September 20th – Massive Corporate Tax cut and it’s impact on equity Markets

Amid growing concerns over the economic slowdown, the union finance minister, Nirmala Sitharaman announced a slew of incentives aimed at stimulating a flagging economy whist maintaining emphasis on domestic manufacturing and demand. One of the most important announcement was lowering of Corporate tax rate from ~35% (including surcharge) to 25.17% a massive reduction of almost 10%.

This move will help companies to increase profitability. One hopes some of these benefits are passed on to consumers and that some are reinvested for business expansion.

This is a permanent benefit for corporates. Even-lower tax rate (of 15% – almost the lowest tax rate globally) for new manufacturing companies will make Indian manufacturing significantly competitive. This will hugely boost the government’s ‘Make in India’ campaign. This move is expected to provide a meaningful boost to exports, which earlier looked difficult due to our lack of competitiveness.

Equity Markets cheered this move as it provided boost to EPS growth.

Average effective Corporate Tax rate Across sectors:

Source: Phillips Capital

As seen from the below graph, Average effective tax rate have come down from 30-34% to 25%

What this means to EPS growth.

We will do an illustration to understand the impact.

Consider a company having EPS of Rs.1,000, primary assumption is that the company EPS will grow at 12% for year 1-5 and then will grow at 5% for Year 6-10, the terminal growth (Perpetual) is assumed 3%. Discount rate is assumed 12%. Now if we do a Discounted Cash Flow (DCF) analysis, then the total PV of Cash Flows which we get is Rs. 17,425.

As the tax rate is cut by ~10%, earlier if my profit was Rs.100 I was charged Rs.35 as tax and I used to receive Rs. 65 in my hand net of tax. With tax rate now coming down to ~25% I will get Rs.75 in hand net of Tax. So, roughly I will have 15% more in hand net of Tax.

Now if I consider same company as above, my EPS goes up by 15%, so EPS increases to Rs.1,150. With all other growth assumptions remaining same, Total PV of cash Flows which we get is Rs. 20,039 or 15% higher than the original estimate.

But, other important point to consider is the discount rate.

Yesterday, the Benchmark 10-year bond yield went up by 15bps. So, if we consider the discount rate as 12.15% instead of 12%, the EPS growth comes down to ~12.75%.  

Yesterdays announcement is expected to have total revenue loss for the government from the corporate taxes foregone would amount to Rs.1.45 lakh crs. Additionally, the export promotion measures announced on 16-Sep’19 would lead to an additional revenue loss of Rs.10,000 crs over the budgeted revenues for 2019-20. The loss in revenue could to an extent be made up from the RBI surplus transfers (Rs.58,000 crs over the budgeted amount). Also, GST collection and Direct tax collection is also not upto the mark. The overall impact could be widening fiscal deficit which can lead to higher yields.

If the yields increase by 1.25% then with discount rate touching 13.25% instead of current assumption of 12% will make this tax cut worthless i.e. Total PV of cash flows will be Rs. 17, 412.

Hence, one needs to keep an eye on Fiscal position as well.

Strategies for Alpha creation

Generating returns over and above the benchmark i.e. generating “alpha” is primary motive of almost all the investors. Sometimes simple strategies lead us to wonderful results. But key part is to execute these strategies without fail.

Here we will discuss some common strategies which can help you beat benchmark (Nifty 50).

  1. Market timing
  2. Active Fund Management 
  3. Passive Re-balancing – Asset Allocation discipline

  Market-timing

Market timing simply means identifying market cycles and investing in times when market are rising and stay away from equities when markets are falling. This is not at all easy and one needs to have lot of understanding of multiple components and first-hand experience at-least 2-3 cycles. Flip side of this is going wrong on market call can significantly erode your wealth.

Active Fund Management

This strategy can yield you alpha in a fairy consistent and dependable manner but you need to bet on right horse (Choosing the right Fund & intern the Fund manager). Again, there can be periods (like CY 2018) where markets can be extremely narrow (only selected few stocks gaining whereas rest of the market struggling). To understand these intricacies of the markets and chose right funds you need able, attentive and active Financial Advisors.

Asset Allocation discipline

“Don’t put all your egg in one basket” is what it at the core of this strategy. Proper asset allocation and periodic re-balancing can help you generate alpha over long period of time in a consistent and dependable manner. To give an example, Nifty 50 index has delivered 11.41% CAGR return over 23-year period. If you had invested 80% of your assets in Nifty 50 and 20% of assets in an income fund (Debt mutual fund) and had done re-balancing every year your return would have been ~ 12% surprisingly more than Nifty 50 returns. This happens because when equities fall debt component help protect downside and hence saves capital erosion.

But again, to reduce equity exposure when equities are giving handsome returns and on a similar note reducing debt when equities are looking lackluster can be a tough mental challenge. In the game of investing often greed and fear take out rational thinking. A Financial Advisor who have seen cycles, understands how to select funds and disciplined enough to help you stick with your asset allocation will help you generate “Alpha” over Medium to long term horizon.

Have you done your and your portfolio’s annual health check-up?

Word ‘healthy’ prompts an array of words in my mind viz. strength, endurance, longevity, immunity. Add responsibility to that and it gives a sense of comfort and security. A HEALTHY PORTFOLIO is what you can count on. It is a manifestation of thoughtful planning, good and consistent feed, continuous attention and adaptation. As a primer, I am highlighting broad aspects of portfolio management.

Environment

Macro-economic environment

“Is our economy doing well?”
“Is the inflation too low or high?”
“Are commodity prices rising?”
Where’s the currency headed?”

Answers to these and many more questions influence asset allocation decisions dictating how much of the portfolio should be in debt, equity or alternative assets such as real estate.

Micro-economic environment

Industry and company specific aspects that define productivity (Return on Equity, Return on Capital), profitability (Profit Margins) form micro-economic environment. This guides in selection of securities and/or investment vehicles in each asset class.

First part of portfolio health-check will focus on whether asset allocation is right for current environment and client’s life cycle stage, assets, liabilities, income, expenses etc.

Construct

Portfolio management at its core is management of risks to maximize the rewards. Portfolio must endure the adversities and thrive during conducive environment. Some elements of construct are:

  • Asset Classes: Am I aware of various assets where I can invest such as fixed income (debt), equity, alternative assets (real estate, commodities etc.). What are the ways in which I can invest in these?
  • Diversification: Have I put all my eggs in one basket? Do I hold excess of fixed income (such as PPF/FD) or I have excess of equity shares? Have I considered my homes as investments? Balance is always better!
  • Liquidity: If need arises, how much can I convert to cash without compromising on fair price? A distressed sale will add to worries during emergencies.
  • Risk & reward management: What is the correlation of my portfolio with my income source? Will I lose both at the same time? What are my post-tax returns? Is there a tax-efficient way of investing?

Review and Management

Whatever is built must be reviewed, maintained and managed with due respect to changing environment.

Is there an ideal review and re-balancing schedule?

How much value professional help will add to my portfolio?

Have a healthy and wealthy portfolio!