITMAN, president and chief executive officer (CEO) of Valens Research, and Chief Investment Strategist of Altimetry, who was in India earlier this month to speak at the CFA Society India’s 10th India Investment Conference. In conversation with Ashley Coutinho, he says the as-reported financial information given under current accounting standards cannot be trusted. Edited excerpts:

Could you tell us more about your ‘uniform accounting’ system, and the flaws with the prevalent reporting and accounting standards around the world?

The as-reported financial information cannot be trusted and has blinded investors from seeing the true earning power, valuation, and credit health of companies. The goal of uniform accounting financial reporting standards (UAFRS) is to create reliable and comparable reports of financial activity. With the UAFRS Advisory Council of more than 50 financial experts around the world, we’ve identified over 130 inconsistencies in both generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS).

Take research and development (R&D) as an example. The R&D a company invests in any given year is likely to generate revenue for future periods as well. Facebook is still generating revenue from the R&D it spent developing its newsfeed and ad-embedding capabilities years ago. Despite the matching principle being a core of any reliable accounting system, current GAAP and IFRS accounting standards require firms to expense R&D, which violates the matching principle.

Ratings agencies have come under criticism for being late in spotting trouble in companies. Where do you think the problem lies, and what is the way around it?

It can be very difficult for rating agencies such as Moody’s, S&P, and Fitch to issue negative credit ratings. Often, the companies they are rating are their clients. That bias has been well-documented.

In other cases, however, the agencies simply don’t have the best tools and resources for assessing corporate credit risk. Being dependent on as-reported GAAP and IFRS (Indian accounting standards are similar to IFRS), it’s no wonder they miss the early signals or problems that the best investors see far ahead of time. Cash flow is a key component to assigning proper credit ratings, and it is impossible to accurately measure cash flow without adjusting GAAP and IFRS data. The as-reported statement for cash flows is notorious for including non-cash items like pension and stock options in the cash flow calculation. It’s also highly susceptible to mis-categorisation, like not placing interest expense or leasing under financing activities.

Investors need to remove their dependency on rating agencies and utilise more reliable analysis.

Valuations of Indian shares relative to Asian peers remain at a premium both on P/E multiples and price-to-book (P/B) value. How bullish or bearish are you on Indian stocks? What is your take on valuations?

We need to reduce our reliance and ongoing commentary on antiquated measures of as-reported P/E and P/B multiples. On a uniform accounting basis, India’s equity market is trading at the upper end of regional valuations, compared to some other Asian countries. India is more expensive than its peers, trading at 23x uniform P/E, but not as expensive as its as-reported P/E of 26x would suggest at this time. With a return on assets (ROA) that has increased from 5 per cent to 7 per cent for Corporate India, as measured by uniform accounting, that’s a major jump in corporate earnings power. We calculated the aggregate uniform ROA by measuring across most of the largest of 412 publicly listed Indian corporations.

Meanwhile, the P/E of Corporate India as measured by uniform earnings is currently at a 10-year low, signalling markets have room to run before valuations get out of hand. These are bullish signals for the Indian stock market and longer term, suggesting more upside than downside when the right trends are in place.

You have said that an active credit default swap market could help Indian firms and banks address the country’s corporate debt problem. Explain.

An active credit default swap (CDS) market, similar to what we have in the US, allows institutional investors to better assess and price in corporate credit risk. Investors can use the CDS spread — approximately the amount of money it costs to ‘insure’ a company’s credit — as a barometer for a company’s perceived credit risk. Lower spreads mean less credit risk, and higher spreads imply higher credit risk. Because many emerging markets do not have an actively traded CDS market, investors lack this source of information.

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