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At Value Research Stock Advisor, much of our effort is devoted to separating the wheat from the chaff. While the investible universe in India is large, only a few companies make for ideal investments. For instance, over the past decade, the shareholders of Hindustan Unilever (HUL) have earned 21 per cent annualised gains. In contrast, the shareholders of GMR Infrastructure have had a raw deal, with the stock witnessing an 8 per cent annualised decline during the same period. With a world-class airport in New Delhi to its credit, GMR (besides also embossing its brand with Delhi Daredevils IPL team) should ideally have done well, given that India is a booming aviation market.
We answer such a puzzling piece by looking at companies' capital efficiency, i.e., the return that these companies have generated on their capital employed (ROCE) during the last decade.
ROCE is defined as earnings before interest and tax (EBIT) divided by the capital employed.
Capital employed is the sum of shareholders' equity and long-term liabilities. The average ROCE registered by HUL during the past decade is 126 per cent compared to a measly 5 per cent generated by GMR.
On a point-to-point basis between FY09 and FY18, GMR Infrastructure invested an additional capital of Rs8,031 crore in its businesses. On this, it generated an incremental operating income of Rs1,078 crore. Hence, the return on incremental capital employed (incremental ROCE) was 13 per cent. Now compare this with HUL's performance, which invested an additional capital of Rs6,769 crore. On this, it generated an additional operating income of Rs4,823 crore. Its incremental ROCE was an astounding 71 per cent.
This phenomenon is emphasised by Warren Buffett in his address to Berkshire Hathaway shareholders in 1992: "Leaving the question of price aside, the best business to own is one that over an extended period of time can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that does the opposite - that is consistently employ ever-greater amounts of capital at very low rates of return."
What is being emphasised here is that growth for the sake of growing is not enough. If growth is being achieved by investing large amounts of capital with a complete disregard for expected rate of return from the businesses, it would lead to wealth destruction. Growth will increase value only if the returns earned on the new investments exceed expected return.
Given the benchmark fixed-deposit rates in India at 8-9 per cent with an additional 5-6 per cent loaded for risk, a 15 per cent threshold for ROCE is reasonable for India. This is also backed up by a study mentioned in the book The Coffee Can Investing by Saurabh Mukherjea. In the book, Mukherjea zeroes in on the best Indian stocks to invest in by applying it as one of the filters. He selects companies that consistently earned ROCE of at least 15 per cent for 10 years. So, how do you spot such companies? They may be found by answering two questions.
What is the nature of business?
Exceptions aside, the nature of certain businesses is such that they would never generate wealth for their stakeholders. This fact was well explained by Warren Buffett in his 2007 letter to Berkshire Hathaway shareholders in which he categorised businesses into three categories - the Great, the Good and the Gruesome on the basis of their ROCE.
The Great (high ROCE with very little capital requirements): These companies are simply a dream to own at the right valuation. They grow their earnings without much capital investment and these returns can in turn be invested in the same or other businesses to generate further earnings. These companies have pricing power, an asset-light model, very low or negative working capital requirements and little or no leverage. Hindustan Unilever, Nestle, Colgate, Page Industries, TCS, Indian Energy Exchange all fall into this category.
The Good (Businesses that need capital to grow and generate required returns on that capital): These businesses grow their earnings at a healthy rate but need capital to sustain growth. They too have durable competitive advantages and have a long runway of growth, which would lead to compounding of returns on additional capital invested over a long term. Buffett quotes these companies as "put up more to earn more." Examples of such businesses are Motherson Sumi, UPL and Maruti Suzuki.
The Gruesome (Businesses that require capital but generate low returns): These companies register very high growth in earnings but at an ever-so-expanding capital base and end up destroying shareholders' wealth over the longer term. Examples of such companies are GMR Infra, GVK power, BHEL, Jet Airways, etc.
How are the capital-allocation skills of the management?
It all boils down to who the jockey running the horse is. Everything ultimately hinges on how well the top management decides when it comes to deploying capital. A company may generate a lot of free cash flows, but if the top management proceeds to invest it in unyielding projects that have little or no value creation, then markets tend to punish such stocks.
For instance, Ajay Piramal of the Piramal Enterprises arguably ranks among one of the best capital allocators in India. He has truly epitomised the quote of the business author William Thorndike, "The best capital allocators are practical, opportunistic and flexible. They are not bound by ideology or strategy." The shareholders of Piramal Enterprises are delighted having witnessed an annualised return of 25.4 per cent per annum over the past decade.
In nutshell, if one stumbles upon a great or good business which is run by an efficient capital allocator, investment gains would not be too far fetched.
Sachin Kumar is Senior Equity Analyst at Value Research Stock Advisor
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