Wealth creators

GUEST COLUMN

on companies that create wealth for shareholders.

Investing could become much easier if it were possible to identify companies that have the qualities of creating wealth for their shareholders.

Over the past decade, we at Motilal Oswal Securities have come out with studies on India's wealth-creating companies, and what makes them stand out. Let us take a closer look.

Need for a high ROE and ROCE
As investors, we have a tendency to lay excessive emphasis on earnings per share and the price-earnings multiple.

But when you use ratios like return on capital employed (this is calculated as the percentage of profit before interest and tax divided by capital employed, which is total assets minus current liabilities) or return on equity, you can measure the productivity of capital.

There are some businesses like textiles and paper, which struggle to generate ROCEs higher than 8 per cent. So if a company has a ROCE of 10 per cent and earns Rs 10 of EPS, then it will need an additional investment of Rs 100 in the business to generate an incremental Rs 10 of earnings.

So, I as a shareholder will get higher dividends only if the business makes money. In many businesses, it will be difficult even to maintain the growth rate at GDP growth rate level, and such businesses are worthless to me. The risk-free return is 7.5-8 per cent, so I am better off putting my money in the banks.

The best situation for wealth creation occurs when you identify a company which has a low ROCE, say about 10 per cent, which has the potential to improve its ROCE to 40 per cent. When that happens, the EPS grows substantially, and the P/E is re-rated, so the returns are huge.

For example, IPCA Laboratories' return on equity shot up from 19 per cent in 2003 to 34 per cent in 2004""the stock shot up by five times in two years.

Similarly, Balkrishna Industries had a ROCE of 11 per cent in in 2002, which zoomed to 35 per cent in three years. The stock multiplied 20 times in this period.

Mid-caps create more wealth
In every study over the past decade, we have found that among our wealth-creating companies with a market cap of less than Rs 250 crore as an aggregate have grown three times faster than companies with a market cap of over Rs 1000 crore over the next five years.

Besides the fact that smaller companies grow faster than larger companies, there are also other reasons. When companies are small, the market has not recognised their rapid growth rates.

Thus, it is possible to identify companies that are likely to grow at 50 per cent but are trading at a P/E of 5 times. Once the market discovers it, the growth rate would have tapered to 20 per cent, but it would be trading at a P/E of 20 times. Mid-caps offer you growth plus P/E re-rating.

Yes, mid-caps are riskier than large-caps, but that is where your experience, research and knowledge will help. But the beauty is that even a small investor has serious wealth creation opportunities by finding stocks that go on to become multi-baggers.

There is a Chinese saying that goes, "Big fish is not found in clear waters." So, for a good catch of stocks, you have to go to the muddy waters of uncertainty.

Passion for leadership
Wealth creating companies have a passion for leadership in their respective businesses. Though this is not an easy parameter to measure, using market share is useful.

Look at the example of Hero Honda, which was a marginal player about 15 years ago, but it came from behind, and grabbed a market share of 50 per cent. ICICI Bank is another recent example""it has become the largest bank in terms of market cap.

A good time to buy stocks is when the company is not a leader, but a marginal player, and then it displays aggression to become number one or two, and does it. I think that in the cellular services space, we could see one of the smaller players coming from behind, and changing the rules of the game in the future.

Besides de-regulation in India, our companies have the global market as their playing field. Many companies are trying to find their own feet in the global markets, and some of them will become mega corporations over the next decade or so.

Focus
We have found that 95-97 per cent of the wealth creating companies have a single line of business, where they excel.

As a corollary, these companies expand in their existing business rather than diversifying into other areas. Look at how Holcim is growing within the same franchise in Gujarat Ambuja and in fact, in ACC, it has divested from unrelated businesses.

The benefit of focus is that the incremental cost of production is lower, there is no need to introduce new brands, sales and marketing costs are lower, all of which result in better profitability. Plus, companies gain dominance in their markets. Even managing people is easier.

For the investor, it is easy to invest in a company that has a single line of business. If I have conviction in cement, I am better off investing in a pure cement play rather than a diversified company. Also, markets typically value diversified companies lower than focused companies.

Improving business economics
I will explain this with two personal examples. I bought Birla Corp and Bharti Airtel around three years ago at Rs 30 and Rs 25 respectively, when both were loss-making companies, and today Birla Corp is at Rs 330 and Bharti is at Rs 600.

In case of Birla Corp, the economics of the cement business has undergone a complete change. This year, the company will post an EPS of Rs 35, which is higher than my purchase price.

Bharti had a small operating margin, high interest and depreciation costs, and was loss-making when I bought it, but after seeing the possible growth and how similar companies had fared in other countries, I was convinced. So, in wealth creating companies, the economics of businesses improves over time.

Five-year payback outlook
Typically, we have seen that a high growth business, which is run by an outstanding management and purchased with a five-year pay-back outlook of less than one times has a good chance of being a big winner. What this means is that will the company pay back what you put in over the next five years.

This is a valuation metric, though a little tricky. First, people do not look at what will happen over the next five years. So, you have to take a call whether the company will pay back your current purchase price.

For example, if a company is trading at a market cap of Rs 1 lakh crore, then the question to ask is will the company pay back that amount over the next five years.

If it pays this back, then the expanded residual business becomes free to me. But this is not easy. The Rs 1 lakh crore company is not going to be earning Rs 20,000 crore a year. It will be at Rs 5,000-7,000 crore, and it is likely to have a P/E of 20 or 25. What can be done is that you have to assume a conservative growth rate that you are convinced about and calculate what it will earn in the next five years.

Here you can use the PEG ratio (which is the P/E multiple divided by the future growth rate). As long as the PEG multiple is below 0.5 (say a P/E of 20 and growth of 40 per cent), you will be fine.

On the other hand, if a company has a P/E ratio of 40 and will grow at 40 per cent, then it will take about eight years to pay back your money. You may make money in this case, but it will not be as good as in the previous case where you buy at a PEG of 0.5.

(The author is Managing Director at Motilal Oswal Securities)