Sunday, April 26, 2015

Macro factors: Corporate profits to GDP

"In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well. In addition, there's a public-policy point: If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems—and in my view a major reslicing of the pie just isn't going to happen."
Warren Buffett

While doing some research for a completely orthogonal topic to this one, I found a Buffett saying similar to the one above. That got me thinking about why Buffett says the magical 6% number. Putting that 6% number together with his quote on total market cap to GDP being under 1x we can conclude that he believes the maximum price to earnings for all companies should be 1/6% or 16.67. The average P/E over the last 16 years of the NIFTY in India is 18.48 which is consistent with this notion as well.

Let’s look at the history of this macro factor: corporate profits to GDP in India:

Overall this graph does not show that there is an earnings bubble. In fact if anything it shows that corporate profits might be at a low. At the time of this writing in April 2015 the NIFTY P/E is somewhere around the 87.5 percentile mark which may indicate a bit of a bubble developing but this factor says the opposite.

Why is this relevant for Value investing (because I think macro betting is exactly what value investing aims to avoid)? It is relevant because some of these factors can give you pointers into a bubble developing and if you can just increase your cash % by just 20% (more is better) before each bubble and sit out the highs the chances of you beating the index are higher. Now the index high in 2010-11 was probably harder to call but the 2008 case is fairly obvious on 20:20 hindsight of course. If the corporate profits to earnings are north of 7% and the index P/E is north of the 87.5 percentile mark it’s probably time to be scared. Now imagine if at that point an investor exited and sat on cash until the index P/E hit the average, the outcome would most definitely ensure index out performance.

This article is a continuation of the following articles: