Return on capital employed is an excellent indicator to select companies that will provide appreciation to investors. The Smart Investor checks out the better performers
The financial years 1995-96 and 1997-98 have been recessive years. Many a company has seen its returns reduce and have not added to their assets in the last two years. At the same times recessive years are a test for companies which are managed well - they emerge stronger.
On the cost side, they tighten their belts, improve their processes to better efficiency and also rethink all expenditure anew. On the other hand they also think about their core business and invest in them so that they can consolidate market share at the cost of their competitors. These are companies which could be portfolio stocks.
The sensex which reflects this recessive mood is still low at 3140 points and is lower than the corresponding figure of 3249 points in September 1996. So this could also be good timing to choose the portfolio stocks and also watch the half year/second quarter performances of these companies.
What we are looking for are companies that have maximised return on investment in the last two years. The idea here is to choose companies which use as little capital as possible but show as high a return as possible on the little that it uses. We could measure this using return on capital employed (ROCE). This is profit before depreciation, interest and tax (PBDIT) divided by net worth plus debt (total assets net of depreciation).
If the company employs additional capital in a year, it should show at least the same return as the previous year if not higher. If it is in a capital intensive industry, the return may drop but it should be much higher than that of most other companies. This measure eliminates distortions because of depreciation and financing pattern and is hence a steady measure of operating performance over time.
Now the crucial question is, is the Indian stock market sophisticated enough to value based on this criterion? The answer is a resounding yes. The Smart Investor in an earlier study (see The Valuation Enigma April 28, 1997 and May 5 1997) had clearly demonstrated that in the Indian market, companies which have high ROCE are valued higher as against companies which are not.
Return on capital employed is got by multiplying the two ratios PBDIT/sales and Sales/total assets (net of depreciation). To increase ROCE then, there are two major options. Increase the margins either by increasing value addition to a product and charging a premium and keeping costs low. The second is to increase the turnover to assets ratio.
One is to make sure that your value addition to the product is so high that you can command a high margin. This could be done in several ways - create a specialised niche product/service, build a very strong brand, constantly innovate and remain on a curve where your products reach the market first and you can skim off very high margins, improve services around the product and so on. It could also be as farsighted as making sure that your systems are so perfect that your channel partners make phenomenal returns on their investment and so push your product. There would of course have to be a trade-off between volume and margins.
This is the way by which India software companies like Infosys, DSQ Software and Satyam are able to retain high returns. They have created a service for their overseas clients which can be delivered remotely through telecommunication links.
Thus they have reduced their clients' costs while they themselves have a very high margin on turnover because of the exchange rate and lower wage costs. In addition they are also continuously moving up the value chain to retain margins as the number of players increase. Any depreciation in the rupee also helps the margins.
On the other hand, one can also increase margins by keeping control on the costs by benchmarking with your own industry as well as perhaps across the industry. Keep working capital low and if possible get your customers to pay for your working capital. Measure the productivity in every process in the organisation and work at increasing it. Munjal Showa for instance is an example where the turnover is increasing but the employee count has remained constant over the past few years. Indigenising components has also reduced raw material costs.
TVS Suzuki has also re-engineered processes to bring down costs. The company has very little inventory and very low debtors. Working capital is also financed by dealers. The computer training companies like NIIT also collect fees from students a few weeks in advance and fund their working capital through this.
The way to increase turnover to asset ratio is to own as little assets as possible. The current paradigm is that the lesser the fixed assets that a company owns, the better it is. In fact, experts now advocate that in balance sheets in increasingly knowledge intensive world, traditional capital expense will be charged off as revenue expenditure in the current year. And also reduce fixed assets in the balance sheet as much as possible. Owning as little assets as possible also means that fixed costs are low and the company can operate at very low margins and reach very high volumes.
A traditional finance person would have several arguments against this. If there is not large enough assets in the balance sheet, how would one leverage the equity for debt? How would one finance growth in large steps? There are two answers to this. One is that if return on capital employed is high, the internal accruals generated every year would be enough for incremental growth. Another solution to this could be to get someone else to invest in the required infrastructure as much as possible, and hence do not increase assets in the balance sheet.
Hindustan Lever for example could double its toothpaste capacity and yet not incur significant costs because it is manufactured outside. Increasingly, TVS Suzuki and Hero Honda have also been following the same strategy. More and more assemblies are being outsourced every year.
The automobile companies investment then would be developing these vendors and having a perfect IT infrastructure which can co-ordinate low inventory levels with all the suppliers and logistics and working capital in the channel.
The ideal solution will be if the entire vehicle can be made outside and assembled, transported by a logistics company and working capital completely financed by distributors and suppliers. The IT infrastructure to integrate all suppliers and distributors would also be run and owned by someone else. The company will only own the brand, decide new products and the product mix itself for production. Essentially all services which are not unique to the company would be run from outside.
This outsourcing strategy has paid for Hero Honda. In the last two years, the company has increased its total assets by 78 per cent while its PBDIT has increased 155 per cent. The computer training industry have also mastered the art of getting some else to invest in the infrastructure through franchising.
Aptech in fact would have a higher ROCE than NIIT because it has more franchised centres whereas NIIT has more owned centres. Another company whose stock price has recently gone up also uses this model to expand. Archies Greetings and Gifts which also expands its sales and marketing infrastructure through franchises.
The company itself will just concentrate on creating the brand, on research for new products/services or processes, developing tools for vendors to work on assemblies for new products, training for channel partners and also running a finance company to lease and finance its consumers.
So The Smart Investor decided to identify a list of stocks which have increased their ROCE in the last two years. It began by pruning the list to eliminate all companies which had an ROCE of less than 20 per cent. The idea here is that we only want companies which have high returns in spite of the fact that they may have invested in new capacities recently.
We then took companies whose current full year ROCE was more than that two years ago unless those companies had increased their assets by more than 30 per cent in the last two years. We then took companies where the current ROCE is more than last year. That takes care of one bad year.
We then eliminated small companies which often cannot sustain growth by eliminating all companies which had a PBDIT of less than Rs 5 crore. We also want companies which can grow at a rate higher than inflation so we also took only companies whose PBDIT had grown more than 25 per cent in two years in most cases.
Finally we want stocks that are valued by the market. So we eliminate all low priced stocks. What we found was that in the list of stocks there are several stocks that are in an uptrend and in many cases with high volumes. We have tabled out more than 50 stocks. In some of these cases it could also be an indication of forthcoming good results slowly being discounted by the market. If the results are going to be good, join the ride.
