Measuring worth: Front-row seats to high return-on-equity stocks

A portfolio of richly valued RoE stocks is expected to outperform the broader market over the longer term.

The return-on-equity (RoE) is one of the best ways to screen high-performance companies in the stock market. Companies delivering high double-digit returns on their equity/networth (or shareholder funds) tend to grow faster than peers with a low RoE.

Higher RoE also empowers companies to invest in their growth and expansion without resorting to debt financing. This makes them less impervious to business cycles and volatility in the financial/bond markets.

Companies that deliver consistently high RoE also tend to be cash-rich and pay generous dividends to shareholders or do large share buybacks. Moreover, they also tend to command higher stock valuations, compared to peers.

This means that a portfolio of high RoE stocks is expected to outperform the broader market over the longer term.

High RoE companies especially do well in an economic downturn when companies with poor financial ratios struggle — or worse, face bankruptcy.

Here are 10 stocks that have reported superior revenue and profit growth in three years, including the current financial year (2022-23).

Most of these companies have a strong balance sheet with little or no debt on their books.

The 10 stocks in our list had RoE of 22 per cent or higher on average in three years. This is more than 50 per cent higher than the BSE 200 companies’ three-year average RoE of 13.5 per cent.

Most of these stocks are also industry leaders such as Hindustan Unilever, Infosys, Page Industries, Divi’s Laboratories, Abbott India, SRF, Larsen & Toubro Infotech, Mindtree, Coromandel International, and Tata Elxsi, among others.

Among the few downside risks is that quite a few of these stocks are highly priced on a price-to-earnings and price-to-book value basis.

But their high valuation should not be a surprise, given most large institutional investors want a slice of their growth story.

As they say, quality never comes cheap

PAGE INDUSTRIES

* Innerwear maker Page Industries (Page) has one of the highest return-on-equity (RoE) — not just in its industry, but across the manufacturing sector

* The company’s RoE has averaged 45.8 per cent in three years, while its latest RoE is even higher at 67.3 per cent

* Page is growing at a healthy pace, with a three-year compound annual growth rate in net sales and net profit at 10.9 per cent and 16.1 per cent, respectively

* Growth in recent times is even faster, with net sales up 55 per cent year-on-year (YoY) in the trailing 12-month (TTM) period ended June, and net profit by 87.3 per cent YoY

* The downside is the stock’s extremely rich valuation; TTM price-to-earnings of 76x

HINDUSTAN UNILEVER

* India’s top fast-moving consumer goods company, Hindustan Unilever (HUL), has one of the best financial ratios among benchmark index stocks, with a three-year average return-on-equity (RoE) of 43.7 per cent

* HUL’s RoE declined to 19.4 per cent in the first six months of 2022-23 (FY23), thanks to cost and demand pressure, but it is still 50 per cent higher than the Sensex’s average RoE

* The company has grown steadily in recent years, aided by market-share gains and margin improvement. In the past three years, net sales and net profit clocked a compound annual growth rate of 10.1 per cent and 9.6 per cent, respectively

* HUL has also outperformed in FY23 (trailing 12-month period), with 14.1 per cent and 14.8 per cent growth in net sales and net profit, respectively

* Analysts expect the growth momentum to continue, but the upside may be limited, given the trailing price-to-earnings (P/E) of 61.4x — nearly 3x the Sensex’s average P/E

INFOSYS

* Infosys, India’s second-largest information technology (IT) services company, has one of the best return-on-equity (RoE) in the industry, at 29.6 per cent on average in three years

* It is also expected to top the charts in 2022-23, given its trailing 12-month (TTM) RoE of 28.7 per cent

* Over a longer period, Infosys has grown steadily with a compound annual growth rate of 13.7 and 10 per cent in net sales and net profit, respectively, in three years

* Like other IT firms, Infosys’ margins have come under pressure recently, with net profit growing 9.5 per cent year-on-year (YoY) in TTM period ended September, against 23.2 per cent YoY growth in net sales

* This has weighed on the stock, which is down 20.2 per cent year-to-date

* The stock remains expensive, compared to its historical valuation, with TTM price-to-earnings of 27.7x

COROMANDEL INTERNATIONAL

* Murugappa Group-owned fertiliser maker Coromandel International has one of the best financial ratios in the industry, with a three-year average return-on-equity (RoE) of 27.5 per cent and a nearly debt-free balance sheet

*  The company has maintained its financial performance in 2022-23 (FY23), reporting RoE of 25.7 per cent in the latest trailing 12-month (TTM) period

* In the longer period, net sales and profit have clocked a healthy compound annual growth rate of 13.1 and 12.8 per cent, respectively, in three years

* Earnings growth has been even better in FY23 so far, with net sales and profit growing 55.5 per cent and 41.9 per cent, respectively, on a TTM basis

* Analysts expect the company to maintain its earnings momentum in the second half of FY23, driven by higher margins

* On the downside, its balance sheet could come under pressure from a 145 per cent year-on-year rise in unpaid subsidy at Rs 4,176 crore in the first half of FY23

ABBOTT INDIA

* A higher share of core brands has pharmaceutical (pharma) multinational Abbott India (Abbott) improve its gross margins by 300 basis points over five years to 45 per cent

* The top 10 brands account for 70 per cent of sales. Constant portfolio review ensures brands that don’t meet the threshold level of sales and profitability are divested on an ongoing basis to drive profitable growth and improve efficiency

* Rising field force productivity, better product mix, higher prices, and improving operating leverage have helped Abbott grow ahead in the domestic pharma market, boost asset utilisation, and expand operating margins

* The company is looking at an annual growth of 13 per cent until 2025-26 to reach the $1-billion revenue target, with profits rising faster than sales

* This is to be achieved through 15 annual product launches, enhance presence across smaller towns, participate in public health programmes, and expand online presence

SRF

* While SRF is a diversified chemical conglomerate with interests in fluorochemicals, technical textiles, and packaging films, the chemical business has been the main driver of revenue (17 per cent growth) and profit (43 per cent) over five years

* Strong demand from agrochemicals and pharmaceuticals — in both the domestic and overseas markets — in addition to enhanced volumes of certain key products, led to substantial growth within the specialty chemical segment

* Demand/growth was adequately supported by capacity additions, improving utilisation, and cost improvements within SRF, according to YES Securities

* Robust demand for fluorine molecules and new high growth applications, creating $8-billion global demand over 2021-22 through 2026-27, opportunity in contract research and manufacturing are expected to drive growth, observes Elara Capital

DIVI’S LABORATORIES

* Smart product selection, with focus on select high-volume active pharmaceutical (pharma) ingredients, which involve complex chemistry and impressive execution, has helped Divi’s Laboratories clock revenue growth of 22 per cent over three years

* Favourable product mix, lower raw material consumption due to backward integration, and improved cost-efficiency through process optimisation are aiding margins

* Double-digit growth in established generics, where its market share is in excess of 60-70 per cent, and focus on improving share in products, where it is raising capacity for molecules in the custom synthesis business, are positives

* Molecules worth $20 billion are going off-patent over 2022-23 through 2024-25 which, coupled with contrast media manufacturing, are major growth drivers. The company is eyeing substantial contracts from global pharma players for the latter

MINDTREE

* Growth levers for Larsen & Toubro (L&T)-owned Mindtree include its 4x4x4 strategy (industry groups, service lines, geographies), helping it to cross-sell to clients, increase wallet share, and lead to a record pipeline with multiple long-term annuity deals

* Its top account (Microsoft) has exhibited strong growth (31 per cent over three years) and strengthened its partnership with a key hyperscaler in the Cloud ecosystem

* Mindtree’s margins have grown from single digits (9.7 per cent) in 2016-17 to high teens at 18.6 per cent. Notwithstanding industrywide supply headwinds, it has been able to maintain over 20 per cent margins through cost optimisation and other levers

* A strong outlook on strategic accounts, decent deal signings, and the ability to sustain improved margins are key positives for the company, say analysts at Motilal Oswal Research. Cost and revenue synergies with L&T Infotech remain a major trigger

The stock is down 26.7 per cent year-to-date, primarily due to its high valuation; trailing price-to-earnings of 30.6x

TATA ELXSI

*  Among pure-play Indian engineering, research and development (ER&D) companies, Tata Elxsi has been reporting industry-leading revenue growth (24 per cent annually) over two years

* In addition to recovery in the transportation segment, a shift towards digitisation has helped it log growth acceleration in media, broadcast, and communication, as well health care verticals

* This reflects in the company’s differentiated technology capabilities, domain expertise, and strong delivery capability, enabling it to address emerging opportunities across focused verticals and drive the transformation programme of customers, says Sharekhan Research

* While the Street is sceptical about margin reversal, given the July-September quarter profitability miss, deal wins, strong pipeline, and the prospects for the ER&D business remain strong, offering revenue visibility

L&T INFOTECH

* Larsen & Toubro Infotech (LTI) has been one of the top-performing second-tier information technology firm, having delivered an average return-on-equity of 29.5 per cent in three years

* The company has also outperformed its peers in terms of revenue and earnings growth in recent years

Its net sales and net profit grew at a compound annual growth rate of 18.4 per cent and 14.7 per cent, respectively, in three years, outstripping many of its bigger peers

* The L&T-owned firm has maintained momentum, with net sales and profit growing 30.4 per cent and 21.3 per cent, respectively, in the trailing 12-month period — among the best in the industry

* The stock price has, however, struggled in recent months and is down 33.6 per cent since the beginning of 2022, primarily due to its high valuation

* Analysts expect LTI to continue to grow faster. But the upside may be limited, given the rich valuation, with trailing price-to-earnings multiple of 33.3x — among the highest in the industry