In this week's newsletter, we talk about  the reliability of the famous Buffett Indicator, the stir caused by advertising spends of PepsiCo, boiling frogs and more.

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Why are tax authorities running after PepsiCo's advertising spends?

Here’s an interesting headline. A couple days ago the Delhi High Court ruled in favour of PepsiCo, dismissing Income Tax Department’s appeal on ₹2,800 crore AMP expenses.

And we know, this probably doesn’t make any sense to you. But bear with us for a minute while we break down that headline.

AMP expenses mean advertising, marketing and promotional expenses. And authorities have been trying to get PepsiCo India to pay taxes on some of these advertising spends. This may look trivial to most people. However, there’s a big problem here. If you understand the basics of tax laws, you know that expenses are usually tax deductible. If you spend on marketing, you don’t have to pay a tax on these spends. Instead, you deduct the marketing expenses from your total revenue and only pay a tax on the profits.

This is what PepsiCo India has been doing so far.

So why on earth are tax authorities trying to get them to pay an additional tax on some of these marketing expenses? Can’t a business advertise legally? And if they do, aren’t they entitled to deduct this sum from the total revenue before calculating the net tax payable?

Well, there is a catch.

Even though your marketing expenses are usually tax-deductible, the situation gets more complicated when dealing with parent companies across the border. For instance, take the case of PepsiCo India Holdings Pvt. Ltd. Sure, it’s an Indian company. But it regularly deals with its parent (or associated companies) abroad. And you could argue that some of the branding and awareness campaigns of PepsiCo India benefit these associated entities.

For instance, PepsiCo India has routinely paid for substantial advertising and marketing to promote products with brands and trademarks owned by their associated entities in countries like Bangladesh, Nepal, Bhutan and Sri Lanka.

So these marketing expenses aren’t done solely for the benefit of the Indian entity but also for the benefit of other foreign entities. And therefore, you could argue that the associated entities should adequately compensate PepsiCo India for its work. And if they were compensated, that would boost the company's income, and the additional income would be taxable.

That’s what the taxman is after. They don’t want to tax all AMP expenses. Just the ones done to benefit associated entities abroad. They believe these are international transactions (governed by separate tax rules) and over the years they’ve raised demands of hundreds of crores based on this interpretation.

How did they arrive at this number, you ask?

Well, tax authorities have often relied on a test called the BLT test (or the BrightLine test).

In simple words, it tries to identify any excessive spending that disproportionately benefits the parent company or associated enterprises. So in PepsiCo’s case, the test would compare PepsiCo India’s AMP expenses to similar companies in India. If the advertising expense (expressed as a percentage of sales) for PepsiCo India is disproportionately higher than Coca-Cola India for instance, then it suggests that the excess may represent a service to the parent company. This spending is beyond a threshold (or a bright line). And the tax demands are raised accordingly. Hence the name — BrightLine Test.

Now at this point, you’re probably thinking — Well, that’s reasonable. If in fact, there's a service being rendered for the benefit of someone outside India, without being taxed appropriately, then that is a disservice to the nation. Surely PepsiCo India should be made to pay up.

Well, not so fast. Despite the demands from the taxman, courts have routinely sided with companies like PepsiCo. And to understand why, you have to look at the other side of the coin.

Just because the associated entity stands to gain from the branding and awareness campaign you cannot claim that these spends were done solely for their benefit. PepsiCo India is just trying to boost domestic sales. Any additional benefit accrued to the associated companies could be purely incidental.

Besides how can tax authorities decide what spends benefit the parent entity and what doesn't?

The real impact of AMP expenses on brand value is complex to ascertain. Factors like customer loyalty, market dynamics, and competitive actions also influence brand value. And if you really think about it, PepsiCo India outspending its rivals may not really mean much. Each company has its own strategic objective. Maybe PepsiCo India sees merit in building its brand by spending aggressively. And it should be allowed to do so without fearing frivolous tax implications from the Income Tax Department.

This is precisely why courts have refused to acknowledge the BrightLine test. They want tax authorities to show actual contracts and agreements that prove that the Indian entity was spending large sums of money to benefit the parent entity. Not just arbitrary comparisons and calculations. In the absence of such agreements, they’ve refused to intervene.

And yet, the IT department continues to try its luck.

Perhaps this latest ruling will finally set the record straight. Or perhaps this will force the government to relook at its tax laws. In the absence of clear-cut legislation on how to tax such expenses, you will likely continue to see frivolous litigation.

Is the Buffett Indicator foolproof?

India’s stock market capitalisation hit the $5 trillion milestone (roughly ₹416 lakh crores) this week. We’re talking about the market value of all companies that have their stocks listed on the BSE (formerly Bombay Stock Exchange).

And that’s quite an achievement because just about 6 months ago it was at the $4 trillion mark.

But this milestone seems to be worrying analysts. They’re saying that this could be a sign of overvalued or expensive markets. How do they know that?

Well, they looked at some important metrics.

Take for instance, the forward P/E (price-to-earnings ratio). It’s the ratio you get when you combine the current share prices of all listed companies and divide it by the sum of their estimated earnings per share (EPS) over the next 12 months.

Now, if you’re unfamiliar with EPS, think of it as the profit that a listed company makes for every share that its shareholders own. Just that with forward P/E you don’t go by the company’s EPS based on its actual profits. You go by forecasts of the future profits instead.

And this metric is moving in one direction and that's upwards. For context, the number of companies whose stock prices are trading at over 50 times their forward P/E multiples has increased 10-fold over the past decade. It simply means that these stocks are 50 times more expensive than the estimated earnings they’ll generate over the next year. That could be sign of an overvalued market.

Then you have something called the Buffett Indicator, the protagonist of our story. You’ve probably guessed by its name that it’s an indicator coined by Warren Buffett, Berkshire Hathaway’s CEO and someone you often think of when you discuss investing. Buffett proposed this indicator way back in 2001 and even called it “probably the best single measure of where valuations stand at any given moment.”

So what’s it about, you ask?

Well, it’s pretty simple. The Buffett Indicator is the market capitalisation seen as a percentage of the country’s GDP (Gross Domestic Product) or the value of all the goods and services the country produces.

To put things into perspective, let’s assume that the market value of all listed stocks is ₹100 and that the value of all goods and services a country produces is also ₹100. Then, the Buffett Indicator will be 100% or 1 (or ₹100 divided by ₹100). This means that the market capitalisation and GDP are the same and that stocks are fairly valued. On the flip side, if stock prices rise faster than the GDP, it could potentially be foreshadowing a stock market bubble. And stock prices nosediving below the GDP could mean that the markets are cheap, signalling a buying opportunity.

And guess what the Buffett Indicator says about India’s stock market right now?

It’s at 154%* and the highest we’ve seen since May 2007.

Now before you panic and think of withdrawing all your stock market investments, here’s something you must know.

The Buffett Indicator may be a metric you could look at when you make your investment decisions. But is it really reliable or foolproof for that matter?

Well, research by YCharts, an investment research firm, sort of tried to look for an answer to this question. So it drew up data for the US stock markets and crunched the numbers to see how accurately the Buffett Indicator predicted stock market crashes since 1971.

And here’s what they found out. If you looked at major market declines in the US since 1971, this indicator gave warning signals ahead of 50% of them. But if you came further and looked at data since 2000, then the Buffett Indicator successfully predicted about 57% of the major market declines.

And while they concluded that the indicator provided well timed warnings of market declines, here’s the catch.

YCharts made some tweaks and came up with a threshold that was more suitable for the markets of the 21st century. So instead of saying that markets were overvalued when the Buffett Indicator touched 100% or more, they adjusted that to about 132%.

Even if you went by that and exited your investments from the S&P 500 (or an index that tracks 500 leading publicly traded companies in the US) you’d have avoided four major market declines of 10% or more. But would have still missed out on about 10% of the annualised returns until June 2022. In fact, it wouldn’t even give you a heads up before the decline during the Global Financial Crisis!

So why doesn’t the Buffett Indicator get it right every time?

For starters, the metric itself may be a little flawed. Just think about it. The GDP of a country is something that you look at over a period. It measures past economic activity for one quarter of a year or the entire year.

But that’s not how market capitalisation works. Stock market prices move on the basis of expectations of future performance. This simply means that if a company has the potential to give you better earnings because it has bagged a big project or contract, its stock will move up. The opposite will happen if something dents the company’s ability to do well in the future. So with the Buffett indicator, you’re not really measuring two parameters that consider the same time frame. And if you give this further thought, you’ll see that forward P/E does this job pretty well.

But you could argue that profits derived from the stock markets are a factor of the GDP simply because GDP depends on production of goods and services which in turn depend on land, labour, capital and entrepreneurship. Land earns rent, labour earns wages and capital and entrepreneurship earn interest and profits. When you put rent, wages and profits together, you get GDP. And stock market capitalisation does depend on atleast one of these components ― profits.

So it might not actually be like comparing apples and oranges.

But here’s the thing. The Buffett Indicator doesn’t consider the effect of global operations on stock markets. Let’s explain. Imagine that you kickstart a company in India and list it on the stock market. In a few years, you open several global branches too. That drives up the value of your stock in the country.

Does it affect India’s GDP, though?

No.

That’s simply because GDP only measures the value of goods and services produced within its borders. So that could again derail the objective of the indicator.

And it doesn’t stop there. The Buffett Indicator was coined with the US markets in mind. So it assumes a strong relationship between stock market performance and economic growth. But that may not make much sense in the context of the Indian economy.

If you’re wondering why, just think about the percentage of households investing in the stock markets in both countries. Over 58% of households own stocks in the US. While that figure is just about 17% in India. One market is mature. The other one is getting there. And market behavior in the these two scenarios can vary considerably.

So yeah, no indicator can reliably tell you if the stock market is collectively overpriced or not. If it could, then nobody would lose money in the markets, would they?

*As of 21st May 2024

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Today’s Discussion💡: The Boiling Frog Syndrome

In 2009, Blackberry commanded a 20% global market share in smartphones. By 2016 it had fallen down to 0%.

In the 1990s, Blockbuster ruled the video rental market. But it missed the shift to streaming led by Netflix. And in 2010 it filed for bankruptcy.

Why did these companies fail?

Well, one reason could be the legend of ‘Boiling Frog Syndrome’. What’s that, you ask?

Picture this—

What happens when you put a frog in boiling water? It jumps out of course.

But what happens when you put the frog in tepid water & slowly increase the heat? Something unexpected. The frog doesn’t realise what’s going on and eventually boils to its death.

Now while there is no scientific backing for the boiling frog story, it’s used to point out that gradual changes go unnoticed until they become too monumental & cause a significant effect. And many businesses who fail to take note and adapt with the times often die the frog’s death.

In Blackberry’s case it was the king of the smartphone industry— the sophisticated look, inbuilt emails and qwerty keyboard made it an indispensable status symbol for business people and professionals. Then came the iPhone with the touch-screen. And Blackberry lost the throne.

You see, Blackberry underestimated how quickly the market was shifting. They didn’t think Apple posed any threat — they were confident in their quality & customer loyalty. By the time Blackberry released their own touch screen mobile, people were already hooked onto Apple and the new features they offered.

But why did no one pay attention until it was too late?

Because everyone was busy looking at weekly, monthly and quarterly changes. They failed to notice the loss of their competitive advantage over the long term. While others were innovating often, Blackberry stuck to what they thought worked best.

In the late billionaire investor Charlie Munger’s words — businesses “often miss a trend that is destiny“ being misled by “tiny changes involving low contrast”.

Do you know of any other brands that have become victims of the Boiling Frog Syndrome?

And that's all for today folks! If you learned something new, make sure to subscribe to Finshots for more such insights :)

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