I strongly believe that the single most important number, at least for me, when considering investment in stocks, is return on equity or RoE (this is the number that Moneylife relies on the most, though we look at other parameters too.—Editor). It is essentially profit after tax (PAT) expressed as a percentage of the total net worth (or shareholders’ funds, as the Americans refer to it). In simple words, it tells me how efficiently the company uses shareholders’ money and how much it earns with that money. All other things—market share, brand value, corporate governance, competencies, etc—are secondary. If a company is good, its numbers should ultimately get reflected in superior earnings.
No one wants to invest in a company that makes the right noises, but does not earn enough ‘bang on the buck’, as they say. One of the first things I look for is that RoE, in the Indian context, should not be less than 8%. That is the minimum justification for any company to exist. I tend to look for RoE of minimum 20%pa (per annum), consistently over the past 10-15 years at least. Maybe in a 15-year span, it could have had one or, at worst, two bad years. I tend to ignore it anything more than that (except as a quality trading opportunity, should the price be really low).
RoE is the starting point for any long-term investment that I make. Once I make the shortlist, then everything else follows. Of course, stocks of companies with no history, or those which are capable of improving their RoE on a sustainable basis, fall into a ‘speculative’ list of probable investments. Here I am not on sure ground, since it is my expectation of their being able to improve the RoE.
Once the RoE list is made, I also try and focus on companies that pay full income taxes, i.e., at the maximum rate prescribed by law (This too is an important criterion for us, as the table in Value Picks on page 40 would show.—Editor). This is my ‘wish list’ for blue-chip companies. For companies that pay lower taxes, the profits need to be adjusted by me for normalised tax payments and then figure out what their position would be.
Here are a few takeaways from this analysis:
• Most MNCs find a place in the list, irrespective of the sector they are in;
• Those that figure on the list are among the top three or four companies in their sectors.
• Indian private sector companies from consumer goods, pharmaceuticals, two-wheelers make it to the list as well; and
• Most government-owned companies are far away from this list;
In an industry, where an MNC makes a fantastic RoE, Indian companies seem to be lagging far behind. Whether this is due to lack of competency or integrity, one is not very sure. My presumption is that there cannot be a third reason. I could be wrong, but I choose to be conservative which will leave less room for disappointment. Why I say this is because MNCs are supposed to have higher costs, but if they are still able to show higher profitability, it says something about Indian companies. Surely, they (Indian companies) are either incompetent or dishonest. Or is it simply because MNCs have better brand power (based on reality or perception) that they are able to generate superior profits?
If you look at the past so many years, companies like Colgate or HUL have delivered RoE of anything between 50%-100%pa! For a government security of Rs1,000 that pays a fixed interest of under 8% each year (pre-tax), we are willing to pay Rs1,000 or one time its ‘book value’. So if HUL delivers an RoE of 50% year on year, I am willing to pay 6-7 times its book value! And if I believe that the RoE will continue without falling for the next few years, I do not mind paying an even higher price in terms of number of times the book value. The premium I am willing to pay depends on the extent of certainty I have about the sustainability of RoE.
It is important that the RoE is sustained by the company by not approaching the markets with repeated offering of shares (that will generally depress RoE) and not keeping too much cash in the bank. For instance, if Infosys were to distribute its cash pile, its RoE would improve significantly and the stock would be worth a tad more. So long as there is cash in the bank, it will just give money-market returns.
There are also companies like ITC which depress RoE by allocating capital to businesses that either lose money or earn poor returns. The reasons are not relevant here. All a shareholder wants is the best possible return on invested money and a company like ITC is not doing that.
For me, RoE as a benchmark provides a ready reference for its price and enables me to take a quick call. I may miss out trading opportunities on poor quality stocks. Ultimately, it is obvious that companies with the best attributes should also deliver the best returns and that too over a long term, i.e., deliver value in the stock markets.
What we are seeing in the markets over the past two years or so is a clear flight of investors to the ‘high’-quality stocks (those with high RoE); these stocks have become expensive. When the bull market rages, these stocks will be forgotten as the markets chase the out-of-favour stocks (characterised by fluctuating RoE that trend towards the mediocre, over the long term). For instance, we will have companies in metals or infrastructure that fall out of favour but, at some bullish moment in the market, reach ridiculous levels. We had real-estate stocks trading at ridiculous values in 2007-08. After that, they have perhaps lost 60%-90% by price. Don’t be surprised if these sectors are the ones that will push the markets higher.
What I would love to see is a bout of madness that makes people sell off high-quality stocks and chase low-quality stocks. If that leads to a price correction in high-quality ones, I will be glad to buy them. I have seen this happening at least once in a cycle of 7-10 years. Thus, if one has a ‘life’ of 30 years of dalliance with the stock markets, there would be three to five big buying opportunities. The key is whether one has the money, the discipline and the courage to capitalise on it.
I have often seen manias where people have chased poor-quality (low RoE, in my parlance) stocks using some flavour of the day attribute like ‘eyeballs’, ‘Price to Sales’ (since there is no visibility of profits), ‘market share’, ‘brand value’ and so on. How often have we seen stock prices moving up when a company announces additional issuance of shares, when it should actually fall? These fads and fancies are temporary and, ultimately, the markets shun them. In the final analysis, when we invest in stocks, we do so to make money; and not for the privilege of owning some shares in a business for the sake of pride and prestige. Invest in companies where the management ensures the highest return on the invested money. It is as simple as that.