The disconnect between economic and earnings growth


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.

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.

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.

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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