I was recently asked by a very smart global investor as to why high-quality franchise Indian stocks trade so expensive? He made the point that quality Indian companies were among the most expensive in the world across sectors. Indian financials or stocks such as Page or Jubilant Foodworks etc. were the most expensive stocks in the world for their respective sectors.
Put on the spot, my immediate response was that given the difficulties in executing and scaling in the country, anyone who has demonstrated a scalable and profitable business model was disproportionately rewarded. The other point was that given the huge growth runway in India, we had many years of these companies being able to redeploy profits at attractive incremental returns on capital still ahead of us. This compounding is hugely valuable, and not available to most companies in other markets, where reinvestment opportunities are very limited.
On further reflection, the huge valuation premium of Indian franchise stocks can also be traced, to my mind, to profit persistence - the ability of companies to sustain their high returns on capital, and profitability for an extended period of time. If a company can fight regression to the mean and maintain high returns on capital and has a huge growth runway in which to reinvest, this is a recipe for very high valuations.
Searching for research on profit persistence, I came across a whole bunch, the most interesting being from Credit Suisse. They have done a global study on profit persistence and come up with some interesting conclusions. They found that while growth rates regress to the mean, returns on capital are far more sticky and persistent than growth rates. In a note published in 2013, they surveyed all global stocks with a market capitalisation greater than $250 million and grouped them into four quartiles based on returns on capital. They then assessed what percentage of these companies changed their quartile rankings over a five-year period. They found that companies in the best quartile for ROIC (return on invested capital) had a 51-per cent chance of remaining in this quartile even after five years and an 80-per cent probability of continuing to have an above-average ROIC profile and placed in the top two quartiles. Similarly, companies in the worst ROIC quartile had a 56-per cent chance of remaining in this quartile and over an 80-per cent probability of having a below-average returns profile even after five years. This is clearly not a random outcome based on chance. Effectively, returns are sticky, and it is very difficult for companies to transition and either improve or destroy returns over even five-year horizons. This makes you question the whole notion of the star CEO. Does he or she really make that much difference, especially if average tenures are below five years?
The report then breaks down the results for every sector, and the persistence of returns is even higher for franchise sectors such as consumer staples, pharmaceuticals, retailing and media. In these sectors, the probability of companies maintaining their above-average returns can be as high as 95 per cent.
I think the persistence of profits is even higher in India than the global averages. Just anecdotally, it is very rare for the leading Indian companies to give up market share dominance or see declining returns. The competitive moats that the top Indian companies have built - be it in distribution, market share, brand etc. - are just very difficult to dislodge. Consumers seem to take time to build trust in brands/products and don't switch easily. The costs and timelines involved in scaling new brands or launching new business in India has historically been very long.
You could argue that a combination of very high profit persistence, combined with a huge reinvestment runway, can justify the premium valuations of the leading Indian companies. In fact, these stocks have continued to outperform despite their valuations, so markets are telling us something. You can see why the notion of buying a good company at any price has caught fancy among most investors in India. Because of the high profit persistence in India, markets are instinctively assigning a very long competitive advantage period for Indian franchises where - in these companies will continue to make super-normal returns on capital.
That was all in the past, but going forward, are things changing? I would argue yes, that profit persistence will decline in the coming years as technology and new business models attack the entrenched incumbents.
Whether it be the consumer staples whose shelf space dominance is now being attacked by new entrants selling through online merchants, or retailers whose real estate dominance is now being rendered irrelevant or media companies and TV networks being challenged by streaming video on demand, the world is changing. Even the banks are being challenged by FinTech, as new upstarts are finding ways to disintermediate the competitive advantages of the existing financiers. I am not even going to the new sharing economy business models, which are a different threat altogether.
If because of all these new technology enabled business models, profit persistence were to reduce, that will have serious ramifications for the high valuations enjoyed by franchise companies globally, including in India.
One can argue what is new? Technology has always been a threat to the incumbents. However today, e-commerce, SVOD and the sharing economy are all real and have hit an inflection point. The pace of change and digital disruption across industries has accelerated. The pace of change seems even faster in India given our penchant to leapfrog entire technology cycles.
Something worth thinking about next time you are tempted to buy a great franchise stock at 40 times, like most stocks are trading in India. To justify the multiple and get a reasonable return on your investment, you are implicitly making assumptions on profit persistence and reinvestment that may no longer hold true. The world is changing and the competitive advantage period of most companies is declining. Buying a great company at any price may not deliver the returns it has over the last decade.
The writer is at Amansa Capital. These views are his own
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
