Read this before you invest in high ROCE stocks

Does the market reward stocks with consistently high return ratios?

Investors of Astral Pipes would say it does. Between FY19-23, the pipe and fitting manufacturer maintained an impressive five-year average return on capital employed (ROCE) of 26 per cent. The market rewarded it with annual share price growth of 34 per cent in the same period.

But ask shareholders of Castrol the same, and the mood would be rather gloomy. Castrol maintained an ROCE of 76 per cent between FY19-23. However, the stock gave a measly 6 per cent annual return in that period.

From the above, it is evident that the market's affections are not solely decided by the magnitude of the ratio. There is something deeper at play.

The tale of two ROCEs

To understand why the market reacted differently to these stocks, we first must recap how return ratios are calculated. ROCE, the ratio in question, is the ratio between a company's earnings before interest and taxes in a given period (the numerator) and capital employed (the denominator), i.e., shareholders' equity plus total debt. Most return ratios share similar relations with the company's earnings and equity.

Thus, there are two ways to attain high return ratios (ROCE, ROE, etc.). You either improve your earnings, the numerator, or decrease your equity, the denominator.

The only way to increase the numerator is to find new growth avenues, invest in them and grow your earnings. And that is what Astral did. It spent around Rs 1,000 crore on capex between FY19-23, aiming to cater to all home building requirements, from pipe and fittings to paints, faucets, sanitaryware, etc.

On the flip side, decreasing the denominator, i.e., shareholders' equity, can also inflate ROCE. This happens when companies dole out huge dividends or conduct buybacks. In our example, Castrol took the dividend road. Between FY19-23, it had an average dividend payout ratio (DPR) of 79 per cent.

So, it is clear that the market rewards efficient reinvestments more than dividends. To answer our original question, the market does reward stocks with consistently high return ratios. However, it more often than not shines its grace on those businesses that achieved it through reinvestments.

A treat of investors

Keeping the above in mind, we filtered 10 companies by market capitalisation from the BSE 500 universe sharing the following traits:

• Five-year average ROCE of at least 15 per cent
  
• Five-year average dividend payout ratio of less than 30 per cent

Also read: A high ROE may not mean what you think